Picture this: you discover a new and promising investment idea. The company sells software with a monthly recurring subscription model, is growing rapidly and is on the verge of achieving profitability. It issues numerous press releases touting its achievements and the merits of its technology. Your in-depth research indicates that this could potentially be a great investment opportunity. Besides, other investors in your network also own shares of the company. After developing a solid investment thesis, you decide to buy a few thousand shares.
A few weeks later, the company releases its quarterly financial results. Surprisingly, revenue growth was lower than expected, and the company failed to earn profits. The balance sheet deteriorated accordingly. But management proclaims loud and clear that this is just a temporary slowdown. Results from operations are moving in the right direction, says the CEO, if you make adjustments to remove stock-based compensation, restructuring costs, technology investments and expenses related to potential acquisitions.
You think it’s just a temporary setback, that your investment thesis has not changed. After all, your initial research demonstrated the company was strong and about to become profitable. One bad quarter shouldn’t make you question your initial assessment so much. Everything should be back on track next quarter, so there’s no need to update your financial forecasts, right? In addition, some investors you follow on Twitter think the same.
Months go by and the company hardly puts out any press releases. Subsequent financial results are disastrous. Suddenly, the value of your investment has been cut in half. But you did your homework before investing, your investment thesis is solid and you know the company well because you have been a shareholder for several months now.
However, doubt begins to settle. Is it time to sell? Of course not, you think; imagine if the company suddenly starts performing and the stock skyrockets. You decide to hold your shares after telling yourself that your initial judgment is probably still the right one.
But is it really? Could you be a victim of conservatism bias?
Conservatism Bias – What is it?
According to Wikipedia, conservatism bias ‘’is a bias in human information processing, which refers to the tendency to revise one’s belief insufficiently when presented with new evidence.’’
This bias is especially dangerous for microcaps investors. Since there are few analysts writing research about microcaps and little media coverage for companies, you are the only person in charge of analyzing new pieces of information. Unfortunately, when you are a victim of conservatism bias, you end up being too slow or simply reluctant to incorporate new information into your analysis.
You put too much weight on your initial forecasts while new information may actually change the outlook for the company you have invested in. An example would be financial results that are well below your expectations. This new information should challenge your existing beliefs and initial assumptions, and possibly lead to changes in your forecasts.
Failure to make changes may lead you to hold an investment long after the initial investment thesis has been proved wrong, even though you don’t want to realize it.
Different Types of Biases
There are two main types of biases that affect investors: cognitive and emotional. The conservatism bias falls into the cognitive category. A cognitive bias is usually a result of faulty reasoning, information processing errors, a lack of understanding of statistical analysis, or memory problems. In this case, it is due to negligence in the processing of new information.
On the other hand, an emotional bias is caused by feelings or intuition, meaning it is not related to conscious thought. Emotional biases are more difficult to control compared to cognitive biases.
Both types of biases are often intertwined, making it difficult to correct them. The conservatism bias is frequently accompanied by two main emotional biases:
- Preference for the status quo
Preference for the status quo makes you feel comfortable with the current situation. For example, imagine a position in a stock that you have held for a long time. Being accustomed to holding this position and knowing the history of the company reinforces your preference for the status quo and will make you reluctant to sell it.
Regret-aversion is a fear of regretting an action after doing it. A good example is when you are worried that a stock could skyrocket just after you sell it. Compared to the preference for the status quo, regret-aversion doesn’t mean you are comfortable with the current situation. What dissuades you from acting is the fear of regretting your move later.
Cognitive and emotional biases affect many investors in multiple ways. Here are examples of some negative consequences for your portfolio:
- While you may ignore new negative information, other investors will update their analyses and act on that information. Your negligence and inactivity may, in some cases, be costly and harm the performance of your portfolio.
- You could continue to hold a stock for far too long, while your initial investment thesis is no longer valid, and the stock no longer meets your criteria.
- Keeping an inferior stock in your portfolio prevents you from putting that money to work into better opportunities. There’s an opportunity cost to holding bad companies.
- Not acting quickly enough, or not acting at all (maintaining the status quo), can lead your portfolio to drift from optimal allocations and become far too risky or too conservative for your financial situation and goals.
- Regret-aversion may lead to herding behavior, which means relying too much on the opinion of others (the herd) when you make investment decisions. You subconsciously believe that your feelings of regret will be minimized if you are wrong alongside everybody else.
Cognitive biases are easier to correct than emotional ones, but in both cases, a change in one’s behavior requires some work.
The main culprit for our reluctance to sufficiently update our beliefs after receiving new information is actually the confirmation bias, according to Michael Mauboussin, Director of Research at Blue Mountain Capital Management. Mauboussin indicates that ‘’we tend to seek information that confirms our belief and dismiss or discount information that disconfirms it. Further, we generally interpret ambiguous information in a way that is consistent with our prior belief.’’ One way to improve as an investor is to make sure you consider all potential information, especially if it’s negative and challenges your investment thesis. Try to understand the short thesis, or why people disagree with you on the merits of an investment.
Simply being aware that the conservatism bias exists, in itself, is a great way to start improving. Make sure you ask yourself the tough questions when you come across new information about a stock you own. Is the information meaningful? Does it challenge your initial assumptions? Should you adjust your financial forecasts? Does the company still meet your criteria? Then, try to include this information in your investment thesis and reformulate it, if needed.
Finally, try to simplify your investment theses and identify the key elements you should focus on. This will make it easier for you to determine whether new information is worthy of further analysis or not. The more complicated it becomes to update your forecasts because you analyze too many variables, the more the conservatism bias is likely to impair your investment process.
Improving your behavior in the face of new information can make a big difference on your long-term returns. While most investors are victims of cognitive and emotional biases, your knowledge of them will help you avoid pitfalls and make better decisions. Now, I leave it up to you to incorporate the information you just read into your investment process, to differentiate yourself from other market participants and to hopefully generate excess returns!
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