In this episode of Industry Focus: Healthcare, Motley Fool analyst Kristine Harjes is joined by contributor Todd Campbell to investigate the relationship betweenpsychology and investing and explain how you canoutsmart yourbiases.
A full transcript follows the video.
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This video was recorded on April 5, 2017.
Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your Healthcare show host, Kristine Harjes, and it is April 5th, 2017. I have Motley Fool healthcare contributor Todd Campbell on the line. Todd, what's new? What are you writing about lately?
Todd Campbell: There's so much going on right now, especially in the healthcare space that you and I have talked about. I think it's going to be a really fun show today,because we're going to step back from everything and help investors get a better idea of how better todigest all that information and turn it into profit.
Harjes: Today's episode is going to be a little bit different from usual,as you mentioned. I'm excited for it. We are going to be exploring cognitive biases. Why is the human brain sometimes, maybe even most of the time, not perfectly logical? If you think about it, thisexplains why we are able to make money in the stock market to begin with. If you'vestudied economics, you knowthe efficient market hypothesis, that all theinformation out there is already factored in, and things arepriced exactly as they should be. But we also know that there are ways to make more money than theaverage stock index in the market. That's because people control the market, and they are not always rational. If you think that psychology doesn't actually have that much to do with investing, consider that in 2002, the winner of the Nobel prize in economics,Daniel Kahneman, wasactually a psychologist. In fact, his work has influencedjust about everything we're going to talk about today.
Campbell: I think, Kristine, it's really interesting to think about the connection between the way that we think about the world or the way our bodies or brains work and thedecisions that we end up making.I also find it interesting to think about how do we get to the point where we decided ontackling this kind of a subject on our show. I think it really stems from the fact thatyou and I were having a discussion about risk and how people view risk in their decision making, andarguably, when it comes to risk, we talk a lot about biotech, andperhaps there's no other industry in the market thatpresents a similar type of risk-reward that could lead us to make good or bad decisions,depending on how we viewthe information that's put in front of us.
Harjes: And we say all the time that youneed to take your emotions out of investing when we talked about how volatile biotech inparticular gets. But there are some specific ways you can do thatonce you understand your braina little bit better.
Campbell:Kahneman's work waspretty groundbreaking because... what I find most fascinating about himwas that he tackled the subject of utility. He basically looked ateconomic theory and said, "We should allact for our besteconomic interest, but oftentimes, we don't." Andonce he realized that and said that, he went out andtried to figure out why that is. Why is it thatsometimes we make decisions that are notin the best interest of our wallet?
Harjes: Exactly. Andeven in terms of basic probability, sometimes people don't make the best decisions, whether it has to do with utility, orif it's even more straightforward than that.I figured I would kick us offwith an example that shows thathumans are pretty terrible statisticians. Todd,have you heard of the Linda problem?
Campbell: I have.
Harjes: OK. For our listeners,if you haven't heard of this problem,here's the quick and dirty. Linda is, in a survey, described as31 years old, single, outspoken, and very bright. She majored in philosophy. As a student,she was deeply concerned with issues ofdiscrimination and social justice, andalso participated in anti-nuclear demonstrations. Which is more probable? -- the survey respondents were asked -- No. 1, Linda is a bank teller. Or, option No. 2, Linda is a bank teller and is active in the feminist movement?
Campbell: Yeah. Give ourlisteners a second to digest that and to weigh in withwhat they think is the most probable answer.
Harjes: All right, listeners. Take a second and hit pauseif you haven't actually come to a conclusion yet. The answer is,it's more probable for her to be a bank teller,simply because it's impossible for No. 2 to be more probable,because in order for her to be option No. 2, a bank teller andactive in the feminist movement,she has to also be a bank teller. But,the fascinating thing here is,85% of survey respondents incorrectly chose option two instead of option one.
Campbell:They hadall this information put in front of them, and they jumped in and said, "I have this information, so thereforeI am now able to make a better assessment,"forgetting the logic behind how probability works. Asyou add more characteristics,by definition, it's going to become less probable.
Harjes:You're completely correct. And it's crazy,because you read an example like this, and you're like, "Oh,I would never do that." But,I know at least for myself,when I was putting together notes for today's episode,I am guilty of just about every single thing that we are about to say.
Campbell: All of these things, it's almost like they are hardwired into us, and we have to literally slow ourselves down in the way that we're thinking. One of the things that he wrote about or talked about a lot throughout his career,Kahneman, is that there are two systems for thought. Youhave the first system, which is fast,it's instinctive,it's emotional driven. Thesecond system is slower, it's more deliberate, it's more logical.
