In his book – The Little Book of Behavioral Investing, James Montier wrote a great passage on how investors can identify and protect themselves from becoming victims of Wall Street’s self-serving biases.
Here’s an excerpt from that book:
So much for nature. Nurture also helps to generate the generally rose-tinted view of life. Psychologists have often documented a “self-serving bias ” whereby people are prone to act in ways that are supportive of their own interests. But, as Warren Buffett warns, “Never ask a barber if you need a haircut.”
Auditors provide a good example of this bias. One hundred thirty-nine professional auditors were given five different auditing cases to examine. The cases concerned a variety of controversial aspects of accounting. For instance, one covered the recognition of intangibles, one covered revenue recognition, and one concerned capitalization versus expensing of expenditures. The auditors were told the cases were independent of each other.
The auditors were randomly assigned to either work for the company or work for an outside investor who was considering investing in the company in question. The auditors who were told they were working for the company were 31 percent more likely to accept the various dubious accounting moves than those who were told they worked for the outside investor. So much for an impartial outsider—and this was in the post-Enron age!
We see this kind of self-serving bias rear its head regularly when it comes to investing. For instance, stockbroker research generally conforms to three self-serving principles:
Rule 1: All news is good news (if the news is bad, it can always get better).
Rule 2: Everything is always cheap (even if you have to make up new valuation methodologies).
Rule 3: Assertion trumps evidence (never let the facts get in the way of a good story).
Remembering that these rules govern much of what passes for research on Wall Street can help protect you from falling victim to this aspect of self-serving bias.
The most recent financial crisis provides plenty of examples of self-serving bias at work, the most egregious of which is the behavior of the ratings agencies. They pretty much perjured themselves in pursuit of profit. The conflicts of interest within such organizations are clear; after all, it is the issuer who pays for the rating, which, as with the auditors above, makes the ratings agency predisposed to favoring them.
In the housing crisis, they seemed to adopt some deeply flawed quant models which even cursory reflection should have revealed were dangerous to use. But use them they did, and so a lot of sub-investment grade loans were suddenly transformed, as if by financial alchemy, into AAA rated securities.
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