Halo Effect And Its Implications On Stock Investing

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Halo effect is a cognitive bias that influences our perception about a person/product/company by focussing on just one personality trait or characteristic of the person/product. It is the tendency for an impression created in one area to influence opinion in another area. This is a bias which can lead to biggest investment mistakes.

A strong opening to Rajnikant or Salman khan movies is a typical example of Halo effect. People making mile long queues for every new Apple product is another example.

Halo effect can also be seen when recent events influence our perceptions. Statistically, a place where a bomb blast has occurred a few hours ago is the safest place; as terrorists never try to bomb the same location twice with a few days - in fact, ever. Yet, the location of bomb blast gets perceived to be the most "unsafe" location in the minds of people for a few days. Same thing happens when investors make big investment mistakes in stock investment. A recent event of a big market decline makes a permanent unfavourable impression on investor's mind.

Halo effect occurs because of an evolutionary need for us to make quick decisions. It allows us to make those snap judgements especially when something unfamiliar comes our way. We are wired by evolution to make sense of our surroundings and make those snap judgements of fight or flight. A "shortcut" mechanism helps us form opinions quickly and influences our actions. Unfortunately, most of the times these opinions formed by us are wrong

Halo effect is closely related to likability factor, and familiarity breeds likability . The more familiar we are with a person or company, the more we tend to like them and hence we are likely to ignore their faults/short comings.

Halo Effect vs Stereotyping

Halo Effect is very similar to Stereotyping. So similar, that the two terms can be used interchangeably . However there are a few subtle differences between the two:

As shown by the above example of Shahrukh Khan, Halo effect and Stereotyping more often than not, lead to same types of conclusions but the path through which these conclusions are reached are different.

Sequence matters in Halo Effect:

What do you think of Alex and Jack from the following two statements?
Alex : Intelligent-hardworking-impulsive -critical -stubborn-envious
Jack: Envious-stubborn-critical -impulsive-hardworking -intelligent

If you are like most of us, you viewed Alex much more favourably than Jack. The first two traits tended to dominate the subsequent traits despite the fact that both had similar traits. So what was the difference? The difference was in the sequence in which the information was presented. Most of us have heard the joke of how a young man was chastised by the father of a church when he requested that he be allowed to smoke while he prays. But when his friend requested that he be allowed to pray while he smokes the request was readily accepted. The sequence in which information is presented plays a huge role in how the entire event   is perceived.

In school exams, a high score on first question ensures overall high score because of that first impression that is carried all the way til the end.

In office, the direction of a meeting and the subsequent decision usually gets influenced by the boss putting his point of view at the start of the meeting

The moot point is, first impressions matter. In public speaking, the audience makes a judgement about the speaker within first 5 seconds of the speech

Framing effects: The way the information is presented also matters

The way information is presented also matters a great deal. The statement that "odds of survival of open heart surgery are 90%" is more reassuring than the statement "there is a 10% mortality rate in open heart surgeries". Similarly, a food item being described as "90% fat free" will tend to sell more than a food item that declares "10% fat content".

Influence of timing of events:

Timing of events also plays a crucial role. We tend to see only what there is and ignore the larger perspective. This leads to over confidence and makes our decisions riskier . We also tend to be influenced by our recent experiences in a related event and try to take a not so appropriate stand.  A recent news of a plane crash makes us more fearful of flying, despite the odds of the crash not changing . People making a beeline outside ICICI banks ATMS during Lehman crisis is a case in point . There was so much panic that one false rumour is all it took to start a run to the bank

Reverse Halo effect

Sometimes, the negative trait of a person/company so dominates the perception about that person, that we fail to make an objective assessment about the person. Hitler is considered to be a mass murderer, perhaps the most evil person who ever lived and quite rightly so. Yet, he was also a charismatic leader who was responsible for great technological advancements in Germany. Yet no one talks about his leadership qualities and Hitler's name has become synonymous with "evil " .

Implications of Halo effect in Investing

Halo effect leads to the common investment mistakes and these investment mistakes can be avoided easily. The examples of influence of Halo effect in stock investing are numerous as enumerated below:

1.    Companies with familiar ticker symbols tend to trade at higher valuations than companies with difficult to remember ticker symbols.
 
