Morning commuters walk on Wall Street in New York's financial district in this file photo.BRENDAN MCDERMID/Reuters
Have you come across the blue dress/gold dress debate?
It all started when Caitlin McNeill, a Scottish singer, posted a picture in late February of a dress worn at a wedding. This picture went viral, as viewers couldn't decide if it was a white and gold dress or a blue and black dress.
Part of the explanation for the differing opinions is pure human physiology – our individual genetic make-up determines the way we each perceive colours. But there is a behavioural component as well. We see what we want to see and believe what we want to believe. In behavioural finance circles, this is called the "confirmation bias" – a tendency to search for or interpret information in a way that coincides with our pre-conceptions. In the case of Caitlin's dress picture, I suspect that the people who sent it on to their groups with their own view had some impact, even if subliminal, on the way those members of their groups perceived the picture.
A perfect example was illustrated in a recent Harvard Business Review (HBR) article. Electrolux, the giant Swedish appliance maker, after having conducted significant market research, decided to offer their washing machines free of charge. The rationale was to forego the typical scenario of driving revenue from each unit sold. Instead, it implemented an advanced proprietary technology to charge their customers each time they used the machine. Despite significant evidence suggesting this approach would be a success, when Electrolux launched a pilot project in Sweden, the projected demand did not materialize and the product was shelved. Why?One explanation that the HBR article offers is that while this business model made economic sense, it did not coincide with customers' identification with their social group. Middle class consumers simply did not see themselves as renting appliances or paying per wash – something that they associated with low-income consumers. So even though consumers said at first that they wanted this free washing machine model, they changed their mind when they referenced their social group – they didn't want to be perceived as being unable to afford a washing machine.
Social group comparison has its limits. Taken too far, it has the potential to create serious harm to individuals. After all, while many people look to their social group to recommend a doctor or dentist, they don't then seek to compare their prescription or treatment plan with that of their social group. There is an implicit recognition that this comparison is wrong. Each individual's personal circumstances are different, as are their problems and, therefore, their solutions.
Similarly, investors have to beware of confirmation bias and social group comparisons. The best recent example is the Bernie Madoff scandal. His outsized returns turned out to be fabricated. Some of the reasons why Mr. Madoff was able to pull off this fraud were rooted in confirmation bias and social group comparison. Mr. Madoff's investors wanted to believe that Mr. Madoff could consistently generate above market returns and interpreted his falsified statements accordingly. And rather than doing their own due diligence and asking the tough questions, these otherwise sophisticated investors relied on the fact that members of their social group had made the decision to invest with Mr. Madoff.
The same can also be said about selectively filtering the news to confirm one's views. For instance, people have been worried that the stock market is over-valued since January 2013, when commentators first expressed their concerns. If you didn't balance these concerns with consideration of other evidence, you may have been tempted to follow along and time an exit from the market. No one, not even Warren Buffett (arguably the greatest investor alive), has consistently been able to time the market. Since January 2013, the S&P 500 Index has been up over 46 per cent. In this case, by placing too much importance on one view without getting the whole picture, you would have missed significant upside.
Being mindful of potential sources of bias – like confirmation bias or social group comparison – can help investors keep a long-term perspective as they navigate volatile markets.
Sam Sivarajan is head of investments with Manulife Private Wealth