To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework. —Warren Buffett
This week we are going to take a look at what is called Conservatism Bias. Conservatism bias is a mental process in which people maintain their past views or predictions at the cost of recognizing new information.
For example, have you ever done a ton of research and identified and booked the perfect beach rental for a family vacation months in advance? However, as the vacation approaches you learn that a category-five hurricane is set to make landfall directly on top of your condo. You know that you should cancel the trip given this new information, but part of you wants to head down to Destin anyway, right? The urge is so strong, that you might even load up the car and plan to still go “unless things look REALLY bad.” The great decision that you made months ago by booking an awesome condo in a pristine location is clouding your judgement given the new information. This isn’t your fault; it’s human nature, and it can be a real danger in the investment world.
So what exactly does this mean for investors? According to Michael M. Pompian, author of Behavioral Finance and Wealth Management, Investors with this bias can make investment mistakes such as:
- Conservatism bias can cause investors to cling to a view or a forecast, behaving too inflexibly when presented with new information. For example, assume an investor purchases a security based on the knowledge that the company is planning a forthcoming announcement regarding a new product. The company then announces that it has experienced problems bringing the product to market. The investor may cling to the initial, optimistic impression of some imminent, positive development by the company and may fail to take action on the negative announcement.
- When conservatism-biased investors do react to new information, they often do so too slowly. For example, if an earnings announcement depresses a stock that an investor holds, the conservative investor may be too slow to sell. The preexisting view that, for example, the company has good prospects, may linger too long and exert too much influence, causing an investor exhibiting conservatism to unload the stock only after losing more money than necessary.
- Conservatism can relate to an underlying difficulty in processing new information. Because people experience mental stress when presented with complex data, an easy option is to simply stick to a prior belief. For example, if an investor purchases a security on the belief that the company is poised to grow and then the company announces that a series of difficult-to-interpret accounting changes may affect its growth, the investor might discount the announcement rather than attempt to decipher it. More clear-cut and, therefore, easier to maintain is the prior belief that the company is poised to grow.
Pompian goes on to say that “Conservatism can prevent good decisions from being made, and investors need to remain mindful of any propensities they might exhibit that make them cling to old views and react slowly toward promising, emerging developments.”
Duncan Williams Asset Mgmt. is here to offer you professional advice to help you avoid the pitfalls of this common bias. Let us help you avoid the hurricane!