Harjes: Getting into somespecific logical fallacies that come as a result of the way that your mind is set up with these two systems,the first one that we want to bring upis called anchoring. Todd, do you want to kick that one off?
Campbell:Did youlook at the stock market closing price yesterday?
Harjes: No,I didn't.
Campbell: All right. A lot of peopleprobably did, and they'reprobably viewing today as eitherbargain-priced or notbargain-pricedbased upon whatever the recent price was that they saw of theS&P 500. Or they're doing it with individual stocks or whatever. They'reanchoring their perception ofwhat's going on now to anarbitrary point in time that they selected,be it yesterday or the day beforeor the week before.
Harjes:Theprinciple of anchoring is thatyou can be influenced bysomewhat arbitrary numbers when you're looking at a relevant number. Itdoesn't matter if the number that you were looking at is somewhat related to the current situation orif it's completely just a random number that was flashed in front ofyour computer screen for a second before youthen looked at, say, the share price of a given stock. The point is, the brain does anchor on to this number that it saw,and then everything that it sees after that, it sees with reference to that number. It's very easy to be tempted to catchwhat we call falling knives, which are stocks that are plunging,because let's say you've been watching a stock for a month and it's20% lower than it was. It's pretty easyto think that must be a bargain, because that 20% lower numberis a good deal lower than the original number. But,you need to look beyond that, andtry not to get too caught up inframing your current valuationbased on a previous valuationwhen the situation may have changed, and thatsort of plunge might be warranted.
Campbell:It's hard to say where you might find value in that, or where the bottom may be established in there. I always think ofValeant(NYSE: VRX) when I think about anchoring, andsaying to myself, what's the right price for Valeant? Was it $150? Was it $110? Was it $80? Was it $70? Was it $60? Was it $10? Anddepending on when you looked at the stock, it'sgoing to influence your decision ofwhether or not you think it's a deal, a bargain, or not. That'swhy you have to step backfrom that and so down and say, "Ihave to understand the story better,I have to not jump to a conclusion tooquickly on this. I have to understand why the stock is falling, rather than beanchored to this perception of this number that I saw at a point in time."
Harjes:Heads-up forlisteners: We will probably be referencing a bunch of different healthcare stocksand stories we've covered in the past. If the quick recaps leave you wanting more, oryou're not as familiar with thebackstory, shoot me an email at email@example.com, andI'll send you either a past episodeif we talked about it on the show,or I can at least send you some relevant articles,because we have a lot to cover, sowe're going to try not to get too in the weedsabout any specific companies. So, yes,from there, let's move on to another concept. This onemight be the most important ofall of the ones that we're going to discuss today, andthis is a loss aversion. The principle behind this one is people will act totry to minimize their lossesmore than they will act to attain gain,because it hurts more to lose $10 than themagnitude of the good feelings from winning $10.
Campbell: And when you look at the other way,once you've made your decision,if it turns out to be wrong, you tend to view things moreoptimistically than you should. So,there's two components to that, "OK,I'm going to make a decision that throws outlogic because I'm afraid of losing." If I have $500,I could make $500 or lose $500. It's the same amount of loss or gain,yet you're going to not make the tradebecause you don't want to lose the $500. Well,if you make the bet,you're morelikely to think the bet will pan out thanit's not, and that's not necessarily true.
Harjes: Exactly. And verymuch intertwined in thereis the sunk cost fallacy, which is what you're alluding to there, whereif you've already purchased into a stock, you might beless likely to sell it and buy something else. I am absolutely, totally guilty of sitting on losers that I knowI would never buy into at the current price, but yetI'm still sitting on them like, "OK,maybe it'll turn around eventually." Butonce I sell, I'm locking into that loss.
Campbell: I bet you every singlelistener out there right now that has a portfolio that has different investments in it issitting on a few of these stocks, Kristine. You and Iare not alone in this.
Harjes:It's so prevalent.
Campbell: Wealways used to joke way back in the day,it's the hope and prayer method of investment management,where you buy the stock and hope and pray thatsomething happens to make it go up,because all it's done is gone down. And like you said,I have no interest in going out and buying it now,because the catalyst has changedor whatever. Yet, why is it thatI'm so afraid or unwilling totake the loss, admit defeat,move on to another, better idea. In the healthcare spaceover the past couple years, Kristine,you and I have talked about various stocks. Two thatjump out, one was a complete disaster, and the other was a temporary disaster that's building back up. Those wereOphthotech(NASDAQ: OPHT)andPortola Pharmaceuticals(NASDAQ: PTLA).
