Countering ambiguity bias

Chas Craig, BridgeTower Media Newswires

“There are many things of which a wise man might wish to be ignorant.”
– Ralph Waldo Emerson

We regularly interweave behavioral finance into this capital markets-focused column because overcoming or succumbing to our psychological tendencies can have as much to do with investment success, or the lack thereof, as does competent fundamental analysis. Specifically, excessive self-regard, over-optimism and availability misweighing were highlighted through the lens of Charlie Munger’s The Psychology of Human Misjudgment. Munger is vice chairman of Berkshire Hathaway and longtime business partner of Warren Buffett. Later work discussed how anchoring, overconfidence, endowment effects and loss aversion can be harmful to investors’ financial health.

Most recently, we revisited loss aversion and highlighted a Dec. 3, 2020, newsletter by DataTrek’s Nick Colas that provided a summary of a recent National Bureau of Economic Research (NBER) paper entitled “We are all Behavioral, More or Less: A Taxonomy of Consumer Decision Making” by Victor Stango (UC-Davis) and Jonathan Zinman (Dartmouth). The full paper can be found at www.nber.org/system/files/working_papers/w28138/w28138.pdf.

An interesting finding from the NBER paper was that loss aversion (explains how the pain of experiencing losses is worse than the joy of accruing equivalent gains) was one of only two of the 17 decision-making biases examined showing a positive correlation to cognitive ability. The other was ambiguity bias, which Mr. Colas described as “avoiding logical choices simply from a perceived lack of information.” Said another way, analysis paralysis.

In The Signal and the Noise (2012) Nate Silver cogently points out that there is a static amount of signal on a given topic, so all other data points simply add to the noise. While we certainly get more of the signal (never all) presented to us than prior generations, we also get so much extra noise that decision making is possibly worse on average owing to the interplay of information overload and our innate tendency toward the ambiguity bias.

As previously argued, the most efficient remedy for the negative impact these biases can have on our decision-making is likely not to overcome evolution by coaching these biases out of ourselves, but to acknowledge their presence and devise processes designed to neuter them. Regarding countering the ambiguity bias, consider the following excerpt from Seth Klarman’s Margin of Safety (1991).

“This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.”

Consistent with the title of Mr. Klarman’s book, a key to overcoming ambiguity bias in investing is having an ample margin of safety between the price of an investment and one’s conservative estimate of what it is worth. For example, let’s say I spend a week evaluating a company and by week’s end I come to a value estimate of $1. Further assume that the shares of this hypothetical company trade in the market for 75 cents. Now, all else equal, assume I spend a full month immersing myself in a company’s fundamentals and, having spent more time on the analysis, I have a higher degree of certainty in my $1 value estimate.
However, the shares are trading for 90 cents in the market. Everyone needs to devise processes that work best for them, but personally, I would most always choose the shorter analysis period with a wider margin of safety and use the other three weeks in the month to perform similar analyses on other companies.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).