Analyse your stocks in seconds
Expert insights you can understand
Improve the odds of your stock picks
Generate investing ideas fast
Track & improve your Portfolio
Time your trades better with charts
Explore all the featuresStockopedia contains every insight, tool and resource you need to sort the super stocks from the falling stars.
I have written before about my strong dislike of Pearson (LON: PSON) the international textbook company and former owner of my old employer, the Financial Times. My dislike isn’t unfounded. Under the leadership of John Fallon (2013 to 2020), the company sold off its most profitable assets, leaving it with an education business which was unprepared for a digital world. That poor management resulted in a series of increasingly depressing financial results and moribund returns for investors.
I must admit that my inherent bias has, on occasion, been a source of pride. Between 2015 (when I started at the FT and joined the army of anti-Pearson journalists) and 2020 (when I left), the company’s share price fell 68%.
But this year, that bias has proved rather unfortunate. In 2022, Pearson has been the top performing stock in the FTSE 100, its share price is up 56%.
I am not alone in ruing a missed opportunity. Most people I know who have ever worked for a Pearson company (or former Pearson company) dislike the stock. As do many of the members of the teachers union, who like to disrupt Pearson AGMs with questions about price inflation and poor quality text books. And spare a thought for famed fund manager Nick Train who called time on is 18-year holding in April this year.
So why have so many of us got it wrong this year? The answer provides an interesting lesson in behavioural finance.
Confirmation bias is a human tendency to seek out information which supports your belief and ignore information which contradicts it.
This can be explained by the following example of a Wasson Selection Test:
The correct answer to the question B) To test the rule you should turn over cards A and 7. Turning over A will help you confirm the rule, turning over 7 will allow you to disconfirm it if necessary (i.e. If a vowel is appears on the other side of the card, we will know that the rule is incorrect).
Did you select A and 4? If you did, you’re not alone. Psychologists have used iterations of this test since it was first constructed in 1966 and more than three quarters of respondents get it wrong. Human inherent bias is to seek out information that confirms what they already know (or think they know) rather than information that disproves their beliefs. For that reason, most of us will turn over card 4 looking for a vowel. But card 4 has no ability to invalidate the rule and therefore, in flipping it, we don’t learn anything new.
The Pearson Problem - confirmation bias in action
Like a politician scouring the dregs of the internet for a rival’s misdemeanours, I have used the internet’s unfailing memory for clear evidence of my own confirmation bias.
Between January and May 2018 I wrote about three Pearson trading updates for the Investors Chronicle. Here are short extracts:
January: “The earnings beat has been caused by a better-than-expected tax rate. On an underlying basis, the company is struggling just as much as ever.”
February: “Debts are down, cash flows are up and profits came in at the upper end of guidance. The problem is that guidance was slashed this time last year, meaning numbers aren’t truly impressive when compared with 2016.”
May: “The first-quarter contributes so little to Pearson’s annual profits that we think it would be foolish to change our opinion.”
None of these trading updates was particularly strong and the company was using annoyingly flowery language to paper over its problems, but in all three cases I was hunting out the bad news. I had my narrative (Pearson is a terrible company) and I was sticking to it, with all the evidence I could find.
The Cure
Our underlying beliefs shouldn’t be ignored, but we should seek to disprove them with evidence wherever we can. Investment research shouldn’t focus only on things that we believe we know, but also things that we know we don’t.
In all walks of life we tend to judge decisions by their eventual outcome, rather than by the quality of the decisions when they were made.
Nobel prize winning economist and psychologist Daniel Kahneman puts this down to our perception of the two systems in our brain - what he calls system one and system two. System one is the fast thinker, it is responsible for immediate and automatic decisions. System two is more measured, considered and deliberate. Biases occur when we associate decisions (good or bad) with our system two brain, when they have really been made by our system one brain - we believe we have made rational decisions, but in reality it is our initial hunch or unconscious bias which has sparked an action.
The outcome of that decision can cause problems. If a decision leads to a positive outcome we are more likely to think of it as a measured skilled decision (made by system two) than an irrational, automatic decision (made by system one).
This is a particularly pervasive problem in investing because the stock markets are so bad at giving feedback. For example, if your portfolio is performing well right now it may be because of good decisions made by your system two brain, but it could equally have been caused by irrational system one thinking: luck in the stock market has the same results as good judgement.
The Pearson Problem - outcome bias in action
The decline in Pearson’s share price throughout John Fallon’s tenure was caused by bad management. He took the decision to sell off assets and focus on the education business without fully preparing that business for the demands of the future. The poor shareholder returns were a fair reflection of the inherent problems at the company.
But was it really my system two thinking that lead me to decide that Pearson was a poor investment time after time? I certainly believed it was. I had done my research, found that Pearson was performing badly and then watched with pleasure as the share price fell and I was proven correct. The outcome was what I expected - it must have been down to my research.
But if I am honest, it was my system one brain that drove that research and lead me to make the decisions which ended up being good ones. In 2022, I have been proved wrong, and it is clear that I haven’t allowed by system two brain the space to make its own decisions.
