You’re at the wine store, and you know nothing about wine. So you buy a mid-range priced bottle with a nice label. And when you drink it, you expect it to be good.
Our perceptions are formed by expectations. That’s how the brain works. But expectations can lead to bad decisions – in wine, and when investing.
Expectation bias, which is also called “experimenter’s bias,” is the idea that people tend to focus on the results and outcomes they expected and agree with – and will ignore results and data that don’t agree with their expectations.
A social scientist at the University of Bordeaux in France tested for expectation bias using (appropriately) wine. He gathered 54 students, and had them taste wine from two bottles. One bottle had a simple label with a notably cheap price tag on it. The other bottle was significantly more expensive, and sported an attractive label.
Which wine did the students prefer? An overwhelming majority of the students used words like “complex” and “well-rounded” to describe the expensive wine. They used terms like “weak” and “flat” to characterize the cheaper one.
The reality was that the wine in the two bottles was the same. There was no difference – something that escaped every single subject. The subjects believed the more expensive wine in the fancy bottle tasted better simply because they expected it to be better wine.
Like wine, investing is all about expectations. We expect a stock to move up in price – that’s why we buy it, after all. Stock analysts develop expectations about company earnings, usually with heavy guidance from the company itself. Thousands of journalists make a living by comparing expectations for economic growth, stock market returns, currency movements, and many other financial and investment indicators, to the way things actually turn out.
Expectation bias gets in the way when we focus on the results that emphasize where we were “right” in our expectations and downplay where we were wrong. If a company’s earnings weren’t as expected, most analysts will focus on what they got right – rather than on where they went wrong. If a stock price doesn’t increase as expected, we’ll look for how we were correct in our expectations (or how “the market” is wrong), and view as less important the fact that our share price estimate was incorrect. Growth expectations can fall flat, but journalists will usually write about which expectations were met – rather than those that weren’t.
One way to reduce expectation bias is to have no expectations for the future. But a more realistic approach would be to assess every situation and make every decision as if it’s new and different – and to consciously focus on abandoning your expectations and pre-existing ideas. And when the facts change, be ready to adjust your expectations.
It might help you make better investment decisions. It might also help you change the way you choose – and taste – wine.