COGNITIVE BIAS
How first impressions shape investment decisions
Published date: 28 August 2024 | 5-Min Read
What is the halo effect in investing?
Imagine a venture capital (VC) firm evaluating two startups for potential investment.
Startup A is led by a charismatic, well-connected founder who previously worked at a renowned tech company. The founder’s impressive background, polished pitch, and the high-profile advisory board instantly capture the attention of the VCs. Because of these strong initial impressions, the VCs subconsciously start to overlook potential red flags, such as the startup’s unproven business model and limited market research. The founder’s previous success casts a „halo“ over the entire venture, leading the VCs to believe that this startup is destined to succeed, despite the risks.
Startup B, on the other hand, is led by a more reserved founder with a less flashy background. This founder has a solid, data-driven business plan and a unique product that addresses a clear market need.
However, because the founder’s presentation lacks the same level of charisma and there’s no big-name backing, the VCs are less enthusiastic. The startup’s merits are overshadowed by the less impressive first impression.
In the end, the VC firm decides to invest in Startup A, driven by the halo effect—the hidden bias that leads them to overvalue the qualities associated with the founder and under appreciate the actual business potential.
Months later, Startup A struggles to gain traction, and the VCs realize that they might have been blinded by their initial impressions. Meanwhile, Startup B secures funding elsewhere and begins to gain significant market share, proving that the halo effect led the VCs to overlook a potentially more promising investment.
In the high-stakes world of investing, our perception can overshadow reality. This is known as the Halo Effect, a cognitive bias where single standout traits influence our entire view.
Let’s explore how this phenomenon works, its impact on investor decisions, and how we can see beyond the mirage.
The Halo Effect Definition
A phenomenon where a single positive attribute disproportionately influences our overall judgment, this universal bias can profoundly impact how we evaluate companies, products, and even individuals.
This mental shortcut can be helpful in making quick decisions in everyday life, but in investing, it can lead to over-reliance on first impressions and a failure to critically assess all available information.
3 most common Halo Effects
- The aesthetic product demo
- The stellar company
- The charismatic founder
The aesthetic product demo
When a product’s aesthetics or presentation are polished and visually appealing, it creates an immediate positive impression that can overshadow a critical evaluation of the product’s actual functionality.
This phenomenon is clearly illustrated by Nikola, an electric vehicle startup that gained significant attention with a stunning video of their prototype truck. The video showed the truck moving smoothly along a road, leading investors and the public to believe in its groundbreaking technology. However, it was later revealed that the truck was simply rolled down a hill, and the doors were even held together with duct tape to maintain the illusion of functionality.
This case exemplifies how the Halo Effect can mislead both consumers and investors. The initial appeal of a product’s aesthetic or a well-crafted demo can create a strong, positive bias, causing people to overlook the importance of rigorous scrutiny. The truth can be far from the expectations set by that first impression, underscoring the need to critically assess what lies beneath the surface.
First impressions of the login aesthetics, users believe the app is more reliable
The image „First Impressions Count! How Your Login Page Sets the Tone for User Experience,“ further illustrates how initial aesthetics can shape perceptions.
Just as a visually pleasing login page can lead users to believe that an app will be intuitive, reliable, and secure, a well-designed product demo can lead investors to assume that the product itself is just as impressive. However, as with Nikola’s deceptive demo, the reality may not live up to the carefully crafted first impression. This highlights the critical need to look beyond aesthetics and evaluate the true substance of any product or technology.
The cautionary tale of Nikola Motors can be found here.
The stellar company myth
Consider the rise and fall of Cisco Systems. In the late 1990s, Cisco was hailed as a darling of the new economy.
Business journalists praised its:
- Customer service
- Strategic acumen
- Charismatic leadership
In March 2000, it became the most valuable company in the world. However, when the dot-com bubble burst and Cisco’s stock plummeted by 80%, the narrative shifted dramatically. Suddenly, the same attributes that were once celebrated—its strategy, culture, and leadership—were recast as shortcomings.
- The strategy was deemed poor
- The culture complacent
- The CEO ineffective
What changed?
Not the company’s management or strategy, but the external market conditions and demand for its products. The halo effect had led investors and journalists to conflate Cisco’s stock performance with its overall business health, obscuring a more nuanced reality.
