We live in a complex and busy world. We're flooded with information to process and decisions to make. That's why our brain uses shortcuts, called cognitive shortcuts, to make quicker decisions. Some of these shortcuts can be quite biased because they're based on past experiences or a physical impression. One such bias is the halo effect, in which we see a person or entity in a positive, or saintly light. Once bestowed, the one wearing a halo can do no wrong, which paves an easier road to success. However, it also exposes those using this shortcut to potential pitfalls down the road.
What is the halo effect?
Psychologist Edward Thorndike was the first to observe the halo effect, after he noticed that people make character judgments based on physical impressions. Because we see characteristics we like, we rate the total package in a positive light. It is as if the person or entity being judged is wearing a halo, much like those seen in religious paintings of the saints during the Renaissance period. Because of the halo effect, our brain takes the shortcut to judge everything about that person or entity in a positive light.
We see the halo effect all throughout the business world. A visionary leader is viewed as someone who can do no wrong. This tendency causes some investors to overlook a company's strategy, balance sheet, or valuation, because they're too focused on the profit potential the leader can bring. This halo around the leader and the company can cause the stock to soar, oftentimes beyond what's reasonable. The potential pitfall is that investors can be left exposed to more downside than they expected if the company's future prospects turn out to not be as promising as they thought.
Elon Musk's halo shines bright
There might not be a brighter halo in the business world right now than the one worn by Elon Musk. The serial entrepreneur was a co-founder of PayPal, Tesla Motors (NASDAQ:TSLA), and Zip2 as well as the founder of SpaceX. He also came up with the initial concept for Solar City (NASDAQ:SCTY.DL), which his cousins then co-founded. Everything he touches seems to turn into gold, which is why investors are flocking to the companies he's associated with these days.
However, his halo can sometimes cloud investors' judgement. This past year we saw a perfect example of how Musk's halo has investors eating out of the palm of his hand. In March he tweeted that Tesla would unveil a major new product line that wasn't a car. That tweet sent the company's stock up about $10 per share, or about 6%, adding $900 million to its market cap. He didn't say what the product would be, how much it would cost to develop, or its projected sales. None of that mattered to investors. They just wanted in on Musk's next big idea. That big idea turned out to be the Powerwall, which is a home battery that stores energy. It could very will be Musk's next billion-dollar idea, but investors certainly got ahead of themselves bidding up Tesla's stock just because Musk's company was coming out with a new product.
Musk's halo also carries over to his involvement in SolarCity, where he's the chairman and the largest shareholder. Last year, the solar panel leasing company vertically integrated by paying $350 million for a solar-panel maker. That deal sent SolarCity's stock up 18%, adding $900 million to its market value. Again, investors saw this as another billion-dollar idea by Musk, even though solar-panel manufacturing has historically been a tough business.
Our brains use shortcuts to make decisions, but these shortcuts can be biased. The halo effect is one example, as we tend to view a everything a person or a company does in a positive light based on a few positive characteristics. It's a bias that can really blind investors, as they see a billion-dollar idea just because a visionary leader is involved, leaving them less prepared to manage the consequences should that idea short-circuit.
Matt DiLallo owns shares of SolarCity. The Motley Fool recommends SolarCity and Tesla Motors. The Motley Fool owns shares of SolarCity and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.