Investments: beware of first impressions

We tend to form a first impression very quickly when we come across a new situation or person. Whether positive or negative and whether we like it or not, this first impression will have a significant influence on our choices and behaviour if we don’t take care. It’s important to take a step back. If there is no basis for our first impression, it may lead us to act against our own interests – this also applies when it comes to investing.

During the course of the myLIFE behavioural finance articles, you have learnt that any decision to make a purchase or investment is based on a complex cognitive process, so you shouldn’t take decision-making lightly. Knowing this is all well and good, but some traits tend to attract our attention, because they appeal more to our emotions than to our judgement. Whatever jumps out at us is the source of this first impression – it may have a strong influence on us and we will usually be unaware of this.

We are not always aware of how our first impressions can influence a thought process that we believe is based on logical steps. Is it possible to learn how to remain on our guard in such situations? Let’s take a look at how we can uncover these first impressions that are embedded within us and that sometimes make us act against our own interests.

The halo effect

Are you the type of person who judges a book by its cover, chooses a restaurant solely on the basis of its sign, or will blindly buy new products from your favourite brand? These examples may make you smile. But maybe you will admit that you have occasionally judged someone you don’t know on first impressions based of their physical appearance when they enter the room you are in. And if you’re an investor, you may have bought shares in a company purely because you were impressed by the charismatic speech of its founder.

These reactions are very human, and result from a cognitive bias called the halo effect, which every investor should learn to recognise in order to best defend their own interests. The halo effect was first defined in 1920 by the US psychologist Edward L. Thorndike to describe the biased way that officers in the military ranked their subordinates.

Thorndike noted that officers systematically gave a higher rating to those who were more physically attractive and strong. So based on this sole characteristic, soldiers were judged as being more intelligent, capable or apt for leadership overall. The people being assessed were judged better or worse based solely on a first impression, which was not necessarily relevant to the area under consideration.

Based on a first impression gleaned from limited criteria, the halo effect shines a positive light on a person, product or brand and alters our perception of them.

Based on a first impression gleaned from limited criteria, the halo effect shines a positive light on a person, product or brand and alters our perception of them. This effect then incites us to make judgements that ignore or minimise other criteria that are relevant to making the right decision.

The halo effect is one of the reasons why it is not advisable to leave the verdict of a trial to a single person who may – in spite of themselves – show greater clemency to a criminal who is well turned out. Don’t believe me? This has been scientifically proven, in particular, in the work of Sigall and Ostrove in the mid-1970s¹. But the halo effect is particularly well-known to brands, which use it excessively to create a strong first impression for their products or name in order to turn you into a faithful client who will purchase all of their new products with no questions asked. And that’s the problem – this can influence your judgement and encourage you to make purchases you wouldn’t have made otherwise.

This explains how companies like Apple have managed to create a community of fans who will sometimes camp out in front of a store for days in advance in order to buy any new products that the brand launches. And this applies even if the products are sometimes more expensive and not necessarily more powerful than those of their competitors. Halos can form around a brand and its products, and can result in a manager being canonised. They can also develop in stock markets around certain shares, pushing their price up above their real value.

The horn effect

The halo effect is very powerful, but so too is what is referred to as the horn effect. A well-known example can be found in recruitment during the process of filtering CVs. A recruiter acting under the influence of the horn effect may automatically exclude some CVs based on criteria that are not, in principle, relevant to the skills required for the vacancy. That’s why some favour anonymous CVs which show the skills and experience of the applicant but no information that can identify them and or lead to them being excluded for discriminatory reasons.

The horn effect consists of demonising a person, company or product based on a single characteristic that we judge negative on first impression.

The horn effect consists of demonising a person, company or product based on a very limited characteristic that we judge negative on first impression. While the halo effect can push a share price up above its real value, the horn effect can clearly result in a share price that is below the real value of the company.

A source of volatility

Halo effects and horn effects can have an impact on investors’ financial decision-making and lead them to ignore important information. For example, it may be that you experienced a sudden and unexpected loss of money on the stock exchange ten years ago and haven’t invested since due to this single negative experience. Today, even if rational analysis led you to the conclusion that market conditions were favourable, you would not contemplate investing again.