The Cure
Stephen Yui, the lead manager at the Blue Whale Growth fund, overcomes this problem with what he calls ‘blank paper investing’. Every time he comes to make a decision on whether or not to buy or sell a stock he begins with a blank sheet of paper. This means that any past decisions (and the outcomes caused by them) don’t impact his decision making.
People tend to feel the pain of a loss twice as acutely as they feel a win of the same magnitude - a psychological factor that English football fans will no doubt attest.
In 1984 - before he started investigating the system one and two brain - Daniel Kahneman wrote a paper on this alongside his friend and distinguished psychologist Amos Tversky. They found that the asymmetry between pain and pleasure manifests in a phenomenon they termed loss aversion: humans require greater evidence of disutility to give up an object than evidence of utility to acquire it.
In stock markets, this loss aversion makes investors hold onto their stocks longer than they perhaps should. In order to sell, they require significantly more evidence than the evidence they needed to add the stock to their portfolio in the first place.
The work of Kahneman and Tversky links closely to a study by Richard Thaler (1980) on what he called the ‘endowment effect’: people demand much more to give up an object than they would have been willing to pay to acquire it. In investment circles that often means that they attach much higher value to stocks that they own than stocks that they don’t.
The Pearson Problem - Loss aversion and the endowment effect in action
I have never been a Pearson shareholder and have therefore shown no symptoms of the endowment effect (except perhaps in the lack of attention I gave the share when new management set in place a turnaround strategy which seems to finally be paying dividends.) But Nick Train has almost certainly been a vicim.
Train arguably attributed more value than he should have done as the share price was crashing under John Fallon’s tenure. In 2015, when the company first began to focus on the poorly performing education business, shares were trading at more than 1500p a share. By the time he had sold his entire stake in April 2022, they were worth just 760p.
The Cure
Systematic investing. Rules are a major help to sentimental investors who get too attached to stocks they own or fail to see the good in stocks that they don’t own. For example, investors should seek to only look at their portfolio performance when they really need to and limit trading times to avoid emotional or irrational decision making.
Rules for buying can also help investors overcome their unconscious (or indeed their conscious bias). In February this year Pearson had a StockRank of 86 and a share price of 640p. If I had added it to my portfolio then, I’d have made a 43% return on my investment this year, not including dividends.
About Megan Boxall
Disclaimer - This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
Very insightful and thought-provoking article, thanks for sharing, Megan.
In your defence - how much value in the business has been destroyed over eighteen years for a (relatively) small increase in the share price in this one year and is it this outperformance sustainable anyway?
I know nothing about Pearson as this is not a share that I've ever been interested in thoroughly researching or adding to my portfolio, but just putting that thought out there.
Ant
"In February this year Pearson had a StockRank of 86 and a share price of 640p. If I had added it to my portfolio then, I’d have made a 43% return on my investment this year, not including dividends."
Yes Pearson has done well. I did a NAPS in January, which are the top 20 VM and QM stocks in each sector. It has performed poorly this year, down around 18%, some stocks are down around 50% or more. Pearson was not selected.
So just using the stockranks is no guarantee it will outperform, many on NAPs have done poorly. 6/20 have lost 40% or more, only 5/20 are showing a profit.
It is easy to pick the winners with hindsight.
In your defence - how much value in the business has been destroyed over eighteen years for a (relatively) small increase in the share price in this one year and is it this outperformance sustainable anyway?
Well, the article isn't really about that. Clearly Pearson (LON:PSON) was a terrible investment for many years and has been a great investment if you picked it up around the bottom of the Covid crash (it's doubled and thrown off more than 10% in dividends).
The point is that people anchor on past performance and their experience of that past performance rather than looking at the current situation. People only look for the information that confirms their existing beliefs.
We see this all the time on Stockopedia, especially when herding effects trigger groupthink - the Boohoo thread was a classic of its type as investors desperately looked for reasons for the share price fall other than the obvious, that the stock was an overhyped dog led by a team who were more interested in their own enrichment than the returns to shareholders. Anyone who pointed this out was outed as a woke, racist, blinkered socialist (I exaggerate, but all of those were raised as issues at one time or another).
Coming back to Pearson, viewed rationally it was clear that it had a virtual monopoly in academic texts and was suffering from the rollover from physical books to online ones. Students were passing on old copies of physical books, rather than paying the hideous fees for the online content but it was a matter of time before that stopped working. Ultimately it was Covid that did for it. Basic lesson - digitisation of businesses takes far longer than anyone expects.
The lessons here are (1) look for evidence that contradicts your existing beliefs, your brain is wired to do the opposite, (2) don't beat yourself up if the result of your analysis goes wrong, investing is fraught with uncertainty, we can't possibly forsee every outcome every time, (3) when things go wrong - sell first, reflect later. It's surprising how often your view of a stock changes when you no longer hold it.
timarr
Megan,
With respect to the test at the top of the page. The ONLY thing that we were asked to do was to test the rule "If the card has a vowel on one side, then it must have an even number on the other side". The logical answer to the question is A & 4 should be turned over. That would confirm or disprove that the rule applied on those two particular cards.
We were never asked to investigate what might be on the other side of cards showing consonants or or odd numbers. We were also never asked to consider how useful the stated rule might be.
