Tuesday, August 4, 2009

Know Your Biases: Irrational Escalation

Have you ever tried to play poker using a system? If so, then you know that a large component of any poker system tells you when to fold - especially, right after the ante. Another component of a good system confines heavy betting to a hand only above a specified value.

One of the frustrations in using a system like that is the restraints imposed when someone else bets big with little evidence of a high hand to back it up. It does hurt to throw away a hand only to learn that an opponent was bluffing with a lower-valued hand. Often, it irritates; in so doing, it creates a fertile emotional field for irrational escalation.

According to Wikipedia, "Irrational escalation" refers "to a situation in which people can make irrational decisions based upon rational decisions in the past or to justify actions already taken." It's closely related to the sunk-cost fallacy, in which the amount of money already thrown in determines or heavily influences the decision to throw more money in now.

Simply put, this bias surfaces when an unexpected and frustrating result makes us mad enough to push harder and escalate our commitment. It's the bane and plague of value investing.

After all, a lot of value investing consists of throwing good money into good stocks with bad price trends. If I thrown a haunch of money at a stock at $10 or so, see it go down to $8, throw more money in, see it go well below $8, throw a little more in, etc., am I beholden to sunk-cost bias? Am I averaging down into a increasingly cheap value play? Am I under the sway of irrational escalation?

The fascinating aspect of value investing is that all three of those questions can be answered with "yes" if asset allocation theory is factored in. I believe that many of the great value investors sometimes use their all-too-human tendency for escalation of commitment to buy cheap stocks even more cheaply. The difference between they and the more hapless kind of investor is a careful lookout for red flags, which help minimize irrational escalation. These red flags are picked up through experience, particularly bad experiences. The trade knows them as "value traps." Put as simply as can be, a value trap is a company that has a knack for inflaming a value investor's irrational-escalation bias.

For example, a low P/E stock shows up in the Low P/E Bin. Its stock price in a downtrend, and a study of the company's financials indicates that it's a cyclical company. The last recession, the company's earnings bottomed out with losses. Losses haven't shown up so far, despite the progress of the recession, but the last time the same company showed losses was in 2002. If it showed losses at the end of the last recession, its time for losses may very well be the end of this one. On the other hand, it may have beat the cycle this time.

It's clear from a study of the long-term financials that this stock runs a real risk of showing losses this year. If I go in, I might be bailed out by a rising market even if the company does go lossy...but that's a hope, not a solid basis for investing. It may also have a low P/E as based on its ten-year earnings, but it still has the potentiality of being a short-term value trap. Such companies, I suggest, are best not doubled down on if invested in. At the very least, they tie up capital for an extended period of time while throwing the entire portfolio out of balance. Moreover, we only know the end of the trough in hindsight. It can get worse than we imagine.

Some of the red flags are subtle, as well as debatable. When I highlighted Harvest Energy Trust as a value stock, I was going against a red flag that many experienced investors use: "Don't bother to invest in a currently-profitable company that's likely to show a loss in the near future, no matter how cheap it is with respect to book value. Such companies can become a lot cheaper in a hurry. It's best to wait until the dust settles."

Harvest has turned around largely because natural gas and the crack spreads have reversed course, as of now. In retrospect, I was counting upon economic recovery and inflation seeping in. If I end up being wrong, I will have stuck a fair bit of imaginary dollars in my actively-managed Marketocracy mock fund into a large and sustained value trap. Had I been value investing for real, it would have been real dollars in that trap.

To return to the poker analogy, a value trap is a lot like a known bluffer that bets meekly, then aggressively, then meekly again, then aggressively with his or her usual air. Then, when the fur stops flying, (s)he lays down a full house.

Once burned, twice knowing.

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