A guy walks into a bar, orders a beer, and declares that the Yankees are going to win the 2019 Pennant. This is their year and there is no doubt.
Another guy walks into a bar, orders a beer, and declares that the Yankees are going to win the 2019 Pennant…with 48% probability.
The first situation is much more common than the second. If it isn’t the Yankees it is another team, or a political candidate, or a company that is poised to disrupt some industry, or a company that is poised to be disrupted. Pick a subject. People tend to take a position on the way the future will unfold and act as if no other outcome is possible. They have examined the facts as they have perceived them, and their mind is made up. Period.
PerceptionsAnika Huizinga
The second situation is rarer than the first. People don’t typically express their views in terms of probabilities. This is unfortunate–thinking probabilistically is the correct way to think about most situations in life. The future is inherently uncertain and adopting a decision-making framework that accounts for the many different outcomes that could unfold only seems logical. Investing is no exception.
Part II of this series (which you can find here) showed how probabilities surrounding cash flow scenarios are incorporated into security prices, and how changes in the market’s perception of these probabilities can lead to mispricing. This final part of the series will look at the belief updating process in more detail to understand how new information should be incorporated into security prices. We will also see how this process can go wrong. Identifying the mistakes of other investors is key to finding investment opportunities.
Humans are just not that good at calculating and thinking in terms of probabilities
Updating our beliefs on the probabilities of future events when new information comes to light is a crucial part of any forecasting exercise.
Phil Tetlock in his excellent book, Superforecasting: The Art And Science Of Prediction, states the following about the process of updating our views on the future in the face of new information: “Belief updating is to good forecasting as brushing and flossing are to good dental hygiene. It can be boring, occasionally uncomfortable, but it pays off in the long term.”
Probabilistic thinking of this sort doesn’t come naturally to humans, however, and this is the root cause of many investing mistakes. If we could easily estimate and update probabilities, financial markets might start to resemble the rational mechanisms of efficient market theory.
Probabilities can be tricky
Some probabilities are easy for us to understand and calculate. The odds of rolling snake eyes at the craps table, for example, doesn’t take much effort (1/36 or 2.78%), but calculating the odds that your baseball team will win the World Series, given that they have lost the first two games, is a bit trickier (just under 19%, assuming the teams are evenly matched).
Calculating the probability-weighted expected future cash flows that a company will produce into perpetuity, given that they have recently missed earnings expectations, hired a new CEO, and are experiencing industry shifts, is significantly more difficult.
Throw in the emotional reaction to losses and gains, small observed sample sizes, and it is easy to see how estimates of probabilities can become biased and inaccurate, causing security prices to deviate from their intrinsic value.
How investors should handle new information
So, how should we (investors) handle the arrival of new information regarding a company’s prospects? When humans deal with complex probabilities that require constant revision as new information comes to light, the rationally correct approach is to use Bayes’ Law to update our prior probabilities to reflect the new information.
Bayes’ Law requires that we correctly calculate two crucial probabilities: 1) the prior probability, or the probability that a certain event will occur before we receive new information, and 2) the posterior probability, or the probability the event will occur given the presence of the new information.
This process requires three inputs to be estimated: 1) The prior probability of the event occurring (also called the base rate which is the probability that a certain outcome will happen prior to the arrival of new information), 2) the probability that we would observe the new evidence given the event in question occurs, and 3) the unconditional probability of observing the new evidence.
If investors could estimate these inputs rationally without bias, then security prices would incorporate new information correctly. For an example on how Bayes’ Law works in practice please go here.
Research from both psychology and behavioral economics has shown, however, that when faced with such situations, humans often rely on mental heuristics instead of rationally heeding and updating prior probabilities. Heuristics – basically mental shortcuts we use to aid the decision-making process – served us well from an evolutionary perspective when the decisions required quick life or death reactions. These shortcuts are not as effective, however, in the more nuanced word of security analysis where we need to estimate probabilities based on incomplete information. Such heuristics ultimately result in biases that degrade the quality of our decisions.
Where does that leave us? Instead of rationally analyzing a prior probability and updating it with new information in a mathematically, unbiased way, we use mental shortcuts that cause us to either ignore prior probabilities, or to update them incorrectly when presented with new information.
And it gets worse. Even if we have the right probabilities in mind, we often fail to properly align our decision weights with the underlying probabilities governing the distribution of future outcomes. Daniel Kahneman and Amos Tversky conducted research that shows how people incorrectly assign decision weights from underlying probabilities. They highlight a “possibility effect” where we tend to overweight small probabilities when making decisions and a “certainty effect” that causes us to underweight outcomes that are more certain.
We should search for mispricing, not “cheap” companies
The ultimate result of this behavior is mispricing. When heuristics and behavioral biases cause beliefs about the probabilities surrounding future cash flow scenarios of companies to be incorrectly updated, and decision weights to be incorrectly assigned, share prices can diverge from the intrinsic values they are supposed to reflect. The implied probabilities surrounding future cash flow scenarios become divorced from the realities facing companies and the prices of the securities begin to resemble mispriced bets. These are the situations where opportunities can be found.
If we wish to outperform the market, we must create a search process that seeks out situations where heuristics and biases dominate the market pricing of a security. Simply searching for stocks that appear “cheap” is not enough. We must dig deeper and understand the mechanisms that cause mispricing in the first place.
Disclosure:
You should not treat any opinion expressed in this article as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of an opinion. Also, the opinions expressed may be short term in nature and are subject to change without notice. You should be aware of the real risk of loss in following any strategy or investment discussed in this article. Strategies or investments discussed may fluctuate in price or value. Investors may get back less than invested. Investments or strategies mentioned in this article may not be suitable for you. This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. You must make an independent decision regarding investments or strategies mentioned in this article. Before acting on information in this article, you should consider whether it is suitable for your particular circumstances and strongly consider seeking advice from your own financial or investment adviser.