Selective Perception in Stock Investing

by Rich Hamilton
July 17th, 2005

Here we present the diaries of Mr. Selective Perception and Mr. Rational. The diaries show selective perception in action – it’s a common frailty and it affects most of us at one time or another.

Selective Perception

Selective Perception describes a human frailty – our tendency to see only what we want to see. Selective perception causes poor investing decisions.

Psychologists class selective perception as a cognitive bias, and the phenomenon has been recognized for years by non-specialists. For example, some of us are said to see the world through rose-tinted glasses – we see the better side of life and block out some of the bad aspects.

The best investors are able to make good judgement calls from the information they receive. They weigh all evidence carefully, whether it agrees with their current line of thinking or not. If they slip up and give stronger weight to evidence that agrees with their current line of thinking than to other evidence, then selective perception is clouding their judgments.

Emotions can be a particularly strong trigger for selective perception. For example, if you hear about an argument between one of your friends and someone you dislike, whose version of events are you most likely to sympathize with? Unless the evidence against your friend is strong, you will tend to believe your friend. Successful investors learn to keep emotions out of their decisions. Whether or not they have heard of selective perception, they have learned that emotion-based investment decisions are usually less rewarding than fact-based investment decisions.

Let’s have a look at a simplified series of events in the history of a stock to see selective perception in action. We’ll look at these events through the eyes of Mr. Selective Perception and Mr. Rational.

Our example is simplified – actually grossly simplified – but if you’ve ever bought and sold stocks we suspect you’ll sympathize with some of Mr. Selective Perception’s reactions.

The problem with selective perception is that if you want a stock to rise you tend to block out negative news. If you want a stock to fall, you do the opposite and ignore the positive news.

To be successful, you need to take a balanced view and act appropriately on all information – not just information that you like the sound of. Some people have a natural talent for this and they generally profit handsomely from stock investing.

If you are prone to selective perception, you would do well to consider using a trading system that relies only on numbers – generated either from technical or fundamental analysis – to signal your buy and sell decisions. If you act on these signals in a disciplined way, you should still be capable of achieving good results from investing.

Diaries of Two Stock Holders

Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
The Buy Both of our people purchase shares in XYZ.	I have bought some XYZ stock. I am not an idiot. I make good decisions. I am going to make some money on XYZ.	I have bought some XYZ stock. It may have been a bad decision. I will monitor my position closely. I will set a stop loss. If the stock falls 10 percent below my purchase price, I will sell it.
XYZ share price: $10.00	1,000 shares bought @ $10 per share. Holding: $10,000	1,000 shares bought @ $10 per share. Holding: $10,000
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
A Falling Share Price Since the day of the purchase, the stock has dropped by 7 percent while the general stock market has risen. There have been no company announcements.	People who are selling this beauty are plain stupid. XYZ is going to be a star performer. I’ll average down and double my stake if it keeps falling. It’s great value!	I’m concerned that the market does not share my enthusiasm for this stock. If it falls 10 percent below my purchase price, I’ll sell it.
XYZ share price: $9.30	Holding: $9,300 Loss = $700	Holding: $9,300 Loss = $700
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
Insider Selling Market announcement – a big insider has sold 25 percent of his stake in XYZ. The stock falls to 10 percent below the purchase price.	These big shots have expensive lifestyles to maintain. The guy probably needs the money to have his luxury yacht refurbished. This stock is great value. I’m going to double up.	The combination of a falling price and a big insider selling is a strong negative sign. I’ll sell today. If signs look more positive in future, I can always buy it back. I shall protect my capital by not exposing it to further losses.
XYZ share price: $9.00	Holding: $9,000 + $9,000 Loss = $1,000	Holding: $0 Loss = $1,000
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
Q1 Results Announced Sales and earnings are both down. The management says there have been some problems with quality and distribution, but these will be solved within the next quarter.	Don’t the idiots who are selling XYZ shares read the reports? Earnings are only falling because of little problems that will soon be solved. Some people just can’t think long-term.	It looks like a few people found out some time back that this company was having problems and jumped ship before the worst came out.
XYZ share price: $8.00	Holding: $8,000 + $8,000 Loss = $3,000	Holding: $0 Loss = $1,000
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
Q2 Results Announced Sales and earnings are down again. Managers state that the quality problem has been solved and growth should soon return to normal. The market reacts badly to the profit figures.	These stinking managers have been lying all along. They said the problems would be solved, but sales have kept falling and the stock price is down again. I’m finished with these crooks. Stock sold.	The management says that problems have been solved. That’s in line with what they predicted in Q1. They have no history of lying in their reports so I’ll believe them. If sales and earnings recover, this stock is a steal at today’s price. The share price is still falling, though. I’ll wait for that to stop before I buy.
XYZ share price: $7.00	Holding: $0 Loss = $5,000	Holding: $0 Loss = $1,000
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
Q3 Results Announced Sales and earnings are flat. Managers say customer confidence is returning after the previous problems.	Only an idiot would buy this stock. They said they had solved the problems but profits are flat. That proves they still have problems.	This stock, apart from the recent blip, has fantastic potential for growth – that’s why I bought it in the first place. It’s reasonable to expect a delay before customer confidence recovers fully. It’s a good sign that there has been no further deterioration. The stock price is up and the downward trend on the chart has been broken. These are positive indicators – the market believes XYZ has turned the corner. It’s possible I’m buying too soon, but I’m going to buy XYZ again. As before, I’ll set a 10 percent stop-loss.
XYZ share price: $7.50	Holding: $0 Loss = $5,000	Holding: $9,000 Loss = $1,000
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
Q4 Results Announced Sales and earnings are up strongly. New orders have been won from overseas. Microsoft has named XYZ as a preferred supplier.	Anyone that deals with Microsoft must be an idiot. I hate Microsoft. I’m really glad I sold XYZ because I wouldn’t want to hold stock in a company that deals with Microsoft. XYZ is still worth less than I paid a few months back. It’s been a suckers’ stock.	Sales and earnings are fantastic. New orders and the publicity associated with the Microsoft deal are going to increase interest in XYZ as a stock and in its products. The signs are more positive for XYZ than they were back when I paid $10 per share. I’m going to double my holding today to 2,400 shares. By selling early on the way down, I preserved my capital and I now have a small profit. 1,200 more shares bought.
XYZ share price: $8.75	Holding: $0 Loss = $5,000	Holding: $10,500 + $10,500 Profit = $500
Event	Mr. Selective Perception’s Reaction	Mr. Rational’s Reaction
Q1 Results Announced Sales and earnings are up very strongly again. The market has become very enthusiastic about XYZ. The stock is now being tipped by newspaper columnists.	Life sucks.	I’m glad I bought when it looked like the company had turned the corner. I’m glad I doubled my holdings when indications became increasingly positive.
XYZ share price: $11.00	Holding: $0 Loss = $5,000	Holding: $13,200 + $13,200 Profit = $5,900

In the example above, Mr. Selective Perception filtered the early information he received through a rose-tinted filter. Then, as events turned against him, he switched, in disgust, to a black-tinted filter. Neither filter was helpful.

Meanwhile, Mr. Rational benefited by dealing with events without any tint to his glasses.

Of course, real life is invariably less clear-cut than our example above. If you’ve ever been a victim of selective perception, I hope this simple example will help you recognize its symptoms in future. If you have never suffered from selective perception, you are one of a rare breed.