“The human mind, I think, cares nothing for the inside of good sound logic but just for the result that makes sense to its own workings.”
Darwin’s quote speaks volumes about human cognitive bias and its impact on decision-making. Among these cognitive biases, Contrast Misreaction Tendency takes center stage, as it brilliantly highlights the peculiarities of human judgement under varying contexts. With this essay, we will delve deep into understanding the notion of Contrast Misreaction Tendency, shedding light on its foundational roots, specific manifestations, and implications with relevant examples and case studies.
Understanding the Contrast Misreaction Tendency
Derived from the field of psychology, Contrast Misreaction Tendency is a mental model that deals with the way individuals perceive, evaluate, and react to different stimuli. It’s part of a larger set of cognitive biases, formulated by the legendary investor Charlie Munger. Munger famously argued that understanding and tackling these cognitive biases is critical for achieving success in various domains, particularly in investment and business.
The essence of Contrast Misreaction Tendency is simple yet profound: we humans tend to misjudge and react to contrasts, particularly when they are juxtaposed. The subtlety lies in how these stimuli are not perceived in isolation but relative to their immediate context or contrasting elements. As Munger puts it, “It’s a lollapalooza when two or more forces are all operating in the same direction. And, frequently, you don’t find just one or two of these 20 tendencies operating. You find four or five operating.”
A classic example of the Contrast Misreaction Tendency is when a consumer perceives an item as less expensive when it is placed next to a highly-priced product. A store might sell an ordinary $2,000 watch right next to a $10,000 luxury watch. The ordinary watch might seem cheaper to the potential buyer only because it is being compared to the luxury watch, thereby exploiting the contrast misreaction tendency.
The Anchor Effect in Negotiation: This is a classic example where the first number mentioned (the anchor) affects subsequent negotiations. If someone starts negotiating a salary with a high number, subsequent offers will usually be closer to that high number. This is why salespeople often start with a higher price; it sets an anchor that contrasts with lower offers.
Another illustration is the “door-in-the-face” technique used by many salespeople and fundraisers. Initially, they will make a large, often unrealistic request (like asking for a $1,000 donation). When you refuse, they will follow up with a much smaller request (such as a $10 donation). The contrast makes the second request appear much more reasonable, and people are more likely to comply.
Decoy Effect in Marketing: In consumer choice, a product (decoy) that’s inferior to other choices can increase the preference for one option over another. If there are two options, A and B, with B superior, adding a third option that’s slightly inferior to B but better than A will lead more consumers to choose B. This effect has been used in pricing strategies by companies like The Economist.
- The Asch Experiment: This social psychology experiment beautifully underlines the Contrast Misreaction Tendency. The experiment involved a line judgement task where the participants were asked to match the length of a line to three other lines. In groups where majority participants deliberately gave wrong answers, the subject often conformed to the group’s view even when it was blatantly incorrect, due to the stark contrast between their individual and the group’s judgement.
- Real Estate Negotiations: An experienced real estate agent may list a property at a significantly higher price than its market value. When negotiations begin, the agent then significantly drops the price. This creates a contrast that makes the reduced price appear like a fantastic deal, even though it might still be above the actual market value.
- Real Estate Pricing: Real estate agents often use contrast mis-reaction by showing clients a more expensive house first, followed by a slightly less expensive one that meets their needs. The contrast makes the second house seem like a bargain. This technique was mentioned in Robert Cialdini’s seminal book “Influence: The Psychology of Persuasion.”
- The J.C. Penney Debacle: In 2012, J.C. Penney attempted to eliminate sales and coupons and instead offer “fair and square” everyday low prices. Without the contrast of a higher “regular” price, customers didn’t perceive the prices as good deals, leading to a significant drop in sales.
To provide further insights, let’s refer to some powerful quotes:
- “The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in.” – Charlie Munger This quote illustrates how human judgement often becomes immune to rational arguments once an initial idea or belief takes hold. The contrast with subsequent, often more accurate, information is usually disregarded.
