From time to time on The Value Perspective we like to discuss heuristics. These are essentially shortcuts the human brain uses when trying to process information because, at some point in our evolutionary history, it has generally been beneficial to sacrifice full intellectual rigour for a speedier conclusion or response – for example, “I don’t know for sure whether it’s a sabre-toothed tiger, but I’m going to start running anyway”.
The way many heuristics work, in effect, is subtly to change a question being posed to the brain so it becomes easier to answer quickly. When the question our brain wants answered subtly changes from ‘What do I think about such and such?’ to ‘How do I feel about such and such?’ that is the ‘affect heuristic’ in action.
The brain can recall how we instinctively feel about something very quickly, whilst weighing up the pros, cons and finer points of a rational argument takes a lot more time. The affect heuristic is not so much about what these instinctive feelings are, but more about how this initial view can distort how we think about something. In the context of investment – and many other decisions in our lives – it can lead us to see a negative correlation between risk and reward.
This is odd because, in investment, we know those two things should actually have a positive correlation – investors who take greater risks should expect ultimately to receive greater rewards. Yet the affect heuristic means that, where people initially have a good feeling about something, they are more likely to think the benefits are high and the risks low. Conversely, where they initially have a bad feeling about something, they are more likely to think the risks are high and the benefits low.
This goes some distance to explaining how opportunities for value investors arise. The affect heuristic makes it easy for investors to feel comfortable with stocks that they like such as consumer staples firms which have the sort of stable characteristics the market wants at the moment. This can lull people into what might be described as a false sense of security (or securities) where they overplay the benefits and are blinded to the potential risks.
On the other hand, when they look at, say, the banking sector, the consistent bad press etc. means the instinctive reaction is likely to be negative. This will colour the way many people think about the risk/reward trade-off of the investment and make it harder for them to appreciate that while the risks accompanying these stocks are quite clearly above-average, so are the potential rewards.
So, if our brains are actually inclined to work against us when weighing up investment risk and reward in this way, how – you might reasonably ask – do we compensate for that? First, simply being aware that the heuristic exists is an important step to fighting it and, second, the best way to fight back is by carrying out detailed research into each potential investment. This will give you a longer period of time to process all the available information and hopefully result in you relying less on immediate impressions. An unemotional appraisal of risk and reward is key to a successful investment career.