Tag Archives: psychology

The ‘Critically Counterintuitive’ Rules Of Investing

A few years ago, I came across the concept of the “critical counterintuitive.” It’s one of the most compelling mental models I have ever come across. And it’s also one that you can readily apply to the world of investing. The “critical counterintuitive” is “critical” because little else really matters. It is “counterintuitive” because the world works in ways almost exactly opposite to the way you think it does. The “nice guys” who take the flowers and candy route rarely get the girl. The smartest kid in the class rarely becomes rich and famous. The class clowns who make it big are oftentimes the most unhinged, the trappings of material wealth notwithstanding. And understanding how you can apply this mental model can spell the difference between your investment success – and utter disaster. Don’t Confuse Luck with Smarts The role of luck in investment success is deceptively subtle. You may think that investing $10,000 into one stock that makes you $1 million would be the best thing that could ever happen to you. But you’d be wrong. Having enjoyed such phenomenal success, you’d suddenly think that you’d cracked the code of the markets. The next time around, you bet your house, your car and your life savings on another “can’t lose” investment. Maybe you’d win this time as well. You calculate that if you do it only one more time, you’d have $100 million in the bank. Eventually, however, your luck runs out. Your last investment flops. And since you bet the farm, you not only lost your shirt but also you’re deeply in debt. You are worse off than when you started. Moreover, you also spend the rest of your life trying to replicate your initial trade, telling yourself that you’ve learned your lesson, and if you do it only one more time, you’ll take all your chips off of the table. That’s the problem with sudden wealth, whether it comes from a big bet on a stock tip or buying a winning lottery ticket. Any Psychology 101 student can cite the study according to which almost all lottery winners end up poorer five years after they’ve won than beforehand. As a wise man once said, “If you win a million dollars, you’d best become a millionaire. Because then you get to keep the money.” The lesson? Understand that if you have ever won a big investment bet, you were at least as lucky as you were smart. But over the long term, there are no shortcuts. Making money on a consistent basis is a grind that is one part “insight” and ten parts “discipline.” Your Analysis Is Irrelevant to Your Investment Success The philosopher Friedrich Nietzsche once observed that “any explanation is better than none.” I disagree. Sometimes, in the investment world, no explanation is really necessary – or relevant. Today, we suffer from the paradox of information overload. If you have a smartphone in your pocket, you can access more information about the financial markets than the world’s top hedge funds did 20 years ago. Yet, I bet your investment returns have not improved one iota as a result. Not only do we seem incapable of divining the future, we can’t even seem to agree on what happened. Was the credit crunch a result of Greenspan’s monetary policy, Bernanke’s incompetence or President Clinton’s “affirmative action” for low-income borrowers? Or was it just a classic mania? We crave explanations because they give us an illusion of control. But it gets even worse. Even those Cassandras who got their analysis “right” in predicting the credit crunch weren’t able to turn their accurate insights into money for their clients. And truth be told, time hasn’t been kind to their predictions either. Gold didn’t hit $5,000 an ounce. The U.S. dollar didn’t implode. Treasuries didn’t collapse. Analysts who promised to “crash-proof” their clients’ portfolios ended up losing more money for their clients than if they had stuck with simple index funds. The lesson? Successful investors are effective in the long term because they admit their mistakes. As the world’s greatest speculator, George Soros, said, “My system doesn’t work by making valid predictions. It works by allowing me to recognize when I am wrong.” Your ‘Intelligence’ is Your Biggest Handicap Warren Buffett famously observed that it takes no more than average intelligence to become a successful investor. I’d add something to that. I’d say high intelligence is actually a handicap to successful investing. Here’s why… When you are smart, you are used to being 100% correct. You just can’t take the possibility of being wrong. So you stick to your guns, even when the market is telling you otherwise. That’s why overeducated Wall Street analysts make such lousy money managers. And it is why hedge-fund managers who flaunt their intelligence inevitably flounder. Think about it this way… If high intelligence were the key to successful investing, top business school professors and economists would be the wealthiest guys on the planet. Instead, the Forbes 400 is populated by dropouts from places like Harvard (Bill Gates) and Stanford (the Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) guys). None could have gotten a job on Wall Street, let alone taught at a top business school. That’s also why poker players make the best traders and investors. They play each hand as it is dealt to them. If they get a bad hand, they fold. They play the investment game the same way. Perhaps that’s also why a former dean of Harvard College, Henry Rosovsky, observed about Harvard students: “Our A students become professors. Our B students go to law school. Our C students rule the world.” After all, it was those C students who stayed up all night playing poker with Bill Gates. So how can you use these “critically counterintuitive” rules to improve your investment returns? First, never bet too big on one idea. You may get lucky once. Maybe even twice. But your luck eventually will run out. And if you bet the farm, you are out of the investment game for good. Second, don’t delude yourself into thinking that you have special insight into the market. Bring that attitude to your investments, and you will have your head handed to you. And it’s not a question of “if” but “when.” Third, learn to think of your investments like a hand in a poker game. Up the ante when you are lucky enough to get a good hand. But also be prepared to fold – and to fold often. But above all, take the advice of a very wise trader who once said: “Some people are born smart. Some people are born lucky. Some people are smart enough to be born lucky.” Here’s hoping that you were born lucky! Until then, I wish you a very Merry Christmas and Happy Holidays.

