I heard an interesting piece on NPR the other morning while I was driving to work. It was about the power of perception – in this case, how it relates to golf. A researcher at Purdue University did an experiment using an optical illusion to change the appearance of the golf hole. She found that, even when the holes were exactly the same size, participants were more likely to sink the putt when they perceived the hole to be bigger than it actually is. Here is an example (it’s called the Ebbinghaus illusion):
The conclusion is that with positive perception comes confidence. However, confidence alone won’t guarantee top performance, at least not in sports. And not in finance, either – the piece reminded me of something psychologists call overconfidence bias. Basically, people have a tendency to believe their predictions are far more accurate than they actually are. And the interesting thing is, the more a person is considered an “expert” the higher their level of overconfidence. Their increased knowledge of a particular topic leads them to believe they are correct far more often than they actually are. Even better, researchers who have studied this phenomenon find that the worst performers tend to be the most overconfident. And of course, if you were to ask a panel of experts to rank themselves against their peers in terms of their abilities, each would most likely rank himself as above average. The same way everyone is an above average driver, or has a good sense of humor, right? It’s statistically impossible, but there you have it.
So if the experts don’t have good predictive abilities, why do we use analysts’ forecasts at all? Well, you have to start somewhere. Psychologists call this anchoring – the need to grab hold of something in the face of uncertainty. When we review a particular company’s equity, we study a variety of research reports and consensus estimates. Sometimes the predictions vary widely, other times the range is pretty tight. We start with these and run different scenarios, in the belief that the outcome will lie somewhere between the best- and worst-case. We always view the analysts’ estimates with a critical eye and make adjustments for those that seem overly optimistic, in order to predict a more realistic outcome. Of course, this is also why we are strong advocates of a well-diversified portfolio – we know that predictions are only that, and anything can happen. Proper diversification dampens the effect that an unforeseen negative outcome in any one security will have on the portfolio as a whole.
The good news is, you can improve your putting with a little optical illusion. Feel free to take a little cutout of small circles to overlay the hole next time you go. Nobody will think you’re crazy or anything.
Sarah DerGarabedian, CFA
Director of Research