When knowledge backfires

Understanding what a company does can skew our perceptions of the risk of investing in the company.

In the context of a tough decision, understanding is our ally. The more we know about a set of choices and the alternatives we’re facing, the better decisions we can make. Understanding can help reduce risk by reducing uncertainty, but when it comes to investing, there is a type of understanding that can lead us wrong.

UNDERSTANDING IS DECEPTIVE

In 2018, through a series of five studies, researchers showed that understanding what a company does influences risk perceptions and predictions of future stock performance. Easy-to-understand companies were judged as less risky than hard-to-understand ones. The researchers were careful to demonstrate that this effect was separate from the familiarity effect (where people prefer companies they know to those they don’t), it was present in both novice and seasoned investors, and it was uncorrelated with objective risk.

These findings make intuitive sense because we all know that the unfamiliar feels uncertain compared with the familiar. If you don’t understand what a company does, you leave yourself exposed to all kinds of mistakes because you won’t know how to evaluate the marketplace and future prospects of that company. The problem with this gut-level assessment of risk is that it oversimplifies the trade-off and produces an emotional response that can lead us to rely on the wrong information when making choices.

WHY DOES IT MATTER?

Knowing what a business does isn’t the same as knowing the fundamental value or risk profile of that company. Understanding the business model isn’t the same as understanding the marketplace and the industry in which that business operates. Likewise, not knowing what a company does is not necessarily an indication that there is a fundamental flaw on the part of the company. It doesn’t mean that the business model is faulty, risky, or unstable.

“Don’t invest in what you don’t understand,” doesn’t mean that everything you don’t understand is a bad investment, and “invest in what you know,” doesn’t mean that everything you understand is a good investment. Yes, you should understand what you’re buying when you invest, but we can’t stop at understanding what a company does, we need to understand how they manage their resources in a competitive marketplace.

Understanding what a company does can give a deceptive sense of safety when we really should be seeking out and relying on more objective metrics of risk. Left unchecked, this emotional bias can lead to misjudgments, misallocations and misalignment of clients and portfolios.

We can also undervalue hard-to-understand companies and miss out on opportunity. Especially in areas where emerging, complex, or novel technologies and business practices are involved, we may be inclined to judge companies as riskier because we aren’t as familiar with their products, services, or business models. Relying on that kind of thinking will keep investors out of the market for cutting-edge technologies and next-generation businesses.

WHAT TO DO?

I’m not suggesting we keep clients in the dark or try to stop them from understanding what they are investing in. Quite the opposite. Understanding what a company does is important. In this case, though, it isn’t enough.

Here are three things that advisers can do to help reduce the negative impact of this emotional bias:

First, be on the lookout for this phenomenon in both your clients’ decisions and your own. Both novice and seasoned investors were found to be prone to this bias, so don’t assume your professional knowledge and experience makes you immune.
Second, help clients to understand the more complex companies that you think are a good buy. When you see a good opportunity, make sure you help clients to understand the business, so they won’t be as likely to write it off as too risky simply because it’s unfamiliar. Likewise, challenge yourself to learn about emerging business models, technologies, and services rather than remaining in the ‘safety’ of the familiar.
Third, seek out objective measures of risk, and teach clients how to understand them. By focusing attention on known, measurable, objective risk factors, you can help clients make apples-to-apples comparisons even when some of the apples are unfamiliar at the outset.

SUMMING UP

Some companies’ products, services and business models will always be harder to understand than others. That fact does not in itself make the company riskier. A sense of understanding, while important, doesn’t provide not adequate information to judge a company’s risk, and we need to be aware of the seductive sense of certainty that understanding can generate, and the sway that can have on our judgment. Objective metrics of fundamental value, volatility and expected returns are more reliable than emotion.

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Sarah Newcomb is a director of behavioral science at Morningstar Inc.