The Wisdom Of Charlie Munger

As you may know, Charlie Munger is the low-profile partner of Warren Buffett and vice-chairman of Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). You may have seen Munger sitting alongside Buffett during the famous annual Berkshire Hathaway shareholder meetings. Charlie Munger, with the younger Warren Buffett Although Munger is six years older than Buffett, they each refer to themselves as each other’s alter egos. Both come from Omaha. Both worked in the same grocery store in Omaha when they were kids – although at different times. At one time, Munger and Buffett were so close that they spoke on a daily basis. Today, they say they don’t have to because they already know what the other one is thinking. Looking at their personal balance sheets, Buffett is by far the more successful investor. Munger’s net worth is a mere $1.2 billion compared with Buffett’s $63 billion. Yet, when they sit side-by-side in interviews, it soon becomes clear that Munger is the more interesting character, with the broader range of both interests and knowledge. Buffett is quick to admit as much. The Mind of Munger Munger prides himself on being an intellectual iconoclast, relishing his role both as a curmudgeon and a foil to Buffett’s folksy image. He is a smart guy, having graduated second in his class at Harvard Law School, and takes pride in having pissed off most of the faculty in the process. Bill Gates said Munger has the “best 30-second mind in the world.” In my view, Munger is a classic INTJ personality, based on the Myers-Briggs test . He is a “mastermind” who thinks in terms of latticework intellectual models. Folks with this type of personality also account for a disproportionate number of the world’s top investors. Munger believes in studying the great ideas across all the disciplines not only to generate investment ideas, but also to live a rich and interesting life. While Buffett cites Dale Carnegie’s “How to Win Friends and Influence People” as a key book in his life, Munger quotes Greek stoics like Epictetus and Roman lawyers such as Cicero. It’s not that Munger never read Dale Carnegie. It’s just that he probably couldn’t be bothered to put what he read into practice. Five of Munger’s Big Ideas Munger’s thinking is eclectic, drawn from a wide range of disciplines and insights. Since he never has written these down, you need to tease them out of his occasional speeches to graduating law school and business school classes. Here are five of Munger’s insights that stuck with me, among the many. 1. Ignore the Propeller Heads of Modern Finance Munger disdains the army of academics who created the discipline of modern finance. He argues that defining financial risk as a function of a security’s volatility – the fundamental insight that won Harry Markowitz and William Sharpe the Nobel Prize in Economics in 1990 – has deluded generations of investors. Like Buffett, Munger was weaned on the mother’s milk of Ben Graham’s philosophy of value investing. But Munger also outgrew Ben Graham along the way, opening himself to the ideas of Philip Fisher. Fisher, the famed Silicon Valley-based investor, focused more on the idea of investing in high-quality companies at a reasonable price. Munger thus transformed Graham’s idea of a value-based “margin of safety” into the idea of a “moat” – a sustainable competitive advantage over time. This moat – say, a brand or some intellectual property – was the key to a company’s ability to generate returns for investors over a long period of time. Buy the right stock in the right company and you may never have to sell it. 2. Avoid Difficult Decisions Munger believes you should avoid difficult decisions. By limiting yourself to investing in the most simple and straightforward investment ideas, you are much more likely to be successful. Munger also recommends that you play to your strengths. This applies both to life and investing. Sadly, this strategy of “avoidance” demands a level of discipline that few investors possess. But if you’re 5″2″, you don’t make playing in the NBA your long-term goal. IQ won’t help you. Stick to what you’re naturally good at doing. 3. Don’t Trust Wall Street Munger disdains what he terms Wall Street’s “locker room culture,” which puts winning above everything else. This leads to counterproductive competitiveness and a willingness to push ethical boundaries just to keep up with the Joneses. This culture of greed and envy – two sins you should work hard to avoid, says Munger – are the source of much of the financial industry’s problems. 4. The Importance of Trust Munger emphasizes trust in investing. That’s why Berkshire invests in companies with sound and ethical managements who are motivated more by the compulsion to do a good job than by mere financial rewards. This emphasis on trust leads to some surprisingly anachronistic business practices. Berkshire’s acquisition of See’s Candies was done on a single sheet of paper. This was despite the fact that Munger is not only a lawyer, but also has his name on one of the most exclusive law firms in the country – Munger, Tolles and Olson, based in Los Angeles. 5. Understand the “Psychology of Human Misjudgment” Perhaps Munger’s most important insight is an understanding that human psychology is the key to successful investing – or what he has termed “the psychology of human misjudgment.” As with his other insights, these appear only sporadically in his speeches and writing. The recent work of behavioral economists and psychologists such as Richard Thaler or Daniel Kahneman echo some of Munger’s own views. Still, these academics’ insights pale in comparison to Munger’s cross-disciplinary “real world” approach. “Mr. Market’s mood swings” – “fear” and “greed” – as described by Ben Graham in “The Intelligent Investor” are a key part of both Buffett’s and Munger’s investment philosophy. But it’ll be a while before behavioral economists start writing on the impact of “envy” on your investment returns. That’s not the kind of research that’s going to get you tenure at an elite university. The Miracle of Munger If you take a step back, what Munger and Buffett have achieved together is astonishing. How is it that a couple of old guys sitting in Pasadena, California; and Omaha, Nebraska, became two of the most successful investors in the world, while generations of the best and brightest on Wall Street have come and gone, never to be heard from again? Munger would say it all comes down to “accurate thinking.” If that’s all it is, accurate thinking is the rarest of qualities, indeed.

