Know Your Biases: Extraordinarity Bias

According to Wikipedia, "Extraordinarity bias is one of the cognitive biases. It is the individual and social tendency to value an object more than others in the same category as a result of an extraordinarity of that object that does not change the value in itself."

The application of this bias to value investing may well be most exhibited in basic chart reading. An extraordinary leap in a stock doesn't change its fundamentals, although such a leap could be signalling a change in them. On the other hand, there may be no change. Similarly, a leap of that sort could be evidence of a catalyst turning an undervalued stock into a fairly-valued issue - but it might not be.

In the short time I've been running my actively-managed mock fund at Marketocracy, I've seen two leap-ups of that sort turn sour. Both of these stocks were in the Low P/E Bin when they started taking off. The first was Teekay, which I put in the mock fund. The second was WSP Holdings, which I didn't. Teekay hasd a run-up in early June which carried it to almost $23.50. Impressed, I had bought in at about $23. It's now below $19.

The other, I didn't react to. WSP Holdings also had a huge run-up in early June, to more than $7. It too fizzled, and the stock sunk back to $5.18 before rallying somewhat over the last week. There's a current example of a stock roaring up simply on the basis of an upgrade: Deluxe Corp. Given the above two outcomes, it may be the best course to wait for a sustained pullback if Deluxe is deemed a buy on other grounds.

Extraordinarity bias, in a chartists' context, also applies to sudden drops. The extraordinariness of a drop, although suggestive of future trouble, does not necessarily mean that the value of the stock has changed for the worse. It may just have gone on sale. The most famous example in value investing lore is American Express' plummet in 1962 after the salad-oil swindle was unearthed. Warren Buffett took advantage of this plunge, after making sure that its fundamentals were not in fact deteriorating, and scored a quick profit. The extraordinality of the exposed fraud made Amex look awful, even though an analysis showed immateriality.

A more recent (if more modest) example of a short-term plunge was Barclays plc dropping more than 10% in the beginning of June, because the Abu Dhabi sovereign wealth fund sold its stake in the bank. Barclays has since recovered to almost the same price the stock was at before the offloading was announced.

In the first case, taking account of extraordinarity bias means avoiding the temptation of buying a stock that's leaping up, unless there's solid corroboratory evidence that its fundamental value has improved. In the latter case, in the absence of any sign of definite weakness, buying the stock would be a proper course if it's a good value on other grounds.

This example of extraordinarity bias is only one of many in the stock market. Many stockbrokers rely on this bias to make sales.