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This is clear evidence of conservatism bias in action. Montier's research documents the behavior of securities analysts, but the trends observed can easily be applied to individual investors, who also forecast securities prices, and will cling to these forecasts even when presented with new information.
Figure 4.1 Montier Observes That Analysts Cling to Their Forecasts
Source: Dresdner Kleinwort Wasserstein, 2012
Implications for Investors
Investors too often give more attention to forecast outcomes than to new data that actually describes emerging outcomes. Investors are sometimes unable to rationally act on updated information regarding their investments because they are “stuck” on prior beliefs. Box 4.1 lists three behaviors stemming from conservatism bias that can cause investment mistakes.
BOX 4.1 Conservatism Bias: Behaviors That Can Cause Investment Mistakes
1 Conservatism bias can cause investors to cling to a view or a forecast, behaving too inflexibly when presented with new information. For example, assume an investor purchases a security based on the knowledge that the company is planning a forthcoming announcement regarding a new product. The company then announces that it has experienced problems bringing the product to market. The investor may cling to the initial, optimistic impression of some imminent, positive development by the company and may fail to take action on the negative announcement.
2 When conservatism-biased investors do react to new information, they often do so too slowly. For example, if an earnings announcement depresses a stock that an investor holds, the conservative investor may be too slow to sell. The pre-existing view that, for example, the company has good prospects, may linger too long and exert too much influence, causing an investor exhibiting conservatism to unload the stock only after losing more money than necessary.
3 Conservatism can relate to an underlying difficulty in processing new information. Because people experience mental stress when presented with complex data, an easy option is to simply stick to a prior belief. For example, if an investor purchases a security on the belief that the company is poised to grow and then the company announces that a series of difficult-to-interpret accounting changes may affect its growth, the investor might discount the announcement rather than attempt to decipher it. More clear-cut and, therefore, easier to maintain is the prior belief that the company is poised to grow.
Am I Subject to Conservatism Bias?
The following diagnostic quiz can help to detect elements of conservatism bias.
Conservatism Bias Test
Question 1: Suppose that you live in Baltimore, Maryland, and you make a forecast such as, “I think it will be a snowy winter this year.” Furthermore, suppose that, by mid-February, you realize that no snow has fallen. What is your natural reaction to this information?
1 There's still time to get a lot of snow, so my forecast is probably correct.
2 There still may be time for some snow, but I may have erred in my forecast.
3 My experience tells me that my forecast was probably incorrect. Most of the winter has elapsed; therefore, the cumulative amount of snow is not likely to be significant.
Question 2: When you recently hear news that has potentially negative implications for the price of an investment you own, what is your natural reaction to this information?
1 I tend to ignore the information. Because I have already made the investment, I've already determined that the company will be successful.
2 I will reevaluate my reasons for buying the stock, but I will probably stick with it because I usually stick with my original determination that a company will be successful.
3 I will reevaluate my reasoning for buying the stock and will decide, based on an objective consideration of all the facts, what to do next.
Question 3: When news comes out that has potentially negative implications for the price of a security that you own, how quickly do you react to this information?
1 I usually wait for the market to communicate the significance of the information and then I decide what to do.
2 Sometimes, I wait for the market to communicate the significance of the information, but other times, I respond without delay.
3 I respond without delay.
Test Results Analysis
People answering “a” or “b” to any of the preceding questions may indicate susceptibility to conservatism bias.
Investment Advice
Because conservatism is a cognitive bias, advice and information can often correct or lessen its effect. Specifically, investors must first avoid clinging to forecasts; they must also be sure to react, decisively, to new information. This does not mean that investors should respond to events without careful analysis. However, when the wisest course of action becomes clear, it should be implemented resolutely and without hesitation. Additionally, investors should seek professional advice when trying to interpret information that they have difficulty understanding. Otherwise, investors may not take action when they should.
When new information is presented, ask yourself: How does this impact my portfolio? Does it actually jeopardize my forecast about how my portfolio will perform? If investors can answer these questions honestly, then they have achieved a very good handle on conservatism bias. Recognizing conservatism can prevent bad decisions from being made, and investors need to remain mindful of any propensities they might exhibit that make them cling to old views and react slowly toward promising, emerging developments.
Notes
1 1 James Montier, Behavioural Finance: Insights into Irrational Minds and Markets (West Sussex, England: John Wiley & Sons, 2002).
2 2 James Montier, “Equity Research” (research report, Dresdner Kleinwort Wasserstein, 2002).
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