Conversely, a strong marketing campaign or an inspirational speech by a CEO may give you the impression that a company is rock solid and encourage you to buy the shares without doing any actual research on its real fundamentals. This obviously isn’t a good idea. There are many things that can accentuate this effect, such as the excessive media exposure of some charismatic leaders, biased focus in social media on incomplete information about companies, etc.

Don’t think that it couldn’t happen to you

It’s not unusual to find incomplete information about a company that does not reflect its economic reality featuring in media headlines. This visibility is a source of volatility that can move a company or its investors from the spotlight into the shadows in the space of a few hastily shared tweets or posts. And this is not a new phenomenon.

At the beginning of 2011, RIM was one of the five most admired companies in Canada. One day, a malfunction and disastrous service outage for millions of BlackBerry users contributed to a collapse in the company’s value. The company’s board waited three days before publicly explaining the service outage and offering its apologies. This dual gaff resulted in a swift loss of confidence in RIM and its share price tumbled 75% between March and December 2011. This fall was not justified by any major deterioration in its fundamentals, but was down to a horn effect caused by this disruptive episode.

The oil company BP represents another example of a company whose name suffered from a negative halo effect following the Deepwater Horizon catastrophe in 2010 and the legal suits that followed. This negative halo was amplified by the headlines to the extent that investor and client behaviour towards the company was affected.

When catastrophe strikes, negative halos usually form, particularly around a company’s management.

In such circumstances, negative halos usually form, particularly around a company’s management. There is a tendency to demonise the alleged inflexibility or incompetence of the CEO when a company is struggling. If you need convincing of this, have a look at the case of Cisco. At the end of the nineties, Cisco Systems was hailed for its brilliant strategy, superb management of acquisitions, and state-of-the-art client focus, but when the tech bubble burst in 2000, at the drop of a hat it was brutally scorned for its inadequate strategy, its botched management of acquisitions, and poor client relations. In reality, the basic fundamentals of Cisco had not changed, but its stock price – for a long time buoyed by the positive halo surrounding its trait of “IT stock” – suffered immensely from the bursting of the Internet bubble and from the negative halo effect relating to that very same trait. This is a typical example of both overvaluation and undervaluation caused by the halo effect and the horn effect, respectively.

Conversely, there is a strong tendency to canonise the alleged skills of a manager when a company is doing well. It’s striking to see the extent to which the social media punchlines of the charismatic Elon Musk have the power to set the share prices of his companies on a rollercoaster ride, whereas, fundamentally, there is sometimes no connection to the performances actually delivered by the companies.

Know how to separate the company from its manager

In the same vein, a series of studies carried out on leadership by James Meindl and his colleagues discovered that the words used to describe leaders were highly dependent on the performance of their company. When companies prospered, their managers were hailed for their vision and strong communication skills. But when companies are struggling, bosses are nearly always automatically categorised as hesitant, poor strategists or arrogant and inflexible.

In summary, the halo effect has a considerable influence on our assessment of a company’s performance, whether this concerns data from experience, empirical studies, surveys or research on media content. The thing to remember, is that it is key to ensure that data is independent and to find a means of carrying out a critical analysis of reliable information before investing.

It is dangerous to base an entire investment strategy on a single characteristic or personality. You can avoid succumbing to the illusions created by the halo effect and the horn effect by seeking the support of experts, and by always asking yourself a few questions before investing:

• • Do I have reliable information on the company’s performance? If this is not the case, do some research and get a professional’s opinion.
  • What criteria am I basing my opinion on? If the answer is solely your first impression, make sure you carry out more research to check if your initial opinion is correct.
  • Am I sufficiently qualified and well-informed to come to a valid and unbiased opinion? In investment, it’s worth remembering that humility is a key element to success.

Generally speaking, canonising and demonising is pointless. It’s important to learn how to approach your investment portfolio dispassionately and to uncover truly interesting investments that match your investor profile, your life goals and your ambitions.

¹ Sigall, H. & Ostrove, N. (1975). Beautiful but dangerous: Effects of offender attractiveness and nature of the crime on juridic judgment, Journal of Personality and Social Psychology, 31 (3), pp. 410-414.