There Are Lies, Damned Lies, and Statistics

OK, Fool, you tell me which culinary scenario you would be more interested in. In each, you will get 10 cookies that are either mouthwatering or nauseating.

  • Scenario No. 1: There's a 40% chance all 10 cookies are absolutely mouthwatering, and a 60% chance that they're all not mouthwatering.
  • Scenario No. 2: There's a 60% chance they are all nauseating, and a 40% chance they aren't all nauseating.

So, which one do you choose?

Some careful examination will show that these two scenarios are exactly the same. And yet, when questions like this are used in psychological studies, there are far more people who will choose the first scenario instead of the second.

What exactly is going on here?

It's called the framing bias
The difference between the first and second scenario is simply how the information is presented. In the first scenario, a positive slant was used: The positive was accentuated with the word "mouthwatering." In the second scenario, the negative was accentuated, through the word "nauseating."

In this situation, there was no harm to the participants -- they were both being given the same hypothetical batch of cookies. But in the real world -- and especially in the investment world -- the scenarios being offered to potential investors are often heavily laden with clever vocabulary.

Being victim to the framing bias can have negative long-term consequences on your investment returns. Recently, I've been investigating the role that certain biases play in the investing process. Read below to see how the framing bias can affect your investments, and see how to negate the negative effects of this bias.

Framing bias in the investment world
There are actually hundreds of ways that we investors can be manipulated through the framing bias, but I want to focus on the different ways that information is provided by the financial media, including many of us here at the Fool.

Generally, if I am interested in talking about a stock that I really like, there are two broad approaches to take. The first is to tell the readers about why there's little chance that the stock could lose money; I call this appealing to people's risk-aversion.

The second approach is telling people why this stock could be worth a whole lot more in the years to come. I like to call this appealing to those who are inclined to invest in stocks with great potential for appreciation (appreciation-inclined).

The problem with this approach, as you can see in the chart below, are the important parts of the argument that get lost in translation. 

 

What You Hear

What You May Not Hear,
But Need to Know

Risk-Aversion

"This is a really safe bet."

"There's not much chance this will increase by a lot."

Appreciation-inclined

"You could become wealthy from this."

"You may also end up in the poor house because of this."

Risk-aversion, in the flesh
Indeed, if you were to read about one of my big energy investments, National Oilwell Varco (NYSE: NOV  ) , you would see that I emphasize its relative safety and downplay the fact that it might not appreciate by much.

One look at my original recommendation for National Oilwell for "The World's Greatest Retirement Portfolio" makes this clear. As I stated then: "[T]he company's parts have a 60% share in the rig equipment market, and 90% of all rigs out there are equipped with at least some of its products." 

Sounds like a pretty safe bet, right? Well, it is -- and it has been for me. But over the past two years, it's also been by far the worst performer in the portfolio, surrendering about 13% of its value.

Appreciation-inclined folks liked this pick
If, on the other hand, we look at my "World's Greatest Growth Portfolio," we see the exact opposite. As I'm focusing on growth, I tend to ignore the risk-averse investors, and focus on the appreciation-inclined.

Just look at MAKO Surgical (UNKNOWN: MAKO.DL  ) , a company whose Rio Surgical System hopes to change the way partial-knee and -hip replacements are conducted in the United States and around the world. In recommending the stock,  I told Fools that with so many baby boomers moving into their golden years, "There are a lot of folks who will be looking toward MAKO to help prolong their lives as active and involved individuals."

Cashing in on baby boomers seems like an enormously lucrative ordeal, but things didn't pan out that way. MAKO's 2012 was one to forget, and the company lost half of its value.

What's the lesson here?
Of course, there's nothing wrong with being a risk-averse investor, or with being someone who likes stocks that make big moves. I'm not trying to convince you one way is better than the other.

As the title of this article states, however, any statistic can be made to serve some ulterior motive. Our job, as individual investors, is to constantly ask the critical question: What does the flip side of this coin look like?

If a writer is downplaying a stock, ask yourself how much of an upside it may have. Do the same with a bullish perspective -- ask yourself how far down the stock could reasonably go. This simple behavior could make an enormous difference in the long run.

If you're the type of investor who isn't afraid of a little risk, Fool.com analyst and MAKO expert David Meier has authored a premium research report covering all of the must-know details on the company, including key areas to watch and risks looming in the future. By covering both sides of the coin, David is trying to negate the framing bias.

As a bonus, David will keep you informed with a full year of updates and guidance on MAKO Surgical as news breaks. Click here now to learn more and start reading.

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Read/Post Comments (11) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 29, 2013, at 11:25 AM, waymilky wrote:

    Article is unreadable. Advertisements are placed over the content.

  • Report this Comment On January 29, 2013, at 4:57 PM, jrdow wrote:

    Check your math. In scenario 1, if we assume that the probability of each cookie being mouthwatering is the same, then the probability of each cookie being mouthwatering is about 91.24%. (0.9124 ^ 10 ~= 0.4, so there's a 40% chance they're all good). Consequently, there's a (100-91.24)%^10 ~= 0% chance they're all nauseating.

  • Report this Comment On January 29, 2013, at 4:58 PM, jrdow wrote:

    You need to specify that either all cookies are wonderful or all are nasty. It's wrong as written.

  • Report this Comment On January 29, 2013, at 5:19 PM, Acesnyper wrote:

    This passed as writing for the Fool?

  • Report this Comment On January 29, 2013, at 7:52 PM, TMFCheesehead wrote:

    jrdow-

    Totally agreed. Somewhere in the editing process, the second sentence was changed. It originally read: "In each, you will get 10 cookies that are either ALL mouthwatering or nauseating."

    Emphasis added :)

    Brian Stoffel

  • Report this Comment On January 30, 2013, at 12:25 AM, ChristopherHamel wrote:

    I would rather take my chance with the "60 percent chance that they're not all mouth watering" than the "60 percent chance they're all nauseating". The first 60 percent are anything less than mouth watering and may or not be nauseating (which includes mediocre) but the second 60 percent are known to be nauseating. :)

    CJH

  • Report this Comment On January 30, 2013, at 12:31 AM, ChristopherHamel wrote:

    Oops. I just read the pre amble to the two scenarios, better.

    There are only two types of cookies.

    I need to remember "a closed mouth gathers no feet"

    CJH

  • Report this Comment On January 30, 2013, at 11:49 AM, TMFCheesehead wrote:

    @waymilky-

    Thanks for pointing it out. Problem should be fixed now.

    Brian Stoffel

  • Report this Comment On January 31, 2013, at 11:56 AM, captainccs wrote:

    >>>Some careful examination will show that these two scenarios are exactly the same.<<<

    No, they are not.

  • Report this Comment On January 31, 2013, at 8:30 PM, TruffelPig wrote:

    The examples, as pointed out, do NOT work because Nauseating is MUCH WORSE than the alternatives. Not mouthwatering I can live with.

    Weird article. What is the point?

  • Report this Comment On February 03, 2013, at 11:18 AM, lisalisarose wrote:

    Also.... there's nothing wrong with MAKO.... I've made tons of money off MAKO..... if you're going to be a successful investor you're going to have to remember that you can't time the market. MAKO is so sorry it didn't perform WHEN you said.... but it will - all those elderly knees you spoke of are still out there... The Market just got pissed off because it was hoping MAKO was another ISRG.... doesn't mean it's not a screaming buy at today's price.

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