Also it could have been possible that the rule only applies sometimes. Nobody would know for sure that turning card 4 over must result in it having an even number on the other side, just because the rule happened to be correct in an earlier example.
Other possible situations were that the other side of the cards could all be blank or all show pictures of animals! Or that there was never any connection between what is on the front of the cards and what is on the back.
However, I do agree with you that we always be on the look out for information which contradicts our earlier conclusions.
My other conclusion is that we should give a lot of thought to both 1) Whether our testing methodology is correct and 2) Whether our testing methodology is actually any use in sorting the good from the bad.
I expect that some people will consider that I am being rather pedantic. I tend to dislike analogies because I see their short comings.
I did enjoy the rest of your article and have learnt from it. Thank you.
With respect to the test at the top of the page. The ONLY thing that we were asked to do was to test the rule "If the card has a vowel on one side, then it must have an even number on the other side". The logical answer to the question is A & 4 should be turned over. That would confirm or disprove that the rule applied on those two particular cards.
You're being asked to test the rule, not whether there are examples that confirm the rule.
Turning over 4 could reveal a vowel, but that doesn't prove the rule, because the rule only says that if there's a vowel on the other side then the number will be even. It doesn't say that if the number is even there's a vowel on the other side. So if you turn over 4 and there's a consonent then the rule still stands.
If you turn over 7 and there's a vowel you've disproven the rule. If you turn over A and there's an odd number then you've disproven the rule. Cards Q and 4 can provide no useful information relating to the rule.
Of course, it's also the case that there's actually no way of proving the rule from these cards - it's an example of the scientific method, that a hypothesis is only valid until we find disconfirming evidence. Which is the point of the article really.
As it turned out the Wason Selection Test is context specific - place this in a real-world context and people tend to get the answer correct. But the stockmarket is sufficiently abstract that it seems to apply there.
timarr
Timarr,
Thank you for a very respectable answer. The original question was very tightly framed. Which cards would we turn over? Whatever answer we give to the question, we would not then have enough information to be sure enough to give a definitive answer to the question If the card has a vowel on one side then must it have an even number on the other side? So thanks to Megan & you, I have now updated my process with a difficult question which is "What information is missing from my analysis? Provide this information and comment on it." I suspect that this question will generally take me too long to properly answer for each company. But I will give it a shot. Thank you to Megan & Timarr for your thought provoking pieces.
On further reflection, most people assume that the same rules must apply to every card. But the puzzle does not state that this is the case. So if you turn over number 7 and find a vowel it does not disprove the rule. It could be that a different rule apples to every single card, letter or number. We need to be very careful about our assumptions.
Also, we were only asked to test the rule. Turning over card number 7 does not test the rule, it is testing some other hypothesis which we were not asked to do. People may argue that turning over card 7 has some validity in that it tests the the converse of the rule. But it cannot test the converse of the rule because a different rule could apply to every single card as outlined in the above paragraph.
Really well articulated. I have read Thinking fast and slow several times and recommended the book and the lessons it contains to many people. I still have to work very hard to put those lessons into practice, especially when it comes to investing. A review of my decision making in relation to investments in 2022 illustrates this well. As you suggest it is important to keep searching for evidence that contradicts current beliefs ( and avoid emotional attachment to a share) and then avoid being too hard on yourself when things don’t work out as you hoped.
In the knowledge that the herd has System 1 'fight or flight' reactions, algorithms are programmed according to support and resistance levels with volume considerations.
The remaining human buyers and sellers have all the biases explained here.
I subscribe to a service that analyses candlestick patterns of indices and individual stocks without any fundamental considerations. The underlying assumption is that the largest markets dictate the direction of the smaller ones.
Pursuing the 'blank paper investing' thesis I then put my Stockopedia choices through the candlestick analysis to avoid preconceived notions. It may be a good company but is it a good time to buy ?
Does it work? Of course......... except when it does not.
I went back to Kahneman's text but our 'apparent inability to acknowledge the full extent of our ignorance' from the preface merely echoes a succinct summary in the article. So then I tried to question Megan's cure limit trading times with my introduction which suggests you should trade according to the general direction of the market.
Does it work? I believe so but obviously I shall have to look for evidence it does not.
With indices in a downtrend PSON is just that. With little value it has gone up all year.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
This site cannot substitute for professional investment advice or independent factual verification. To use Stockopedia, you must accept our Terms of Use, Privacy and Disclaimer & FSG. All services are provided by Stockopedia Ltd, United Kingdom (company number 06367267). For Australian users: Stockopedia Ltd, ABN 39 757 874 670 is a Corporate Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773, AFSL 521404.
Hi Megan, this week I have been digging deep into my methods in investing. They leave a lot to be desired and your article I just read is inspiring. Only yesterday I made this footnote to my delving:
Mostly every instance of investing that caused me to rue my buying has been “just because you bought them at the wrong time”.
My own system one is impetuous, My Plan A has been to re-invest dividends as they come in. I determine that my New Year's Resolution (Plan B) will be to save the dividends up and give system two a fighting chance.
Happy Christmas,
William