Investors often overestimate the probability of a favourable outcome coming to pass in a given situation. We also put great faith in mathematical models despite major flaws and create models based on past data, which is validated only against that same past data. This can have some strange results

Investors certainly have a lot of enemies these days. Governments are certainly near the top of the list. Capricious governments are happy to indulge in dubious macroeconomic experiments while failing in their basic regulatory function to prevent fraud and establish a stable investment climate. The failure of government has taken its toll on the one important area where government can make a difference, accurate, complete and timely information. But the investors' real enemy is still themselves.

Our real problem as investors is that not only do we not get good information, we have a tendency to ignore the information we get. For example, many commentators assume that the United States (US) will raise its debt ceiling and that the Eurozone will solve the Greek issue without a default, despite a great deal of accurate information to contrary. This is called the positive outcome bias, which is the tendency of people to overestimate the probability of a favorable outcome coming to pass in a given situation. We put great faith in mathematical models despite a major flaw. We create models based on past data which are validated only against that same past data. This is called the forward bias. These and others can have some very strange results for investors, none so much as the idea of a hot stock. In the US we have a very obvious example, Netflix.

Netflix was a company with a very good idea. Rather than go to a store to rent DVD movies, you could get them by mail. Not only was the delivery a good idea, unlike Blockbuster, the brick and mortar franchise, Netflix did not charge irksome late fees, which often cost more than the rental fee itself. When Netflix started in 1999, Blockbuster had few competitors and so dismissed the threat from Netflix. Blockbuster went bankrupt in 2010.

Meanwhile, Netflix went from strength to strength. It achieved 10 million subscribers in 2009. The stock also did quite well. For much of its history the stock traded barely above 20, but with the demise of what was considered its only competitor, it started doing much better. At the beginning of 2007 it was trading at 22. By March 2009, when all the other stocks had crashed, it had increased 75% to 35. In another year, in 2010, it had doubled to 70, and increase of 40% in five weeks and it was trading at 27 times earnings.

By that time, another cognitive bias had come into play: an availability cascade, a self-reinforcing process in which a collective belief gains more and more plausibility through its increasing repetition in public discourse. The Netflix 'story' had taken hold, but it took off with internet streaming. The service was actually available as early as 2008, but really got going in the fall of 2010 with the 'Watch Instantly', service, initially free with a regular subscription. The stock doubled again to 120.

The main part of the collective belief was that Netflix did not have any competition. This is far from true. Its original competition Blockbuster went bankrupt, but not out of business. There are other companies like Amazon and Hulu that stream movies and television shows. Hulu is small, but it is owned by NBC Universal, Walt Disney and News Corp. Other competitors include such heavyweights as Google and Apple. Besides the entertainment and tech giants, Netflix competes against the large cable companies that all allow movie rentals.

Netflix managed to increase its subscribers to 25 million, 70% of this last year, thanks in part to the strength of its brand. Then, Netflix decided to change its fees. The internet streaming which had been free, would be subject to an additional charge. The new charges increased the monthly fees by 60%. The reaction was immediate. Over 12,000 customers posted complaints on Facebook and a survey suggested that 26% of Netflix customers would cancel. But it did not slow the stock. The momentum of the bandwagon effect was firmly in control.

The stock actually reached new highs, based on Netflix's plans to expand into Latin America. Investors thought only about the millions of new customers. Since they were subject to confirmation bias, investors never considered that in emerging markets the bandwidth necessary for streaming movies is not widely available. The stock hit a new high of 300.

But all good things must pass. Netflix, now trading at 80 times earnings, recently fell 16% on disappointing revenues. Did the analysts admit a mistake? No, Anchoring bias. Analysts said the bad news was temporary, only temporary. Netflix would recoup its $300 price target and would hit $1,000 in five to seven years. A perfect example of an 'overconfidence effect', which is an excessive confidence in one's own answers to questions.

In the words of an American cartoonist, Walt Kelly, "We have met the enemy and he is us."

(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)