Continuing on with our series on cognitive biases and fallacies as inspired by Rolf Dobelli in his book “The Art of Thinking Clearly” (refresh your memory on part 4), below are another three examples that can cloud our thinking, perception, and judgement.
Human minds are trained to think linearly, and normal arithmetic progression (i.e., adding up numbers sequentially) is easy for our brains to envisage. However, in recent years, and with the advent of the Internet, some companies and businesses have experienced exponential growth, which is a geometric progression (i.e., multiplication of a sequence of numbers by a common ratio).
Investors may find it tough to fathom the growth of such companies as such growth is considered gargantuan compared to the slow and steady growth of traditional businesses. Remember that the network effect is at play in such instances, and the growth of such companies represents a positive feedback loop that enhances its economic moat over time. Thus, such companies are able to grow very quickly and have sticky customers.
The winner’s curse describes a situation where the winner of a bidding contest (for an acquisition) ends up paying too much. This is usually a result of attempting to outdo the competition and secure a highly-prized asset, and pride and ego are inextricably tied up in the bidding process.
To compound the problem, the values of many assets and businesses are inherently uncertain. This means different acquirers often designate different values for the same company or asset thanks to the subjective methods of assessment. The “winners” who bid too high end up being the “losers,” and investors need to be wary of such behaviour as it is all too common in the business world.
Fundamental attribution error
This error occurs when investors over-estimate the influence of human factors in the success of a venture rather than pinning it on external, situational factors. For example, the launch of a new product by a company may have been met with resounding success, leading investors to conclude that management did a wonderful job of strategising and marketing the new product.
In reality, other factors may have come into play to contribute to the success of the product — a competitor’s product falters, a shift in consumer sentiment towards the new type of product class, or improved economic conditions that increase customers’ propensity to spend. Investors need to account for all of these extraneous factors when assessing success and resist attributing it all to management’s effort or ingenuity.
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