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the psychology of successful trading

The Late Evaluation Effect And Financial Markets

Introduction

It is no secret that people dislike working hard.  The corollary is that they like not working hard.  This much is well-known, but perhaps less obvious is that this can affect our judgments.  This is called the Late Evaluation Effect. We tend to be more positive about things we saw most recently or have looked at before.

Various experiments show that if a scenario is arranged such that the people involved are having a better time, or working less hard, they will make more positive judgements.  This can be quite alarming.  For example, it has been shown that judges making parole decisions are more likely to be lenient right after lunch and more strict before it.

New Data on the Late Evaluation Effect

A recent experiment has expanded this literature in a direction which I think is interesting in a financial markets context.  The University of Virginia’s O’Connor and Cheema, writing in Psychological Science in the issue of 01 May 2018, describe a bias of this type.  See: https://journals.sagepub.com/doi/abs/10.1177/0956797617744517

I will term it the Late Evaluation Bias.  They observe the following.

Evaluations become more positive when conducted later in a sequence

The authors examined three particular types of evaluation.  Firstly, they looked at judges from 20 years of Dancing With The Stars. Second, university professors who had taught the same course for several years. Thirdly, they investigated people judging short stories over a couple of weeks.  In each case, they found that evaluations became more positive as time went on.

People find it easier to do something when they have more practice doing it.  This means they need to put in less effort so they will find it less like hard work.  This is fine, but the strangeness is that this will then lead them to make more positive evaluations. This is a bias since it will lead to a systematically false evaluations.

The Late Evaluation Effect in Financial Markets

How might this play out in financial markets?  One simple and obvious answer is that investors will tend to be more positive than they ought to be when evaluating a stock they have evaluated many times before.  Someone who has looked at owning GE stock many times in the past will be more likely to find it easier to do again. They will therefore be more likely to come to a positive decision on that stock.  Clearly GE stock does not get any better because you looked at it before.

This could feed into bubbles such as Bitcoin. However, there is no reasoned positive evaluation possible of that cryptocurrency since it is valueless on fundamentals.

Similarly, people will evaluate asset classes with which they are more familiar more positively than they ought to.  This explains why investors tend to be over-invested in their home markets. That particular bias is extremely dangerous. Some Brexit voters for example have their entire portfolios in the UK, which is madness. Some geographical diversification is always beneficial.  

Photo by Andrea Piacquadio on Pexels.com

There is no need to combat lack of diversification by entering risky frontier markets.  US investors could safely invest in the UK market without taking much additional risk and vice versa.  Both groups would gain valuable diversification.

People who have never bought a corporate bond will find it harder to evaluate than an equity if they have considered equities many times previously.  This will also rob them of a potentially valuable diversification.   The answer, as it often is, is to do more work!

See Also:

The Illusory Truth Effect And Financial Markets