'Run your winners' and 'never look a gift horse in the mouth'. Such old pieces of advice can sometimes cost us money. The collapse of Patisserie Valerie highlights this. It raises the question: why did investors, some of whom had big stakes and lots of experience – not notice the fraud? One possibility is simply that they weren’t looking hard enough. All of us have limited attention: we cannot trouble ourselves with everything. We therefore devote our efforts to what troubles us – investments that are losing money or that face clear dangers. If a business seems to be pootling along nicely, as Patisserie Valerie seemed to be doing for years, it’s natural to leave it alone and focus on other ones. If it ain’t broke don’t fix it.
In his recent book, The Perils of Perception, Bobby Duffy of Ipsos Mori, writes: “Negative information draws and holds our attention more than positive information.” He believes there’s an evolutionary reason for this: cavemen who paid attention to warnings of sabre-toothed tigers in the area survived to pass on their genes whereas those who looked only for good news did not. Neuroscience is consistent with this. Researchers at Ohio State University have found that negative signals such as disturbing pictures stimulate much more brain activity than positive ones.
Successful fraudsters exploit this. Bernie Madoff gave his investors steady returns in the hope that they would not investigate his activities; that they wouldn’t look a gift horse in the mouth. He was right for many years.
Which poses a troubling thought. If we tend to ignore businesses that seem reasonably stable, how much other fraud might we be overlooking?
By definition, we can’t know for sure. But we have one clue. The University of Chicago’s Luigi Zingales and colleagues looked at US companies that were forced to change auditor after Arthur Andersen collapsed. The change led to the detection of four times as much fraud as Andersen’s had uncovered. Professor Zingales and colleagues inferred from this that one in seven US companies is engaging in some kind of fraud, costing investors around a fifth of the value of those companies.
It’s not just fraud, though, that can cause investors to lose money by not paying attention to apparently good investments. The same can be true for successful stock-picking strategies and good funds.
If a strategy or fund has done well for a long time and especially well recently this could be because investors have wised up to it and so piled in, causing the stocks in that strategy or fund to become overpriced. Until last year, for example, many momentum and mid-cap strategies had paid off well. Then they stopped doing so. Success breeds both complacency and inattention, and so causes us to hold on to overpriced shares: as Anton Cheremukhin and Antonella Tutino at the Dallas Fed have shown, inattention can contribute to bubbles as people run their winners.
All this sounds like a plea for investors to pay more sceptical attention to successful companies and strategies. But there’s a strong counterargument. Andrew Abel at the University of Pennsylvania has shown that investors should ignore the stock market for long periods. This is because paying attention can make us worry unnecessarily when the market dips briefly. And, given that we all have countless ways of making mistakes, close attention could merely lead to us make more bad decisions.
Inattention can therefore save us from error: it can stop us from trading on what is in fact noise rather than signal.
Cliches such as 'run your winners' and 'if it ain’t broke don’t fix it' are clichés precisely because they contain big elements of truth. Not noticing a fraud at an apparently successful company is therefore an entirely understandable mistake.
But as the physicist Niels Bohr famously said, the opposite of a great truth is another great truth. What makes investing so interesting and so hard is that it is very difficult to tell which truth we should apply. Which is why even good investors often get things wrong.
