The halo effect can overshadow good investment sense
I have written often about the many cognitive biases that we have as humans. Many of these are bad for our investing or trading.
This week I want to focus on the halo effect. This is a cognitive bias where a single positive (or negative) impression of a person, company, or object causes us to assume other unrelated qualities that match that first impression.
For example, strong company results may cause us to expect everything that follows to be positive: for example, the share price will go up. This makes sense but doesn’t always happen because results are more about the expectation rather than being viewed in isolation.
The halo effect was first identified by psychologist Edward Thorndike in 1920. He noticed that army officers who rated soldiers highly on their looks also tended to rate them highly on intelligence, leadership and character. These qualities have no logical connection to how someone looks.
Daniel Kahneman later embedded it firmly in behavioural economics, describing it as one of the most pervasive biases in System 1 thinking. Your brain forms an overall impression fast and then fills in the blanks that fit within that impression.
Kahneman called this “What You See Is All There Is”. Your brain constructs a coherent story from whatever it has and doesn’t naturally go looking for contradictory information.
So, a charismatic CEO gives great interviews, and we all just assume that his or her company is of the highest quality and is worth almost any valuation. Sound familiar?
The solution to fighting it is simple and hard. Hard, because we need to actively stop falling for the trap and consciously work past the easy solution of the halo effect.
But also easy. Because you just need to ensure you’re evaluating each attribute independently. So that company with a great, charismatic CEO might look good. But score the CEO separately from the balance sheet, the balance sheet separately from the valuation. Don’t let a strong impression on one dimension bleed into the others.
More recently we’ve seen this with the US-Israel attack on Iran. Yes, the Top 40 had a horror March (one of the worst since the 2008/2009 financial crisis). But as I write on the day after the ceasefire rally, we’re down only a little over 8%.
Will the war have long-term implications? Absolutely, and to be clear, many of these will be bad. But how bad over the long term? Short-term troubles are real but quality businesses adapt, that is in part what makes them quality.
Oil is the big worry and the spike in oil is second-worst only to the 1990 Gulf war. But four months after the 1990 war started, oil was below the pre-war levels. And UBS research shows that on average, after an oil shock the oil price oozes back below the pre-shock levels.
Maybe it will be different this time, but I would rather go with the trend. Fight the halo and consider both sides of the equation, not just the horror of war.