Harjes:Weboth for shareholders, right?
Campbell: Yeah. We both owned it. We talked about it different times on the show.Ophthotech had an interesting drug in phase 3. That trialwas a miserable failure and the stock lost the majority of its value. Then,you have Portola that had a coupleFDA decisions that were postponed. So,you had to look at it and make a decision based on that story -- had the catalyst changed to that story that would make you want to sell or not sell? In my view, theOphthotechcatalyst had changed significantly,and there's no reason to continue to hold it. But inPortola, thecatalyst had just been pushed back,so there is a reason to hold it.
Harjes:Right. That'sanother reason why it's so important to keep an investing journal,write down why you're buying into these stocks and what couldpotentially change thereason that you have for holding them. That way, you can easily reference it, andhopefully you'll be more inclined to sell a loser that deserves a sell.
Todd,let's dive back into some of the more cognitive biases.Talk to me about framing.
Campbell: Framing issomething that we absolutely have to pay attention to,especially as biotech investors, because we'realways receiving, on a daily basis,press releases from companies that we may be interested in. Andif we don't understand that there can be some framing of words or numbers that would bemore inclined for us to view them favorably, then we might fallvictim to that bias and ending up going out and buying whenmaybe we should dig deeper and not do that.
Harjes:A quickbackground on what this concept is,here's an example for you. When asked ifpeople would opt in to thissemi-elective surgery,some people had the surgery described to them as having a10% mortality rate. Other people in the study had itdescribed as having a 90% survival rate. That's10% mortality vs. 90% survival. That's the same thing,but it's phrased in very different ways. Turns out, more people elected for the surgery when it was described as having a 90% survival rate. So, that'sin the world of healthcare, but not necessarily investing related. How could that possibly apply to investing?
Campbell: I think there's a fewdifferent things. One of the things that jumped right out to me is the shift years ago,especially when we're talking about the internet boom. I'm dating myself a little bit. Alot of the press releases shifted fromtalking about their earnings per share to their EBITDA figures -- soshifting the focus away from traditional net incometoward these other measurements that they wanted us tobelieve were equally as valid. Unfortunately, when the internet boom became a bust, we found that there really is nosubstitute for good old-fashioned net income and net earnings. There are a lot of different times as abiotech investor where you're going to look at a press release andtry and digest the meaning of it. Make sure that you always slow yourself down, and don'tjump to conclusions about the findings. Make sure you try and get as much information as you can before doing that,because it could very well be that they'reputting their best foot forward, andthat's going to fake you out.
Harjes: AndI don't think that there's any malicious intent theremost of the time. It's just kind of a fact thatthe positive news is going to come out first,whether it's in a press release or the earnings call. Thesecompanies are going to say the best things first. That positions you to have apositive idea of the company, and prepares you to hear, maybe, the bad news in a more positive way.
Harjes: Nextbias that we want to talk about is called the confirmation bias. Ifanybody was on our website on April 1st,you may have seen our April Fool's Day joke,which was called The Motley Fool Echo Chamber. It was a very elaborate and well done --snaps for that team -- joke construction where you would click on the top-of-site article and it would take you to the Echo Chamber, which was this toolyou could use to refine the waynews was presented to yousuch that it would only send you things that you already agreed with. Of course,this was a joke. We were playing on news lately, and somevarious things that we've all seen going on. Butthere's a lot of truth to that. You are more likely to click on an articlethat has a headline that you agree with. Or,even if you read something you don't agree with, you'remore likely to dismiss it as flawed,rather than truly considering any contrary evidence to what you currently think.
Campbell: Kristine, I got so faked out by that April Fool's joke.
Harjes: [laughs] Did you? You work forThe Motley Fool! You know it's April 1st!
Campbell: I know. Andevery year, listeners, they do something special like this. And yet I got sucked in and was like, "What?!"
Harjes: [laughs] That'skind of awesome.
Campbell: WhenI was thinking about confirmation bias,the first thing I thought of was a quote by Voltaire, which was, "Illusion is the first of all pleasures." What I thinkVoltaire was saying there was, we getincredible joy and happiness frominterpreting information that backs up what we already believe. That isextremely risky as investors. Maybe less riskyif you're just buying the S&P 500 index fund. Butif you're buying individual stocks, youwant to have divergent thoughts,you want to listen to people who are approaching things differently than you are,because it will either solidify your argument or it will lead you to a new argument. AndI think that's incredibly important forinvestors to generate long-term success in the markets. Because, the reality is,it's very easy to think you're the smartest stock picker in the worldwhen the stock market is going up.
