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Thomas Macpherson
Thomas Macpherson
Articles (183)  | Author's Website |

Extreme Markets and Decision Making

August 27, 2015 | About:

In 1815 at the battle of Waterloo, forces of the Allies defeated the Napoleonic forces in a violent two-day battle. The leader of the British forces, Lord Wellington, was famously quoted as saying it “was the nearest run thing.” Less quoted but far more interesting in our eyes was his response to the question of how he defeated the greatest living general of his time. “Oh,” he responded, “They came at us in the same way and we beat them back in the same old way.” Napoleon was suffering from confirmation bias – the idea that what had worked so many times before would work again. In his eyes, how would an army of shopkeepers stand against the flower of the French army?

We think this story is quite illustrative in today’s markets. We often hear about confirmation bias during bull markets, but we rarely hear about it in the context of buying stocks during market crashes. During days when the markets drop by more than 5% and some stocks on your watch list drop in synch, do you often think bargains are to be had? Do you immediately see bargains where there were none just the day before? You wouldn't be alone. We all suffer from confirmation bias.

But drops of 10% to 20% do not guarantee great investment opportunities. As usual, the drop in price must be put in the context of value. We believe the past few days have shown an enormous reaction based on confirmation bias.

To See and Not Believe

In Daniel Gilbert’s published article “How Mental Systems Believe[1]”, he wrote that understanding a statement begins with our attempt to believe it. Danny Kahneman is his “Thinking, Fast and Slow” stated that this attempt at believing is the basis for confirmation bias. He wrote, “You must first know what the idea would mean if it were true. Only then can you decide whether or not to unbelieve it. [2]” He went on to describe the attempt to believe is processed through System 1 (the more automatic and accepting process) while attempting to unbelieve (or test the idea) is processed through System 2 (more associated with critical thinking).

The past week has greatly activated many value investors’ System 1 thinking. Huge drops in the markets must mean there are significant values to be had if you only look close enough. On Monday, anchors on Bloomberg stated they heard investors were purchasing stocks “with both hands” and “hand over fist.”

But is it really the best time to buy shares in the market? We would propose that confirmation bias is as dangerous in market drops as it is in bull markets. Just because a stock has dropped suddenly by 10% does not make it an automatic value. Even though every emotion in our investing mind is telling us to buy, we must engage our System 2 and engage in critical thinking. More importantly we must focus on one specific question: What is the new price relative to the company’s value?

Confirmation Bias: A Working Example

As an example of this we wanted to use one of our current holdings – Ansys (NASDAQ:ANSS). We first purchased its shares in December 2008 at $28.14 per share. On Aug. 21, the shares peaked at roughly $97 per share. Within the two trading days, the stock price had dropped to roughly $86 per share. During trading on Aug. 24, the stock was briefly down 8%. By the end of that day several individuals had written to me asking if we would be purchasing additional shares.

I must admit out initial reaction was to salivate at the price drop. Over the next 24 hours we took a look at the history of our holding, its valuation and its price movement. On Oct. 24, 2014, the stock was priced at roughly $72 per share. In January of this year we estimated an intrinsic value of $84 per share. By August, when the stock was trading at $97 per share, we believed the stock was priced roughly 15% above fair value.

The rapid drop of 10% during Aug. 21 to 24 had simply brought the shares in line with our estimates. It was still trading for $12 per share more than it was less than nine months before. If we didn’t purchase it in October 2014, then why would we purchase in August 2015? With our intrinsic value being static, the decision to pass was a not a hard one. But getting to that decision certainly was difficult. Confirmation bias – processed by System 1 – instinctively informed us a large price drop in a short time should be a buying moment. Only upon using System 2 were we able to critically analyze these emotions and make a more reasoned decision.

Switching Systems: Mauboussin’s Checklist

In Michael Mauboussin’s great book “Think Twice: The Power of Counterintuition [3],” he suggests a checklist of five steps to avoid focusing on only System 1 thinking. In regards to the questions of purchasing additional shares in ANSS, they provided significant value in the decision making process. These include:

Explicitly Consider Alternatives: By reviewing Ansys’ past price history, its valuation and our investment thesis, we found that such a significant price drop was inconsequential to purchasing the stock or changing our valuation.

Seek Dissent: Within an hour of discussing the stock, several individuals pointed out that the price drop didn't offset the run up over the past nine months. This forced us to broaden our outlook.

Keep Track of Previous Decisions: Because we outlined our investment thesis and detailed our valuation methodology, we were able to see that the price drop simply brought the stock in line with our current valuation model.

Avoid Making Decisions While at Emotional Extremes: Certainly when the Dow drops by over a 1000 points or the Nasdaq drops by 11%, the adrenaline starts to flow. It turns out that would have been exactly the wrong time to make the investment call.

Understand Incentives: We aren’t paid by the amount of trades. We are paid for performance with a risk incentive to protect to the downside. This form of incentive forced us to pause and reflect on both the risk and uncertainty of purchasing more shares in ANSS.


The ability to avoid confirmation bias – both on the upside and downside – becomes critical on days of extreme market gyrations. Sudden price movements can be incredibly tempting times. The emotional and intellectual pressure to act combined with our experiences make it vital to step back and allow our second systems time for critical thinking. In doing so, we can become far more successful in our decisions. Who knows, it might even prevent your own investing Waterloo.

[1]How Mental Systems Believe” Daniel Gilbert, American Psychiatrist. Volume 46, Number 2, February 1991.

