The Halo effect is a subjective bias we use when comparing investments and it can cause us to to unfairly favour one investment over another.
Reference: “Thinking Fast and Slow”, by Daniel Kahneman
The idea is that the first attribute we observe about a person or a thing, biases our interpretation of the attributes to follow.
One example is a lecturer marking essay questions. For a given student if the first part of the essay is very impressive, the lecturer is prone to mark the rest of the paper more favourably than may be its due. The lecturer is prone to overlook or justify negatives.
On the other hand, a poorly started essay makes the lecturer more prone to observe the faults or deficiencies in the remains of the essay and mark accordingly.
This subtle bias, that is possible in even the most accomplished marker can go entirely unnoticed until later comparing the scores given for each part of the essay with those of other students.
The same subtle danger can be present when carrying out investment due diligence. The old adage is that first impressions last, and our initial reaction to an investment, be it from past experience or the degree of our positive reaction when being introduced to the investment for the first time.
Once there is awareness of this, there are solutions. To nail this bias pretty comprehensively, professional investment research companies (such as ourselves) use as many as possible of the following techniques to counter the Halo Effect in due diligence:
- Blind evaluations: In due diligence, this could mean removing company names, logos, and other identifying information from financial reports and other materials before presenting them to investors for evaluation.
- Multiple raters: Having multiple people evaluate a company can help to mitigate the influence of the Halo Effect by providing a more well-rounded perspective. This could include having multiple due diligence teams working on the same project, or involving a diverse group of stakeholders in the evaluation process.
- Structured evaluations: Using a standardised due diligence checklist or framework can ensure that all relevant factors are considered, and that evaluations are based on specific criteria rather than subjective impressions. This could include considering financial metrics, market trends, competitive analysis, and other relevant factors.
- Controlled comparisons: Comparing a company to its peers or to similar companies in a controlled setting, where extraneous factors are held constant, can help to isolate the specific traits being evaluated and reduce the impact of the Halo Effect.
- Self-reflection: Encouraging due diligence teams to reflect on their own biases and assumptions can help them to be more aware of the Halo Effect and reduce its influence on their evaluations. This could include providing training on cognitive biases, or encouraging team members to challenge their own preconceived notions about a company.
By using these techniques, one can reduce the impact of the Halo Effect in due diligence and make more accurate and fair evaluations of investment opportunities.
OK, so that’s a lot to do.
A simple solution
So here’s one simple & practical solution to try when your doing your own due diligence at home:
If you have several prospective investments available and are ranking them as part of you due diligence, with a view to selecting the highest ranking, a proven solution to address the halo effect is as follows
Rather than carry out your entire due diligence process for the first investment – going through each of your defined research topics – then moving on to the next investment and so on, run your research on the first topic for each investment, then the second topic on each investment and so on. This will make it much less likely that the conclusion from a given topic is influenced by the previous one.
The simplest solution are often the most impactful!