2.    Likeability of the CEO makes a huge factor in the eyes of even seasoned investors. Big M&A deals get influenced by the likeability factor

3.    We have seen numerous examples of stocks getting re-rated just because a star manager joins the company. The business might be completed unrelated to the manager's past experience but who cares? Tata Elxsi got re-rated when Mr Ramadorai joined the company. Similarly, Apcotex got re-rated. CEBBCO had representatives from the Tatas on its board. Not surprisingly, it got a buy rating from all brokers. Only later the bad news related to its corporate governance slowly started making the rounds. Soon the stock crashed by more 80%. The best example of reverse halo effect in stock market is the tag of "PSU" on companies. All PSUs are trading at historical low valuations without regard to their underlying fundamentals. Same goes for the tag of "Power companies" "Infra companies". REC is perhaps the best example. It had the tag of both power and PSU and so got corrected to 50% of book value and a PE of just 2.3 and a dividend yield of 11%! Even after the negative affects of UDAY scheme were taken into account this is still a company that would continue to generate 12-15% ROE, and has a bright future with huge power demands in the country.

4.    Who hasn't tried to emulate ace investors to ride the gains? We have seen numerous examples of stocks jumping to new highs when the news that a top Investor like Mr. Jhunjhunwala or Mr Damani have invested in it. Not all of Mr Jhunjhunwala's picks have made money. Many investors lost big time when he sold Hawkins at low valuations and when he held on to stocks like Bilcare and Delta corp. Hawkins went on to be a 100 bagger in the next 12 years while BIlcare and Delta corp languished. 

5.   Time and again small cap stocks get touted as the next Infosys, the next Sun pharma etc. Imagine being told of a little known stock as the"next Infosys" in a cocktail party by a self styled "expert". Add to that the feeling of exclusivity you get when he whispers the stock name as if it's a great secret and if the news comes out, it will sky rocket- and you are sold!. ICSA was touted as the next Infosys only to crash 90% from its highs. Opto circuits was featured in the "Forbes best under a billion company" list and became a darling of investors for years. Only later the market realised the problems related to its high receivables and Opto circuits crashed from 330 levels to 16! Even seasoned venture capitalists fell into this trap when every other start -up marketed itself as the "amazon or Ola of xyz industry"

6.    In a bull market, halo effect from recent wins by novice investors tends to make them believe that they have superior stock picking capabilities. This overconfidence makes them take riskier bets on leverage. When the corrections happens, they pay dearly.

7.    We have seen stocks jumping on news containing adjectives like "capex", "expansion" "forward integration", "backward integration"  etc appear. Investors tend to latch on the stocks without digging deeper and then lose money

8.    Even the diligent investors get biased because of halo effect:
a.    We tend to make judgements about a company based on just one report on the company . If the first report that we have read gives a "sell" rating to the company we tend to discount the positives outlined in the next report .
b.    Many investors who tend to analyse a company get emotionally attached to the company. Familiarity breeds likeability and so they tend to view the company favourably and ignore the negatives

9.    Investors after a recent crash are more panicky and risk aversion despite valuations being much lower. The memory of the pain of recent crash clouds their judgement and instead of buying more they tend to wait on the sidelines missing out on valuable opportunities.

Lessons for the Prudent investor:

There are many lessons for the prudent investor here. Remember the following tips to prevent yourself from the scourge of Halo effect

1.    Do your own analysis. Don't buy stocks simply because a well-known investor has invested in it . They may go wrong.
 
2.    Don't depend in tips by those who call themselves "experts".

3.    Be extra careful when you hear of companies being touted as the "next Infosys", the "next sun pharma". Look at the fundamentals and buy with margin of safety

4.  Remember that an inherently poor business and poor business model cannot succeed no matter how talented the management is. Many investors bought Spicejet just because it was bought over by promoters of Sun TV, only to regret later. Airlines is an inherently bad business with huge government interference and factors like crude prices, government policies etc that are beyond the control of management.

5.    Try to look at a company holistically. If you make a favourable impression about a stock, follow Charlie Munger's advice and invert, invert . Think of scenarios of what may go wrong. Do the opposite when you find a stock being shunned by most people.

6.    Don't get too emotionally attached to stocks just because you own them or have done detailed analysis of them. The temptation will be high but be objective and give it a pass if you are not fully convinced.

7.    Don't be influenced by information that may not have bearing on the business. Many investors were not comfortable by the fact that the promoter of Acrysil India (a sink company) plays polo. Why? Because Polo gives you the image of a playboy rich guy who would rather while away his time in pursuits of pleasure and not work hard. Acrysil has multiplied its market cap by 10 times in past 4 years .

Psychology plays a major role in Investing. It is our constant endeavour to figure out the pitfalls in the cognitive process of investment process that may lead to not so wise decisions. Hao effect is just one of the many biases that influence our decision making process and it is important to recognise the threats posed by this bias. We will soon be back with more such biases so that you become a much wiser investor. If you can remember any example from your daily life or investment decision where halo effect played a role do let us know by writing about it in the comments.