J.P. Szafranski, BridgeTower Media Newswires
The intersection of behavioral psychology and investing is fascinating territory. The tendency to fall victim to behavioral biases that are inherently ingrained in our humanity often helps explain investing mistakes, and conversely successful investors are often able to recognize and overcome these biases. We’ve written previously about investing great Charlie Munger’s interest in psychological tendencies.
Daniel Kahneman is a Nobel Prize-winning professor of psychology who has contributed groundbreaking work on human decision making. In his book, Thinking, Fast and Slow, he recounts how he and his longtime research partner Amos Tversky conducted an experiment where they had a rigged wheel of fortune numbered from 0 to 100 that would land on only two numbers: 10 or 65. What follows is an excerpt from the book:
“One of us would stand in front of a small group, spin the wheel, and ask them to write down the number on which the wheel stopped, which of course was either 10 or 65. We then asked them two questions: Is the percentage of African nations among UN members larger or smaller than the number you just wrote? What is your best guess of the percentage of African nations in the UN? The average estimates of those who saw 10 and 65 were 25 percent and 45 percent, respectively.”
Astoundingly, people were clearly and unwittingly influenced by having seen a totally random number, as it affected their attempt to answer a completely unrelated question. This is known as anchoring, which Kahneman aptly describes as occurring “when people consider a particular value for an unknown quantity before estimating that quantity.”
In any negotiation, the tendency to anchor on the first number proposed is powerful and potentially dangerous for counterparties. I might find it useful to make the first offer when I’m negotiating with my 3-year-old on the number of minutes before bedtime. Clearly, this useful parenting tactic is in fact in the best interest of both of us. A car salesperson’s first lowball offer on someone’s vehicle trade-in might lead to a disadvantageous deal price. While such a suboptimal financial outcome is regrettable, the customer is unlikely to suffer grave financial distress as a result.
Anchoring can contribute to severely adverse economic consequences. Let’s consider merger-and-acquisition activity, whether the selling company is a privately held small business or a massive publicly traded enterprise with thousands of employees, oftentimes the buyer will receive optimistic pro forma projections for future financial results from the seller or a related deal adviser. Even as the buyer conducts an independent analysis of the target company’s future earnings power, the mere exposure to the seller’s pro forma numbers beforehand can skew projections in an overly optimistic direction.
If actual future results underperform those projections, the agreed upon deal value might end up looking like anything but a deal. If the buyer uses debt financing to close such a transaction, the risks of financial distress and job losses are magnified.
The tendency for anchoring is inherent in all of us. It’s impossible to eliminate but if we consciously remind ourselves of it, we can employ tactics to try to avoid anchoring-driven suboptimal decisions. As we pursue our day job analyzing the investment merits of securities, we always try to start by evaluating a company’s historical financial results published in regular regulatory filings. While an investor relations slide deck should contain useful incremental information, we recognize that the slides are packaged just as management would like us to see and think about the company. Before we get to such material, we want to be anchored to the reality presented in audited financial statements.
—————
J.P. Szafranski is CEO of Meliora Capital in Tulsa (www. melcapital.com).
