Human beings are naturally wired to make quick judgments. Studies have shown that, when meeting someone new, a first impression can form in as little as a tenth of a second — and the impact can last for the life of the relationship.
“First impression bias” is a problem on Wall Street, too. It impacts everyone from individual investors to futures traders to professional equity analysts. The first impression that develops can lead to a permanent emotional bias — even when facts and circumstances change.
For traders, first impression bias can even color a whole career. Richard Dennis, the legendary trend follower who turned a $400 trading stake into more than $200 million, and then trained and funded a wildly successful protege group nicknamed “the turtles,” described this as a form of imprinting. In his Market Wizards interview Dennis said:
“There are a lot of people who get imprinted like ducks. You can teach them that a warship is their mother if you get them young enough. For a lot of traders, it doesn’t matter so much whether their first big trade is successful or not, but whether their first big profit is on the long or short side. Those people tend to be perennial bulls or bears, and that is very bad. Both sides have to be equally OK. There can’t be anything psychologically more satisfying about one than the other. If there is, your trading is going to go askew.
I think that is what happened to a lot of people in the 1973 runaway bull market in soybeans. Even if they didn’t make money themselves, but were just present to see the market mania and see a few people make a lot of money, they were imprinted with it.”
First impression bias hurts professional equity analysts and individual stock investors, too. This was confirmed by research from David Hirshleifer and Ben Lourie at University of California Irvine, in collaboration with Thomas Ruchti at Carnegie Mellon University, and Phong Truong at Pennsylvania State University.
Their joint research paper, “First Impressions and Analyst Forecast Bias,” looked at equity analyst behavior based on whether their initial view of a company was positive or negative. By examining thousands of data points, they confirmed that analysts with a negative starting point tended to stay biased towards pessimism more than warranted, with the reverse holding true on the optimism side.
This shows that, even for professionals, it’s easier to stick with a given point of view than update it properly with new facts and circumstances. There is another study that shows how first impression bias hurts individual investors, too.
Katrin Gödkerof of the University of Hamburg, and Peiran Jiao and Paul Smeets of Maastricht University, report a “self-serving memory bias” in the investor group they studied.
“Subjects who previously invested in a risky stock are more likely to remember positive investment outcomes and less likely to remember negative outcomes,” they write in their research paper, “Investor Memory.”
They further note that subjects who only observed, but did not invest, “do not have this memory bias,” and that subjects “do not adjust their behavior for the fallibility of their memory.”
This creates the potential to throw good money after bad, as the investors they studied “form overly optimistic beliefs and re-invest in the stock even when doing so reduces their expected return.”
So how do we guard against first impression bias — or find a way to beat it? The most basic solution is seeking input from a neutral third party — or from algorithms that don’t have first impressions at all.
The beauty of a well-designed algorithm, or some other software-based analysis tool, is that it will only “see” exactly what it is told to see. The data is the data and that’s it.
There aren’t any emotions to cloud the algorithm’s judgment; it weighs old information and new information exactly the same (or with whatever balance ratio is deliberately programmed into it).
The ultimate way to beat first impression bias might be having Mr. Spock, the famously detached Vulcan from Star Trek, as your personal investing assistant. Spock could then give you real time feedback, based on data, as to whether decisions were logical or illogical.
Because Spock is not available, though, we can turn to something almost as good and in some ways even better — investment software. While human skill and judgment are still highly valuable to the investment process, investment software can play a big role in neutralizing first impression bias (and many other cognitive biases).
Richard Smith, Ph.D.
CEO & Founder, TradeSmith