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Taking a Second Look at First Impressions
Let the Facts Get in the Way of a Good Story
First impressions, as we know, can often be deceiving. In Jane Austen’s Pride and Prejudice, the heroine, Elizabeth Bennett, makes a decision about the character of the wealthy and handsome Mr. Darcy based on several erroneous misconceptions. In turn, Mr. Darcy is boorishly critical of Elizabeth from the first moment they meet. Acting on these first impressions turns out to nearly have disastrous consequences — a theme with which Austen was so intrigued that she originally titled the novel First Impressions.
Although Elizabeth and Mr. Darcy eventually overcome the barriers imposed by their joint rush to judgment, it’s quite common for all of us to place too much weight on our own first impressions.
In their book I (Doubleday, 2008), Ori and Rom Brafman describe a mother who brought her 2-year-old daughter to the emergency room. The girl was experiencing stomach pains (common enough in toddlers), but treating a small child depends heavily on a parent’s description of symptoms. The child’s mother was anxious and flustered and (in the eyes of doctors) “overconcerned” — just the kind of parent who would overreact to a simple ailment. The physicians sent the child home.
The next day, the mother reappeared with her daughter in tow, again complaining of stomach pains. This seemed to confirm the doctor’s initial diagnosis — that the mom was a hypochondriac — and they sent the girl home without running any tests.
On the third day, the mother and daughter returned with the same complaint, and faced the same response from the ER staff. Only this time, when the daughter lost consciousness, the doctors realized something was terribly wrong. Unfortunately, it was too late to save the child.
Physicians use the phrase diagnosis bias to describe the tendency to ignore objective data that contradicts an initial analysis. Once we’ve made even a preliminary judgment about an issue, we put blinders on and ignore data that might contradict our original assessment. Instead, we look for facts that support our original opinion. We spend far too much energy trying to confirm our initial diagnosis and too little effort trying to come up with reasons that would argue that point.
When it comes to studying a stock, once we’ve found a candidate and done that little bit of research that convinces us we may have found a winner, our brains switch gears. Instead of looking for reasons not to invest, we focus on all the reasons we can find to justify buying the stock. We become irrationally biased toward our initial diagnosis.
This tendency continues even after we purchase a stock. We downplay negative news about holdings — that would contradict our original diagnosis — and focus instead on the positive. Regrettably, having a rosy outlook can prevent us from taking action when conditions warrant.
Understanding diagnosis bias can go a long way toward correcting our mistaken first impressions. In the case of the toddler with a stomachache, doctors could have performed any number of additional tests and procedures when initially presented with a case.
When analyzing a stock, we can especially seek information to refute our initial assessment and study the risk factors that affect the firm’s performance. These are conveniently detailed by management in 10-Q quarterly and 10-K annual Securities and Exchange Commission filings.
We can avoid lowering our standards when a company reports poor financial results and resolve to take action to remove poorly performing companies from our holdings.
Whenever the outlook for our stocks becomes less clear, we can avoid making excuses for those companies simply because we became attached to them the first moment we started studying them.
Above all, the best antidote for diagnosis bias is to stick to a structured approach to stock analysis. Remember: Discipline is usually more important than conviction when making investment decisions.
Douglas is ICLUBcentral's product manager, helping develop the company's programs including Toolkit 6, myICLUB.com, and the Investor Advisory Service. He is also the author of several investing books, including The Pocket Idiot's Guide to Direct Stock Investing, The Complete Idiot's Guide to Online Investing, The Armchair Millionaire, and Investment Clubs for Dummies.