Let’s continue with this series on cognitive biases and fallacies written by Rolf Dobelli in his book “The Art of Thinking Clearly”.
Here is a quick rundown of the first four parts in case you have not read them.
Part 1 – click HERE
Part 2 – click HERE
Part 3 – click HERE
Part 4 – click HERE
We feature another three examples of how our thinking, perception and judgement may become clouded.
12. Exponential growth
Human minds are trained to think linearly.
Normal arithmetic progression (i.e. adding up numbers sequentially) is easy for our brains to wrap around.
However, in recent years and with the advent of the Internet, some companies and businesses have experienced exponential growth.
Exponential growth requires you to think in a geometric progression (i.e. multiplication of a sequence of numbers by a common ratio).
Investors would find it tough to fathom the growth of such companies as such growth is too swift for the mind to grasp in contrast with the slow and steady growth of traditional businesses.
Remember that the network effect is at play and that the growth of such companies represents a positive feedback loop which enhances its economic moat over time.
Thus, such companies can grow very quickly and have sticky customers to boot.
13. Winner’s curse
The winner’s curse describes a situation where the winner of a bidding contest (for an acquisition) ends up paying too much.
Overbidding results from the need to outdo the competition and secure a highly-prized asset.
Needless to say, pride and ego are inextricably tied together with the bidding process.
To compound the problem, the values of many assets and businesses are uncertain.
Different acquirers will designate different values for the same company or asset due to subjective methods of assessment.
The “winners” who bid too high end up being the “losers” as they may have overpaid for the asset or investment, thus dooming it to poor future returns.
Investors need to be wary of management displaying such behaviour as it is a common theme in the business world.
14. Fundamental attribution error
This error is one where investors tend to overestimate 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.
Investors may then 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.
These include the failure of a competitor’s product, shifts in consumer sentiment (towards the new product class), or improved economic conditions.
Investors need to account for these additional factors when assessing success and not simply attribute it all to management’s effort or ingenuity.
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Disclosure: Royston Yang does not own any of the companies mentioned.
