Investors find it hard to escape Optimism Bias

Some biases are so pervasive that adjustment is hard; optimism is such a deep rooted aspect of investor psychology that its impact is usually missed. A recent book, Fish Can’t See Water, describes the way in which an aspect of the environment or culture is embedded so widely that it becomes invisible. Yet, though never entirely absent from markets, optimism can ebb and flow. Understanding its changing characteristics can be useful, and closer analysis reveals more troubling recent patterns.

Optimism owes its long term persistence to its value. It is a helpful trait, along with patience, to achieve the waiting that investors need. It takes time to capture equity risk premiums, and investors need to ride out a lot of anxiety during the journey. And a deep-seated belief on long term economic and corporate growth underlies most equity investors. A bias to optimism was undoubtedly helpful for investors who held tight in late 2008, and kept faith through the 2009 recovery even when hard evidence was limited.

But it can get out of hand, and too readily run away into exuberance. There are always some signs if this, but the most interesting indicators are not necessarily the high level of markets or even for share ratings. IPOs are one indication of belief in growth. Twitter’s IPO might have captured the headlines, with its float at 10x book value and 50x price to sales, but many other new issues also embed a lot of optimism. Yet this may not represent a market extreme. The number of IPOs is still well short of the 1999/2000 peak, and the rate of activity does not by itself confirm excessive optimism.

But there are other signals of subtle changes in the bias. One new market pattern is a belief in turnarounds. Unprofitable businesses represent an astonishing 61% of company IPOs, the highest level since 2000. This is not always obvious in the presentations that new issues give, so prevalent is the use of the term ‘adjusted’. Many companies are freely wishing away significant costs as somehow exceptional, or use options to pay executives. The true cash flow can be hard to see. Interestingly, presentations that mention “growth” the most, are also typically the most leveraged businesses.

It is not just IPOs that are being backed to reinvent their business model and achieve profitability. Many banks, such as Barclays, also need to change. Shareholders are not just reflecting a general optimism about economic growth, but hopes for a transformation of bank culture and an end of returns that lag cost of capital. The high rating for the bank sector despite its underlying challenges, represents a new phase of investor optimism. Surprisingly, Barclays shares with Twitter heavy repetition of the “adjusted” word in its presentations. Barclays Q3 IMS used the term 99 times, Twitter’s prospectus, 68 times.

The human bias to accentuate the positive is understandable, and allows resilience in the face of adversity. And there has been little reward this year for pessimism. But the recent trends show a remarkable faith in unproven business models, relying on figures flattered by unaudited accounting adjustments. Investor beliefs are beginning to run ahead of hard analysis. Within the IPO boom are many businesses that are only floating because they have consistently lost money. Investors need to discriminate between companies that just need some help from economic growth, and those that are almost entirely dependent on management to deliver a brand new business model.

A version of this article appeared Citywire Wealth Manager on December 4th 2013.
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By Pumbaa80 (Own work) [Public domain], via Wikimedia Commons
Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.