…and those who don't.
That classic joke has come to mind more than once as I've written about companies recently. We seem to be seeing increasingly binary outcomes in the markets at the moment.
Continuum Investing
Most investing is based on continuums. Investors judge whether a company looks cheap, expensive, or somewhere in between on a given multiple. We take a view on whether a company will beat or miss expectations, and by how much. When news arrives, we adjust our priors and update our view.
Ed's recent research on Clear Trends shows that investors like continuums, especially as good news tends to follow good news. However, our investing lives are rarely that simple. Step changes in prospects happen far more likely than we'd prefer.
Binary marmite
Especially in smaller companies, a single outcome can have an outsized impact on the value of a business. Perhaps an oil company is drilling a major well, a company is seeking regulatory approval for a blockbuster product, or a key contract is up for renewal. In these situations, and many similar ones, investors will see their fortunes rise or fall based on a single RNS.
It is tempting to think that investors hate binary situations, and it is logical to avoid them at all costs. However, the reality is more nuanced. Many investors have a love-hate relationship with binary outcomes. Our reactions aren't consistent and tend to be determined by how a scenario is framed. Several behavioural biases mean our decision-making becomes flawed.
Loss Aversion
If I simply told you that investors hate losses, I'd be labelled Captain Obvious. It is the scale of how much we hate losses compared to the equivalent gains, and the lengths we will go to avoid taking a definite loss, that are surprising. Most studies put the pain of a loss at twice the joy derived from an equivalent gain.
We tend to quickly back away from any binary situation where we face big losses if the news flow goes against us. I think one of the main reasons we avoid these is due to ego protection. We feel stupid if we buy a stock that quickly loses most of its value. Most of us would rather avoid the feeling of being stupid, and many investors will recognise that revulsion towards anything that feels binary in its outcome, even if the overall risk-reward is positive.
Lottery-preference
However,…
