The human brain is extraordinary, and it doesn’t always work the way we think it should. For example, I have yet to meet someone who can rotate their right foot in a clockwise direction and simultaneously repeatedly draw in the air with their right index finger a large ‘6’. (I know you are trying it right now, and I also guess that you may be laughing that your foot inadvertently turns anti-clockwise.)

My fascination with how the brain does, and doesn’t always, work –this applies as much to investment as anywhere else – has led me to fly the flag for behavioural economics.

150 different biases

Around board tables and within committees, human biases can lead to sub-optimal decision-making, so understanding key aspects of social psychology is an important defence against what is often referred to as “group think”.

Psychologists estimate that the human brain is potentially subject to more than 150 different biases – some of which make perfect sense from an evolutionary perspective but may sometimes be inappropriate in the modern business world. Common examples include the bandwagon effect, overconfidence and the optimism bias.

A lesser-known, but equally challenging, bias is ‘the halo effect’. The term was first used by psychologist Edward Thorndike in the 1920s, as he sought to explain a bias present in how military commanding officers judged qualities in their subordinates. His conclusion was that humans perceive the quality or skill of a person in one area based upon how they perform in another area. Thorndike originally applied the term to people; however, its use has been greatly expanded to include businesses and brands.

Professor of psychology Robert Cialdini says other simple examples of the halo effect include the way “we automatically assign to good-looking individuals such favourable traits as talent, kindness, honesty and intelligence”. This is why celebrities are used to endorse products. We are more likely to buy a brand of coffee if George Clooney is associated with it. But why should consumers want to buy a brand because it is associated with a movie star? This makes no sense from a purely rational perspective. It shows the power of the halo effect.

Phil Rosenzweig exposed how such thinking pervades the business world in his provocative 2007 book The Halo Effect,in which he pulls no punches describing how most commentators are systematically delusional when it comes to picking theories about the reasons for strong company performance. For example, one unconsciously assumes that a measure of success such as share price performance or profits must directly reflect good strategy or top-quality management. There is little room, the assumption goes, for luck or subtle shades of grey. And if an overall impression of a company is favourable, then thoughts about all aspects of its make-up are likely to be seen as consistently positive.

Put simply, Rosenzweig believes we too often have pseudoscientific explanations for business performance.

As noted, the halo effect equally applies to individuals, corporate brands, investment teams – even music. Diehard fans of The Beatles will tell you they never made a bad record but listening to Revolution #9 on the White Album is the best way on the planet to waste 8 minutes and 22 seconds of your life.

How to dodge the pitfall

How can we avoid falling for this cognitive bias? In a nutshell, we need to examine the evidence objectively and independently and try to avoid confirmation bias.

A model that works well for some investors and companies is not necessarily the correct one for others, nor indeed for the future. As the brilliant professor Costas Markides of the London Business School tells his senior executives, “Stop thinking out of the box, because there is no box. Just ask yourself three simple questions: Who is your customer? What is the benefit to the customer? How should I sell it?”

Only then can you decide on the right strategy for your organisation. Investment is rarely formulaic. And don’t assume today’s winners will even be playing the game in a few years. As behavioural economist Daniel Kahneman wrote, “If people are failing, they look inept. If people are succeeding, they look strong and good and competent. That’s the halo effect.”

Self-awareness trumps best-selling advice

Things change but the halo effect will remain as long as we are human. People will keep buying the latest business management book assuming it will contain a scientific formula for success. There’s a joke that if you read just two books, What They Don’t Teach you at Harvard Business Schooland What They Teach you at Harvard Business Schoolyou must, by definition, have read the sum total of all human knowledge.

The truth is that no investment or business management book can provide you with anything other than a modicum of true wisdom. For example, one should be skeptical of any text claiming to be able to define what makes a successful investor, company or great chief executive. Such judgements are so prone to general survivorship bias and the specific heuristics of that author that a different writer could theoretically argue the opposite view. Evidence is often filtered to the point that what looks superficially convincing may be little more than pseudoscience.

As someone who believes improving people’s self-awareness and self-discipline are two keys to success in most things, I think the best way to close the gap between potential and performance is unlikely to be found in this year’s business best-seller, which will be stuffed full of examples of the halo effect.

We would do better to concentrate on our own abilities, through a better awareness of our own biases, coupled with various self-discipline behavioural techniques that can mitigate mistakes and enhance skill, whether in investment, business or life.

As I note in my TEDx talk and training masterclasses, the key reason to promote behavioural economics in the investment and business world is that it can provide individuals and firms with a competitive advantage by recognising and mitigating some of our mental shortcuts, including the halo effect.

Above all, behavioural economics emphasises the importance of challenging our hardwired biases and much of our traditional thinking to optimise our chances of reaching better conclusions. Nowhere is this more important than in the world of investment. We need to question our assumptions.

I have always, therefore, liked the John Maynard Keynes quote: “When the facts change, I change my mind. What do you do, Sir?”

 

Paul Craven combines his love of decision-making, investment and psychology to promote the importance of behavioural economics.

 

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