Image Credit: Christophe Vorlet
By Jason Zweig | August 27, 2011
This week, the stock market sported a couple of halos.
Steve Jobs, the co-founder of Apple universally regarded as a visionary who saved the company, stepped down as chief executive — and his cool glow still clung to Apple. In Thursday’s falling market, its stock outperformed the Nasdaq index by 1.3 percentage points. On Friday, Apple closed up nearly 3%, again beating the Nasdaq.
Also Thursday, Bank of America announced a $5 billion investment from Berkshire Hathaway. That vote of confidence from Berkshire’s chairman, Warren Buffett, not only sent Bank of America’s stock up by $18 billion at its high for the day; it may have added billions more to the market value of the shares of other banks like Citigroup and Wells Fargo (also a Buffett holding).
In both cases, what psychologists have christened the “halo effect” was at work. In this quirk of the human mind, one powerful impression spills over onto our other judgments of a situation. The effect was first documented in the U.S. Army decades ago, when soldiers who earned high scores from commanders for one quality (such as neatness) also got high marks for entirely unrelated qualities (such as loyalty and physical strength).
Halos can be cast by many aspects of a company. Consumers who know a firm is highly profitable are more likely to believe its products are high-quality and its advertising honest. That helps build loyalty among customers, making companies more resistant to competition. And if you love a company’s products, it is natural to conclude that it has superior management, too.
The aura of cool that Steve Jobs has cast over Apple’s products has turned customers into religious believers, many of whom undoubtedly use their Macs or iPads to buy the company’s stock and their iPhones to check the share price. Mr. Jobs’s brilliant design sense makes Apple’s products — and everything else, including the stock price — seem attractive. Apple’s zealous fans aren’t likely to believe that its magic can be extinguished by Mr. Jobs’s resignation.
Likewise, Mr. Buffett’s reputation for probity and unrivalled investing record can cast a warm glow over the stocks he buys. In 2008, Goldman Sachs Group got the same kind of boost from his buying that Bank of America got this week. That is partly because many money managers, and countless individuals, copy any trades Mr. Buffett discloses.
If earnings at Apple and Bank of America grow robustly, the stocks could even be cheap at today’s prices.
But halos also can lead investors astray. As management professor Phil Rosenzweig points out in his book The Halo Effect, a soaring stock price can lead investors to regard the company’s managers as focused, disciplined and passionate — while, in the negative halo of a falling stock price, the same executives will now seem stubborn, unimaginative and resistant to change.
Investors think, at either time, that they are evaluating the stock and the managers independently, but one opinion inevitably colors the other, often leading investors to be too bullish on the upside and too bearish on the downside. The managers haven’t changed; our perceptions of them have.
Just think of Cisco Systems’ chief executive, John Chambers, whom a major business magazine once called “the world’s best CEO” shortly after Cisco became the world’s largest stock by market capitalization. Have Mr. Chambers’s skills faded, or has the fall in the stock simply changed how investors see him?
The trick, then, is to recognize that halos can be valuable without letting them hijack your determination of value.
You can adapt a procedure described by the Nobel Prize-winning psychologist Daniel Kahneman — who is widely admired for his insights into decision-making — in his forthcoming book, Thinking, Fast and Slow. Start by identifying a handful of objective factors that you believe can predict superior returns. You might, say, include low debt as a percentage of total capital, stable earnings growth, high return on equity, low price relative to earnings and a history of raising prices without losing customers.
For any prospective investment, rate each of these financial factors on an identical scale — say, from 0 at the bottom to 5 at the top. Then add a final, subjective factor: your overall intuitive impression of each company and its management, rating them on the same scale. Finally, total all the scores and divide by the number of factors; the company with the highest average is the one you should favor.
This way, even while acknowledging the warm glow that a company throws off, you won’t let yourself be completely dazzled by the halo.
Source: The Wall Street Journal, http://on.wsj.com/2wC3zFk
For further reading:
Definitions of BEHAVIORAL FINANCE, IRRATIONAL, MANAGEMENT in The Devil’s Financial Dictionary
Chapters Six and Seven in The Intelligent Investor
Daniel Kahneman, Thinking, Fast and Slow
Phil Rosenzweig, The Halo Effect