‘If the facts don’t fit the theory, throw out the facts’ – Albert Einstein
We tend to mistakenly believe that, for the most part, we make decisions rationally. In reality, we are prone to a range of non-rational influences – cognitive biases – when assessing uncertain events or making decisions in the face of uncertainty.
While we remain unaware of their influence, those affect the quality of our decisions and can create a number of dangers for hedge fund and private equity investors who each make several investment decisions every year, based on limited data points, and where long feedback loops often lead to skills being confused with luck.
For example, representativeness is a pattern-matching bias in which a person assesses risk based on how closely one situation resembles another, ignoring relevant statistical facts.
When an investor considers a potential asset in an industry he or she knows well, he or she becomes susceptible to confirmation bias, a tendency to search for, or interpret information in a way that confirms one’s preconceptions.
Anchoring is a tendency to rely too heavily on one factor or piece of information when making a decision. It often comes disguised as hard won experience, and painful experiences tend to create strong anchors. For example, if a promising portfolio company fails because of the CEO’s technical failings, one is likely to be extra sensitive to the technical expertise of CEOs in the future, regardless of the importance for that factor for a particular company. As a result, one becomes oblivious to other points of view and immune to contradictory evidence.