Heard about the cat that didn’t want to drink milk? If not, here’s the story. A cat was given hot milk every day and after a few days, when lukewarm milk was kept, it refused to drink the milk thinking that the milk will be hot. This is the contrast effect. The contrast effect impacts our perception of new information based upon exposure to prior information.
As they say, everything is relative and you always tend to compare products and experiences. For instance, a billionaire might say that Rs. 1 lakh is a small amount while for some others, Rs. 1 lakh might be their life savings. Real estate agents show clients an overpriced property to make their other properties more attractive. These examples of the contrast effect show us that we judge things not just based on their own merits but by comparing them to other things. Sometimes we might even compare them to irrelevant ones. Investors follow the contract effect too.
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Even hard-core stock market fans will admit that behavior can influence investment decisions. After all, humans aren’t robots and they learn from their investing experience. The previous experience is likely to influence their present decision-making. Samuel Hartzmark at the University of Chicago and Yale University’s Kelly Shue worked on an experiment to reveal how contrast effect works in the stock markets.
They discovered a trend in investors’ reactions to earnings news given by corporations. They found that if prominent and well-known companies announced good results, then the market reacted poorly to earnings announcements by other companies the next day. This happened even if the results of other companies were reasonably good. Also, the market reacted well to these announcements by other companies if the previous day’s news was bad. So, good news one day makes good news the following day seem less attractive, while bad news makes average news seem good.
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Hartzmark and Shuemade an estimate that a strategy of going short after the results were good, and going long if results were bad, might have generated a return of 15 percent every year in the US between 1984 and 2013. So, the authors found that investors are influenced by behavioral bias and this bias is reflected in stock prices.
The contrast effect is even used to fool the shareholders of a company. How? A particular year’s poor income statement is made to look even worse by increasing expenses and selling assets. As a result, in subsequent years, the statements look much better in contrast. Satyam’s case is an example that shows how big accounting scams happen.
In our lives, we fail to notice how our money disappears. It constantly loses its value because of inflation. If it were imposed on us in the form of income tax, we feel the pinch. Another area where the contrast effect can harm is the fixation on the stock prices. When investors analyze a business, it becomes extremely tough to overcome the temptation to ignore the past stock price trends. If a stock has risen recently, investors think that the stock has become expensive. A recent fall in price triggers convinces them that the stock has become cheaper.
Here’s an example that will explain the contrast effect on investing. Let’s say that you just lost Rs. 10,000 in the stock market. This loss can be perceived as a huge victory or a huge defeat, depending on your prior experience. Let’s take two scenarios. One is where you meet a stock market expert who lost Rs. 20,000 and another is where you meet an expert who made Rs. 20,000. A Rs. 10,000 loss is a Rs. 10,000 loss. However, in scenario 2 you may consider your Rs. 10,000 loss as a huge disappointment.
While in scenario 1 you may consider your Rs. 10,000 a ‘victory’ as a stock market expert has lost Rs. 20,000. In scenario 1, you might decide to invest more in the market if the expert says that losses are common while in scenario 2, you might even decide that the stock market is not for you.
Let’s take the present market situation. If you have a diversified investment portfolio, there’s a good chance it’s presently worth more than what it did a year ago. However, there’s also a good chance that it’s worth far less than it was three years ago if you didn’t choose the right investments. By tweaking the factors “compared to what” and “since when”, you can make any investment strategy look like it’s working or not working. So, experiences tend to impact your investment decisions. This is the reason you need to get a hold on these biases.
Conflicting emotions can impact your investing decisions. Investing evokes a broad range of emotions in investors depending on their risk profile. You might feel yourself drifting towards the extremes of the fear and greed spectrum. You should consider the contrast effect to see if there is any bias in your actions. This is why successful investing is so tough. Before understanding how to overcome the contract effect, here are lessons you need to learn.
Contrast effect messages
The contrast effect proves that the efficient market hypothesis just doesn’t work. This theory says that existing information gets reflected in share prices. However, as the contrast effect shows the fact is that yesterday’s price moves affect some of today’s moves. So, the markets aren’t as efficient and there’s a continuous influence.
The second point is that the contrast effect explains the phenomenon of post-earnings announcement drift. This is when prices underreact to good news and drift up in the following days. Investors wise up to their mistakes and the shares rise to reflect the good news after a few days. Hartzmark and Shue’s research shows that these reactions to earnings announcements caused by the contrast effect are corrected in the following two months.
The third point is that financial professionals are likely to do more analysis and are less prone to the news. Since they have financial knowledge, they will be able to analyze whether the company’s results are good or bad. This is done using financial statements, peer reviews, and industry information.
What should you do?
Understand that contrast effect is everywhere and that you view the world through its lens. Interestingly, most of the bad habits are formed because of this tendency but fortunately, this bias, if used intelligently, can help you form good habits too. For instance, you can compare your portfolio with your friends to ascertain where you might be going wrong.
John Wooden, one of the most successful coaches in basketball, said “When you improve a little each day, eventually big things occur … Do not look for big, quick improvement. Seek the small improvement one day at a time. That’s the only way it happens and when it happens, it lasts.” So, ensure that the contrast effect is not influencing your actions.
Take care and keep learning. Manage your money prudently on Moneysage.
