Halo & Horn Effects in Life & Markets
One psychological bias I’ve been thinking about lately is the halo/horn effect and in particular, its application in financial markets.
For background, the halo effect is the bias to view actions by someone you have a generally positive view on, positively. The horn effect is the opposite.
Other’s actions influence your judgement of them less than your initial view of them.
For example, a girl receiving flowers from someone she’s interested in would likely perceive the gesture as romantic and further reinforce her positive view of her suitor. On the other hand, a girl receiving flowers from someone she has no interest in is more likely to view the gesture as desperate, further reinforcing her negative view.
The act in question (receiving flowers) is the same, but the perception is very different. It depends on her base perception of the person doing the gesture.
This happens in all areas of life.
We are forgiving of the transgressions of politicians we support, but are unforgiving when those same transgressions are done by people across the aisle. Couples in the honeymoon stage can see no wrong in each other. Mothers tend to have blind spots towards the faults of their sons and vice versa.
It’s difficult to build meaningful relationships with people who lack some level of halo effect towards you because odds are you have some faults that need to be overlooked. It’s also next to impossible to build a close relationship with someone that has a generally negative impression of you. That person is more likely to have your actions reinforce their initial negative impression of you than change their view of you based on new evidence.
Adjusting your perceptions of others in light of new evidence requires mental effort and the ability to admit you were wrong in your initial impression. Most people avoid mental effort and admitting they were wrong like the plague. As such, the halo and horn effects tend to be quite lasting. It takes dramatic action in the opposite direction to cause someone to recalibrate their initial impression.
This has significant implications in financial markets as markets are aggregations of how individuals view the world. As with the effect of many psychological biases on markets, the best way to understand it is through the lens of technical analysis.
Investopedia give the following description of technical analysis:
- Technical analysis is used to evaluate investments and identify trading opportunities based on patterns seen on charts.
- Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
- Technical analysis may be contrasted with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.
In my early days as an investor, I thought technical analysis seemed like fairy dust and a waste of time. The nice thing about markets is if you’re wrong on something, you’ll find out quickly.
Often, I would have near certainty on the fundamentals of an investment idea, take a position, and then proceed to watch the trade go in the opposite direction. Often times, I was right on the fundamentals, but this didn’t stop me from losing money along the way. This is because the psychological biases of other market participants can drive prices further away from fundamentals for longer than you might think.
This is where technical analysis comes in. It can help you determine entry points into a trade and guide your understanding of the ‘fundamentals’.
The most important psychological bias technical analysis helps account for is the halo/horn effect. Once a positive or negative market trend becomes widely accepted by market participants, it takes a lot to reverse it. This is because all news around a given trend gets filtered through the lens of the base perception of investors.
For example, the current narrative around Tesla is Elon Musk is a genius, electric cars are the future, and Tesla will capture the majority of the cashflow coming out of this EV future. This narrative has led to a 1,500% return in the stock and 900B of incremental market value added to the company over the past 21 months.
I’m not taking a position on Tesla, but it is important to note the company’s clearly benefited from the halo effect. In December of 2020, Tesla announced a share issuance to raise ~5B. In the month following the announcement, its shares surged almost 50%. The act of issuing shares is dilutive to existing shareholders, but when done by a company viewed as the embodiment of modern genius, it had a significant positive effect on valuation.
Now like the flowers, imagine the same thing done by a company dealing with the horn effect by investors.
In 2019, Tesla was in a different boat. The widely accepted narrative was the company is run by an erratic CEO, future profitability is unlikely, and it’s on the brink of financial distress. In May of 2019, Tesla announced a share issuance to raise ~2B. In the three weeks following the announcement, its shares fell by ~25%.
The same act of issuing shares was viewed very differently based on the overarching narrative around the company at the time.
Technical analysis helps you understand the lens through which the market views a given asset, and where the likely inflection points will be. You don’t want to invest in something where everyone else will continue to view it through the lens of the horn effect, and it’s dangerous to short something benefitting from the halo effect.
Seeing how a company trades relative to its moving averages and trend lines can tell you important information about how favorably/unfavorably other market participants feel about a given asset. Establishing criteria around this tells you when to enter a position once your fundamental thesis has already been fleshed out. This brings further discipline to your investment process and helps to avoid big losses.
You could be completely correct on your fundamental read of a situation, but if you ignore technical analysis, you will lose money. Markets are driven by both logic and emotion, and if you only focus on the former, you’re playing the game with a significant handicap.