How inherent cognitive biases and environment can influence company risk

We see biases as systematic errors of judgement – partial or illogical perspectives on sets of information. A financial market is fundamentally the flow of information between people; they are driven by human judgement. Hence, we think markets are perfect for incubating bias.

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We see biases as systematic errors of judgement – partial or illogical perspectives on sets of information. A financial market is fundamentally the flow of information between people; they are driven by human judgement. Hence, we think markets are perfect for incubating bias.

By Jeremy Lang and Ben Fitchew

We see biases as systematic errors of judgement – partial or illogical perspectives on sets of information. A financial market is fundamentally the flow of information between people; they are driven by human judgement. Hence, we think markets are perfect for incubating bias.

There is a constant stream of information, complexity, and lurking at the end of misplaced forecasts, risk. Behavioural finance has recognised this, and moved investors centre stage to study their biases. Investors may be obvious candidates for bias, but most risk in financial markets springs from company management – the rest of the market reacts to it.

Kahneman and Tversky wrote in their New York Times Bestseller, Thinking, Fast and Slow, that the way we think is best seen as two systems: ‘System 1’ is effortless, automatic and intuitive. ‘System 2’ shifts attention to effortful mental activities, churns logic, deliberates. ‘System 2’ takes over when things get challenging. ‘System 1’ is great at keeping us alive, but in particular environments its neat bag of tricks can create systematic errors, and ‘System 2’ is often ill-equipped to bail it out. Kahneman and Tversky catalogued the main biases of ‘System 1’, and the environments that liberate them.

Kahneman and Tversky found that we are poor intuitive statisticians and outlined a group of key biases. We are prone to be unduly influenced by memorable, salient information. We judge likelihood by superficial similarity, not base rate statistics. And, we are unusually influenced by irrelevant quantitative information; we view the world as more benign and predictable than it really is.

Now, we think overconfidence bias is most relevant to company management. Why? Company management take risk with capital, and justify those actions to shareholders. Most have spent 20 years scrambling up the career ladder to reach the top. They are prime candidates for optimism bias. The bias literature shows company management is generally prone to: giving insufficiently narrow error ranges for predictions; rating themselves higher than peers; ignoring base rate statistics; overestimating their ability to influence events; preferring to act over doing nothing; viewing risk as a challenge to be overcome; and underestimating the time and cost of complex projects.

We think managers reveal their riskiness in two ways. Firstly, it is shown through their investment plans and the level of patience they apply to these plans. Patience is not an attribute of overconfident people. So the size of balance sheet bloat partly reflects the degree of their impatience. The second way it is revealed is through reporting and how these managers justify their plans. Managers are held accountable via their company’s accounts and by what they say in public. While there are accounting rules, there is a certain amount of latitude in how the accounts are put together. How much managers chose to use these rules to paint a flattering picture can, in our view, reveal how hard they are straining to justify their overconfidence – the gap between accounting earnings and cash earnings.

We think bias gives the motivation but environment lends the means, and opportunity. Means and opportunity act as switches that when flipped on, release these biases.

Confidence biases can do little damage if managers can’t act on them to seek growth. This happens two ways: if a business is starved of capital, then manager’s biases are straitjacketed; or if a business has plenty of capital from its current operations to fund easy growth, then management have no need to gamble. Inverting this helps us define a bad environment for company managers: they need the means of access to external capital, and face a growth opportunity that requires action.

Not all opportunities are equally bad for biases. Some encourage more biased behaviour, particularly the biases of denial. We see two kinds: myopia and denial of change. Myopia proliferates when a doorway of dazzling opportunity is open to capital from competition, leading to gold rushes or booms – the illusion of control blinds managers’ eyes to competition. Denial in face of change, on the other hand, is prevalent in industries where the future is seen as a variant of the near past, but there has been a shift and growth is harder to come. And both of these biases are amplified when accounting regulation gives company managers latitude to obscure risk (Enron is the poster boy of this).

Given the right conditions, we think it’s safe to assume that company management is prone to overconfidence and its cheery henchman over-optimism. But management do not always have the opportunity to release these biases; that depends on the nature of opportunity and the means to risk capital blindly.

Jeremy Lang and Ben Fitchew are portfolio managers at Ardevora Asset Management

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