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Avoidable errors

This is a common mistake. It’s the same one that explains why infrastructure and IT projects often run over time and over budget, and why Network Rail’s engineering works over Christmas took longer than expected. It’s the planning fallacy: we under-estimate how long complicated jobs will take.

One reason for this is simple overconfidence; we over-estimate our ability. But there’s another reason. It’s the anchoring effect - our failure to appreciate how probabilities multiply.

Imagine a project comprises 100 jobs, each of which has a 99 per cent chance of being finished on time. What’s the chance that all 100 will be done on time? The answer is just 36.6 per cent. There is therefore a more than 60 per cent chance the project will over-run.

This explains why bookies are so happy to take accumulator bets. A combination of highly likely events is unlikely to occur. Naïve gamblers fail to see this. So too do heads of government enquiries and some project managers.

What’s all this got to do with investing?

Plenty. I suspect the planning fallacy is one reason (of several!) why small growth stocks (and Aim stocks in particular) are often over-priced. There are many hurdles between having a good idea and having a big business, and investors over-estimate the probability that a firm can jump over every one of these hurdles.

The anchoring effect also explains why some people invest in expensive funds. An additional change of one per cent per year might not seem much - but investors under-estimate the fact that it compounds horribly over time.

And here’s the point. Although he was a successful and able civil servant, Sir John was not able to avoid a common and well-known mistake. Intellect alone, therefore, is no protection against cognitive error. This point has been demonstrated by the great Gerd Gigerenzer. He and his colleague Ulrich Hoffrage have shown that the majority of German doctors are horribly wrong when asked to infer from probabilistic diagnostic tests whether patients have a disease.

I fear the same applies to investors. Being clever and successful in one field does not protect us from making errors in other fields - perhaps even the opposite, to the extent that success breeds overconfidence. The world is full of clever people doing stupid things.

Luckily, though, we do know what sort of errors are common and costly. These include: trading too much; holding onto losing stocks in the hope they’ll come good and so exposing ourselves to adverse momentum; and being swayed by peer pressure or herding into buying at high prices.

In a complex and unpredictable world, some mistakes are inevitable. Others, though, are not. We should at least be able to minimize these.

In public affairs, avoidable and well-known errors seem to be acceptable. Investors, however, should have higher standards.