Harjes: Exactly. So, avoid confirmation bias if you can. It'spretty impossible,but at least being aware of it,maybe you can try. That's whatThe Motley Fool is here to help you do, by the way. If you go to our website,you can almost always find conflicting views on various stocks. We are a very motley company, so we have people that are bulls and bears on the exact same stock. Anyway,the next bias we want to talk about is thepeak-end rule, which is something I will tee off by talking about a 1993Kahnemanstudy that showed that participants that wereexposed of 30 seconds of14-degree ice water, which is super cold, rated theexperience as more painful than participants that were exposed to 60 seconds of 14-degree ice water plus 30 additional seconds of 15-degree ice water. In other words,participants found that 90 seconds of ice water exposure wasactually less painful than 60 seconds ofpretty much equally cold water, just because the 90-second exposure ended with a somewhat warmer temperature water.
Campbell: Yeah. And we're only talking about one degree. For some reason, that was enough to offset the extra 30 seconds offreezing cold water.Kahnemanalso referenced another study --I was just watching a TED Talk that he hosted andit was fascinating. Check it out, listeners, if you can --the example he gave therewas about colonoscopies. Essentially, what happened was,the same exact funny. People who had a shortercolonoscopy and people who had a longer colonoscopy, butin the longer colonoscopy, there was lessmovement of the instrument, etc.,so there was less associated pain with thatadditional time. Sure enough,people walked away thinking, "That was less painful," even though, by all measures, they wereexposed to a longer period of discomfort. I think it's a very interesting finding.
Harjes:So,the point of it is, the way that you remember experiences in your life hasso much to do with the very final moment of that experience. So,how does that relate to investing?
Campbell: He talks a lot about happiness,and how it's not about the experience, it's about, like you said, what we remember in the last final thing of it. One of the things he'd mentioned was,someone had told him abouthow they had gone to the symphony,and the symphony was phenomenal, it was the best symphony ever for 15 minutes, and it ended with this big screeching noise, and that ruined it for him,because the only thing he could think of now was the screeching noise,not the 15 minutesof enjoyment. I think what we have to worry about is looking at it and saying, "I either lost money or made money on this stock at this point in time," and forgetall of the other things that went into the decision-making process, the other variables that could have affectedwhether or not the stock rose or fell in the period. Youhave to consider the experience, too. You can't just focus on the end result.
Pro tip for listeners: You've already mentioned it once: Journal, journal, journal, journal. It'sso important to write down why it is that you're buying a stock, and keep track of how it's going and things that are happening. That way you can go back and look at it and relive the experience of it, and not just have that final takeaway of "Oh, I lost money," or, "Oh, I made money." The other pro tip I would give out was thatKahneman's advice was to frown,because he found that if you frown,you are more willing to be critical of the information thatyou're being presented with. So,normally, I would say to smile more. But maybe, every once in awhile, throw a frown on your face if you're looking at information about a stock you hold, andmaybe you'll come to a new conclusion.
Harjes: That's super interesting. I think the next thingwe want to talk about is pretty related to that, because this peak-end rulesays that you most easily remember the very end of an experience. Thenext thing we want to talk about has to do with, how easy is it to think of an example that is relevant to the question that you're trying to answer? This is called theavailability heuristic. For example,you might be looking into a drugmaker that makes something for onespecific disease, and you'rewatching the company's numbers get bid up and bid up. That couldactually just be because acompany working in a similar space but with a totally different drug is seeing positive results. So,the way the availability heuristic plays in there is, it's easy to think on the top of your head, "Ijust saw a positive diabetes results the other day, thisunrelated diabetes company must be onto something good," and bid it up. It can bedifficult recallthe entire spectrumof everything that's ever happened. In fact, that would be totally impossible to do. But, the problem here is, we can rely a bit too much on the things that are readily able to be recalled.
Campbell:And one of the things, Kristine, I wanted to mention too, I worry thatpeople are going to fall into this trap for this biaswhen they're looking at and hearing about marijuana, and thereform that's going on with marijuana laws. A lot of positive momentumfor passing these laws, andtalking about the potential market opportunity formarijuana stocks. It would be very easy for people to take a brush stroke and say, "All of thesemarijuana stocks are going to do well," whenthe reality is that very few will end up being the winners.