[2]Thinking, Fast and Slow”, Daniel Kahneman, . Penguin Books Limited, 2011. p. 81.

[3]Think Twice: The Power of Counterintuition”, Michael Mauboussin, Harvard Business Review Press, 2012

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website

Rating: 4.2/5 (5 votes)



Dr. Paul Price
Dr. Paul Price - 4 years ago    Report SPAM

Maybe the right question to have asked in early August was, "Why don 't we sell ANSS since it is already 15% ahead of what we think is fair value?"

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Paul. Thanks so much for your comment. We sold 25% of the position in July and decided to hold on to the rest. We generally sell 25-50% when we reach a 15-20% above fair value and sell out entirely at 140% (like we did with FDS and MANH). To your point - and with 20/20 hindsight - we likely should have sold the entire position. Perhaps a bit of anchoring held us back. As of now we will hold on for the foreseeable future. Thanks again for your comment. Best. - Tom

Jtdaniel premium member - 4 years ago

Hi Tom,

Thank you for a most interesting and enlightening article. I made only one purchase during the quick correction. Exxon-Mobil stock finally dropped below my $70 target price this week. I was hoping the bottom would fall out of Wells Fargo or Nestle, but no such luck. Maybe next time. Best, dj.

Carlos premium member - 4 years ago

Thank you Tom. It helped me to understand the concept of confirmation bias.

Tonybuffett - 4 years ago    Report SPAM

I'm so glad you're still writing pieces! I thought you stopped writing :( Great piece as usual. I missed the 1000 point drop on Monday as i was sleeping after a busy weekend at work but it was a wild one!
PS: Did you seperate yourself from Nintai and doing your own now?

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

DJ and Carlos: Thanks so much for your comments. Glad you enjoyed the article. As we reviewed our thinking, it suddenly dawned us that confirmation bias can kill you in both selling AND buying for the wrong reasons during down markets. It isn't discussed much but we have a feeling it's far more prelevant than we think. Another example of this was a litany of famous value investors doubling down on financial stocks in 2008-2009. We would posit that many thought purchasing additional shares was taking advantage of a market downturn (confirmation bias because it had always worked) versus really evaluating the fundamentals behind the business (such as credit risk). Thanks again for your comments. Best. - Tom

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Tony: Thanks so much for your comment. I'm still here (some may see this as a negative!) and regularly writing for GF. Nintai Partners has officially dissolved and I'm currently CIO of the Nintai Charitable Trust. In addition, I've been working with Dorfman Value Investments (John is a writer here on GF) as Director of Marketing. I'm currently getting ready to pass the Series 65 and become a more traditional RIA in the next quarter. Thanks again for your comment. Best. - Tom

Tonybuffett - 4 years ago    Report SPAM

@Tom: Thanks for commenting back and hope you stay with GF for a long long time!

Adib Motiwala
Adib Motiwala - 4 years ago    Report SPAM

thanks for sharing Thomas. I did nothing on monday. did not buy or sell...but it does seem for a brief while some stocks were down 15-20% and could have been good bargains.

Coming to the point raised by Dr Price, why do you hold on to your positions much higher than your estimate of value. Is it because

1) your estimates are conservative and you have often sold early so want to capture more

2) you acknowledge the momentum factor that can take stocks from a certain level to much higher coz the 'stock is working'.?



Batbeer2 premium member - 4 years ago

@ Adib

You say:

Coming to the point raised by Dr Price, why do you hold on to your positions much higher than your estimate of value. Is it because

1) your estimates are conservative and you have often sold early so want to capture more

2) you acknowledge the momentum factor that can take stocks from a certain level to much higher coz the 'stock is working'.?

There is at least one rational alternative.

Let's say you've selected a handfull of growth stocks that you'd like to own.

For example, you would want to own Costco for the next few decades but not at any price. You peg the value at $150. Just to be safe, you wait patiently for a chance to buy if/when that stock dips under $100.

So one fine day it dips and you pounce. The stock subsequently runs up; it becomes expensive but your analysis shows the intrinsic value is compounding at satisfactory rate. By your estimate, the intrinsic value is now $200 but the price is $300.

Nevertheless, you tell yourself that as long as:

1) You bought at a discount to intrinsic value and

2) the intrinsic value is compounding at a good rate,

you have absolutely no reason to sell. You will do well over time and you won't need to spend much time tracking stock prices.

I'm not saying that's the best strategy for anyone but it is rational. You are not trying to outsmart mr. Market by buying low and selling high. You'll note Mr. Market exists precisely because everyone out there thinks they can second-guess the rest. Unsuprisngly, the aggregate behaviour is quite often asinine. NOT playing that game may be the best decision a given investor can make.

Just some thoughts.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Adib. Thanks so much for your questions. I think the answer would certainly be more of # 1 than #2. If I was completely honest I would say the thinking behind letting the stock ride up to 40% above fair value would be:

40% - We are conservative in our estimates and we are comfortable hanging on. By this we mean we are comforable the company will continue to compund value and see no reason to sell immediately.

40% - Sloth, Indolence, and Taxes: We are frequently not watching the markets enough to sometimes see these upwards movement. In addition we rarely like to take capital gains so we probably hold longer than we should.

20% - Anchoring: It's incredibly hard to see a stock leave your portfolio after a long, succeful run. Though this is entirely counterproductive, we likely suffer from it just as much as everyone else.

Hope this helps. Thanks again for your great questions. Best - Tom

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