- “We need to look at the subtle, the hidden, and the unspoken.” – Malcolm Gladwell This encapsulates the need to delve beneath the surface level contrasts and examine the underlying processes that inform our perceptions and judgements.
- “The contrast principle is well established in the psychological literature. This principle affects perception of size, length, weight, and attractiveness.” – Robert Cialdini, “Influence: The Psychology of Persuasion”
- “People are more likely to recognize and adapt to incremental change than to sudden change.” – Charlie Munger, discussing the Contrast Mis-Reaction Tendency in his famous speech at Harvard in 1995.
Role of the mental model “Contrast Mis-Reaction Tendency” in equity Investing
The role of Contrast Mis-Reaction Tendency in equity investing is significant and multifaceted. Investors are continuously comparing stocks, bonds, companies, and various economic indicators, and this tendency often unconsciously affects decisions and perceptions. Here’s how the Contrast Mis-Reaction Tendency specifically plays out in equity investing:
1. Relative Value Traps
Investors often compare stocks or assets to one another rather than evaluating them on their inherent merits. This can lead to relative value traps where an equity might seem undervalued compared to its peers, but in reality, it may be overvalued in absolute terms.
Example: Suppose Investor A sees that Stock X is trading at a lower price-to-earnings (P/E) ratio compared to similar companies in the industry. Without considering the fundamental reasons behind this discrepancy (such as lower growth prospects or higher risks), the investor might erroneously conclude that Stock X is a bargain.
2. Anchoring Bias
Anchoring refers to the human tendency to rely too heavily on the first piece of information encountered (the “anchor”) when making decisions. In equity investing, past prices or performance often serve as anchors, leading to misjudgments about the future potential of a stock.
Example: Investor B bought shares of Company Y at $100 each. When the price drops to $80, Investor B is hesitant to sell, waiting for the price to return to the original $100, even if all signs point to further decline.
3. Misjudgment of Risk and Return
Contrast can lead to underestimating or overestimating risks and returns by drawing inappropriate comparisons between different equities or asset classes.
Example: Investor C is comparing a high-growth tech stock to a more stable utility stock. If the tech stock has recently outperformed the utility stock, Investor C might underestimate the associated risks of the tech stock due to the recent favorable contrast in performance.
4. Emotional Impact
The contrast between winning and losing stocks in a portfolio can significantly affect an investor’s emotions and subsequent decisions. A sharp contrast between a successful investment and a failing one might lead to overconfidence or excessive caution.
5. Influence of Market Trends
Contrast Mis-Reaction Tendency can cause investors to be swayed by prevailing market trends without a deep understanding of the underlying factors. They might contrast a current bull market with a previous bear market, leading to either excessive optimism or pessimism.
Mitigating the Effects of “Contrast Mis-Reaction Tendency” in Equity Investing
Understanding and being aware of the Contrast Mis-Reaction Tendency can help investors make more rational decisions. Strategies to mitigate its effects in equity investing include:
- Fundamental Analysis: Focus on the intrinsic value of a stock rather than comparing it with others.
- Diversification: Spreading investments across different equities to avoid over-concentration and comparison traps.
- Emphasizing Process over Outcome: Concentrate on the decision-making process rather than contrasting outcomes, which can lead to emotional reactions.
- Consulting Financial Advisors: An unbiased third party can help in offering a more objective perspective.
Contrast Mis-Reaction Tendency is an influential factor in equity investing that can lead to irrational decisions and misjudgments. Investors, both novice and seasoned, need to be aware of this mental model and consciously work to overcome its biases by focusing on intrinsic values, diversification, and sound decision-making processes. By doing so, they can navigate the complex world of equity investing more effectively and make more rational investment decisions.
In conclusion, the Contrast Misreaction Tendency offers a powerful framework to understand the innately biased human decision-making processes. It serves as a reminder of how our judgement can be swayed by our predisposition to overreact to contrasting stimuli. The challenge, then, lies in cultivating an awareness of this tendency, so as to not fall prey to its potential pitfalls. As Warren Buffet says, “What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”