Harjes:When one issue is in the news a ton, it'sso easy to think that it could impact your investment. But realistically, lawmakerscould be completely focused on different issues. And newsactually does relate to this quite a bit. For example,when you think about media coverage of different diseases, it can sometimesdrastically impact your view of the market. AndI think people are sometimes more inclined to bid up shares ofcompanies that are working in diseases that aregetting a lot of coverage as opposed to ones thatmight actually be much more prevalent and have a lot larger of a market, but you don't really hear about as much. Theexample that came to mind for me wasdiabetes spending vs. spending on ALS, which isLou Gehrig's disease, it's the one you heard about with the ALS Ice Bucket Challenge. ALS spending annually is estimated to be between $256-433 million nationally. If youlook at diabetes, just the direct medical costs are $176 billion,every single year.
Campbell: Yeah,it's a tremendous, huge market. The thinking there would be, "Any stock that hasanything to do with diabetes isgoing to be a stock that I want to own." Or,if you happen to be looking at a stock andyou happen to see the word diabetes andyou just read an article about the diabetes market, you'remore likely to be positively influenced in yourassessment of that stock. And that's risky. So,make sure you're slowing down, maybe frowning little bit, and thinking about the experience in all of the two plus twos, not just the end result,whatever that number might be at the end of the calculation.
Harjes: Right. We are almost approaching the end of the episode. We haveone more cognitive bias to share. This one is called substitution. It's basically replacing a complex issue with something simpler, because your brain iskind of lazy, whether you like to believe it or not. The way that I've heard this explained before is, it's an issue of changing a question like, "Howhappy are you with your life?" Which is a verycomplex question. You will instinctively turn that into, "What's my mood right now?" Which is aneasier question to answer.
Campbell: Yeah,substitution, picture a tab, and you have acheck mark in this column and a check mark in the other column, andit's all based upon, theexample, the memories, not the experiences. My finalmemory of the symphony, that was negative,so I'll put that in the negative camp. It's easier to say, "Idon't want to go to the symphony now becauseI had a bad experience at the last one," but that's notnecessarily the way that it is. Taking a look from a healthcare perspective, saying, "OK,do I really want to dig in and figure out howGilead Science'sclinical stage drug forautoimmune disorders isreally impacting the central nervous system or immune system, or whatever?Do I want to just say that they'vedone a great job in the past, so I'm going to assume that they have themanagement there to figure it out?"
Harjes: Right. Going back to the Linda problem from the earlier part of this show,Kahnemanand his research partner,Amos Tversky, argued that in judgingwhether or not it's more likely for Linda to have been a bank teller or a feminist bank teller, the people in the study relied on resemblance between Linda'spersonality andher behavior. So, that's an example ofsubstitution, because the people who were asked that question turned it from an issue that was aprobabilistic calculation into one of simply just matching up causes and effects. So, I guess, toend the episode today, the last thing I wanted to touch on is, we're biased even after being told that we're biased. This iskind of crazy, but here'sone final experiment for our listeners to chew on. Kahnemandescribes an experiment known as theInvisible gorilla. In this experiment,participants watched a short film of two teams passing basketballs. One team was wearing white shirts, the other team was wearing black. The viewers ofthe film were instructed tocount the number of passes made by the white shirt team, andignore the players that were wearing black. Halfway through the video, this woman is wearing a gorilla suit, she appears andcrosses the courts,she thumps on her chest and moves on. The gorilla is in the frame for about nine seconds. Andthousands of people have seen this video, but because they're socompletely absorbed in the counting task, abouthalf of them don't notice anything unusual when they're asked afterwards. And, even more interestingly, people who miss the gorilla areinitially extremely stubborn, saying that there was no gorilla. So, after you'velistened to this episode,I would encourage all of youlisteners to go through your portfolio, your track record, your diary of investing thesis, which you hopefully have, and try to spot the cognitive biases that may have subconsciously influence you. You may be surprised how many gorillas are lurking in plain sight. Todd, thank you so much fordoing this episode with me. I have had a blast.
Campbell: It was a lot of fun.
Harjes:As always, people on the program may haveinterests in the stocks that they talk about,and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's episode was produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!
Kristine Harjes owns shares of Gilead Sciences and Portola Pharmaceuticals. Todd Campbell owns shares of Gilead Sciences and Portola Pharmaceuticals. The Motley Fool owns shares of and recommends Gilead Sciences and Valeant Pharmaceuticals. The Motley Fool has the following options: short June 2017 $70 calls on Gilead Sciences. The Motley Fool has a disclosure policy.