Investors might fail to conduct thorough due diligence processes if a company has a stellar reputation or a CEO with a strong track record.
The charismatic founder
With Stanford University as her backdrop, Elizabeth Holmes’s narrative as a dropout challenging the established norms only enhanced her appeal. Silicon Valley has a long history of charismatic founders who left school to chase their dreams and, in doing so, transformed entire industries:
- Notable examples include:
Apple’s Steves, Michael Dell, Bill Gates, Mark Zuckerberg, and Jack Dorsey, among others.
While multiple cognitive biases played a role, the halo effect was particularly significant:
- VC Decision-Making:
For venture capitalists, dropping out of a prestigious university signals bold risk-taking and potential success.
- Holmes’s Media Presence:
By positioning herself as the next Steve Jobs and consistently appearing in the media, Holmes became an unstoppable force.
- Influential Board:
Another key element in the Theranos story was the strong halo effect created by her board of directors, which included prominent figures like retired generals, Defense Secretaries, and even a legendary Secretary of State. This gave the company an aura of credibility and invincibility.
These factors, combined with social proof and the fear of missing out (FOMO), built the narrative of a revolutionary medical technology company that promised to transform blood testing.
- The Reality:
Investors and the media were captivated by this image, but beneath the surface, the technology was flawed, and the promises were empty.
Theranos, the notorious health technology startup, serves as a textbook example of the halo effect in action:
- Holmes’s Charisma:
Elizabeth Holmes was initially hailed as a visionary who could revolutionize blood testing with just a single drop of blood.
- Board Influence:
Her charisma, along with the prestigious board she assembled, cast a powerful halo over the company.
- Overlooked Red Flags:
This positive impression led investors to overlook critical warning signs, such as the lack of transparency and the absence of peer-reviewed validation.
Investors assumed that because Holmes was charismatic and the board was influential, the technology must be legitimate. This bias blinded them to the reality that Theranos’s claims were too good to be true, ultimately leading to one of the most infamous collapses in Silicon Valley history.
More in-depth examples can be found in the The VC Factory article „SBF, Holmes, Madoff: How They Fooled Investors“
How to Mitigate The Halo Effect
- Focus on data-driven decisions: Look at key metrics—like financial performance, debt levels, and market share—rather than getting swept up in the narrative. Data can help you cut through the noise.
- Comparing against industry benchmarks and historical data: Create a checklist of KPIs to evaluate. By focusing on quantifiable data, you can make more objective decisions and reduce the influence of the Halo Effect.
- Reassess regularly: Don’t let your initial impressions dictate your long-term decisions. Quarterly and annual reviews against other investee companies, industry trends and market conditions can help answer if the investment is still a good one today before you decide to double down!
- Seek diverse perspectives: Another effective way to minimize the halo effect is to seek input from others, especially those who are neutral or may have a different perspective. Engaging with a “devil’s advocate” can help challenge any overly positive or negative impressions.
- In a fund administration context, this could mean consulting with analysts who are less emotionally invested in the fund or bringing in external advisors to provide an unbiased assessment. Diverse opinions can balance the influence of a positive halo and lead to more well-rounded decision-making.
Conclusion
The halo effect is a powerful cognitive bias that can shape our perceptions and, in turn, our investment decisions. Whether you’re evaluating a fund manager, a new product, or a brand, you can avoid the traps that can lead you astray by seeking out neutral and diverse opinions, relying on data, and regularly reassessing your investments.
Understanding these biases is essential for achieving flawless investment decisions and navigating the complexities of fund administration.
Source: Rolf Dobelli, “The Art of Thinking Clearly” (2013)
Graph source: The Decision Lab The Halo Effect in Consumer Perception: Why Small Details Can Make a Big Difference by Itamar Shatz (2019)
About ACE Alternatives
ACE Alternatives, a leader in managed services for the Alternative Assets sector, specializes in venture capital, private equity, fund of funds, private real estate, and more. Leveraging tech-driven processes and extensive industry experience, ACE offers tailored solutions for fund administration, compliance and regulatory, tax and accounting, investor onboarding and ESG needs.
Our vision is to redefine fund management standards with data-driven processes, combining advanced technology with deep industry knowledge. We are committed to demystifying complex fund operations, promoting transparency, and achieving sustained growth across the fund lifecycle.
