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Coherent Arbitrariness Bias – Absolute Value vs. Relative Value

Saturday, March 3, 2018 0:46

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We are not very good at understanding the absolute values of products, but we are good at figuring out how much something is of value relative to other products.

Researchers asked subjects to assign values they would be willing to pay for a variety of different products, including a bottle of wine. However, they were first prompted to write down the last two digits of their phone numbers. This basically provided the subjects with an “anchor”. In other words, they were predisposed to certain numbers, which would influence future thought processes. You could have guessed that those who had higher last two digit phone numbers assigned higher values to the bottle of wine than those with lower last two digit numbers. One thing that was consistent was the relative ranking of the products. For example, cheese was ranked lower in cost than wine or rice lower than cheese. While the prices were arbitrary, the rankings were coherent hence “Coherent Arbitrariness.”

In investing, the investor may anchor against stock indices such as the S&P 500 or Russell 2000 and the stock’s 52-week low or high. This anchor can be seen as arbitrary because though indices are the average of the market, each stock is unique and its value can diverge from the mean.

Similarly, past performance is not indicative of future performance. Just because a stockwas trading at $230 per share and now is trading at $20 per share (such was the case with Valeant Pharmaceutical (VRX)) does not guarantee that the stock will eventually go back to $230 per share.

Next an investor typically will compare the attractiveness of the company’s stock against other stock of comparable companies. Studies have shown that when analyst want to argue that their selected stock is cheap, they would find peers with high valuations. This begs to the question whether or not the analysis is objective or not. Furthermore, two companies in the same industry with similar growth rates can still have different business models with differing returns on invested capital. Therefore, you may be comparing apples to oranges and come up with incorrect conclusions.

At the end of the day, the coherent arbitrariness bias is something we need to watch out for. While it may be useful in comparing consumer products, it can be tricky when it comes to evaluating securities. Too often we anchor our beliefs and therefore improperly value companies. As an investor, the remedy to coherent arbitrariness bias is to remain as rationale and objective as possible when evaluating securities.

Source: http://www.stockkevin.com/2018/03/coherent-arbitrariness-bias-absolute.html

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