Behavioral Reasons For You Being Merely An Average Investor

Summary Most of us are held back by our behavioral barriers. Knowing them helps you to understand why markets behave as they do. Anchoring and the bandwagon effect are one of the most important. If you are not happy with your investing returns, then you can basically find fault in two areas: Your knowledge of investing, or your behavioral barriers. This article will go through the most common behavioral barriers that you need to understand before you can climb over them towards greater wealth. I have long believed that investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. The ability to overcome the natural human tendencies to be extremely irrational when it comes to money is equally important. Warren Buffett agrees, commenting that, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The following text is taken and modified from my master’s thesis that focused on value investing and behavioral finance. If you want to read more on the subject, two excellent books to read are Thinking, Fast and Slow and Beyond Greed and Fear . For even deeper knowledge on the matter, you can look for articles written by people named in the following text. Behavioral financial experts basically do not have much faith in the rationality of investors and therefore are against the idea that markets are efficient. If it was, then value premium would be easily explained by the relationship between risk and return. Lakonishok, Shleifer and Vishny write that, due to irrational behavior, the market prices value stocks lower and growth stocks higher. Naive investors typically overreact to the stock market related news and forecast the same growth far into the future. Because of this type of actions, they enhance the effect that might have already been taking place. In simple cases, purchase happens because stock price has gone up, and selling happens because price had gone down. But, as a simple example, this can be due to one large investor selling or buying a large amount at the same time, resulting in a price change. Some investors might take this as a sign of change and hop on or off the train. This type of investor behavior can also be explained, at least partly, by agency issues. Many professional investors might be under pressure from their bosses, clients, or due to peer competition they are forced to deliver quick results. Therefore, they are being forced to favor short-term profits over better quality investments that require longer holding periods. This type of investment pattern is often seen among institutional investors and even CEOs. Also for any professional investor, it is greatly easier to recommend the purchase of well-doing growth stocks that have a good track-record, than value stocks with a long period of negative returns. Representativeness A financial example to explain representativeness is the winner-loser effect that was proven by De Bondt and Thaler. They find that stocks that have been biggest winners during the past three years do much worse than the stocks that were the biggest losers during that same timeframe. De Bondt proves that as analysts make long-term earnings forecasts, their views tend to be biased to the direction of recent success of the firm. Meaning that analysts are overly optimistic about recent winners and feel pessimistic about recent losers. Also, De Bondt finds that market predictions are overly optimistic (pessimistic) after three-year bull market (bear market). Therefore, it becomes quite clear that analysts’ recommendations are not particularly useful when they can be linked to representativeness. One reason for this behavior is that people underweigh evidence that disconfirms their prior views and overweigh confirming evidence (Shefrin). Overconfidence In simple terms overconfident people overestimate their skills to complete a difficult task and therefore are surprised more often than they anticipated. Clarke and Statman proved that people are overconfident. They showed this by simple questions such as: How long is the Nile? Give your answer with minimum and maximum so that you are 90 percent confident that the actual length is inside your low and high guess. They asked this type of questions in survey form and found that most people are not well aware of such things but are overconfident as their high guesses were often very low compared to the actual numbers. So when people are overly confident they set too narrow confidence bands in such questions and just like financial analysts, are surprised by the results. One way to understand this is to think of a stock you were following and should have sold much earlier than you did, but you didn’t because you kept believing it can’t go lower. Anchoring and Failure to Adjust Mendenhall and Abarbanell and Bernard find evidence that analysts underreact to earnings information. Even when they get to adjust their forecasts based on new information (such as a profit warning), they are still underreacting to actual results. Their work shows that analysts fail to appropriately tweak their forecasts. What happens is that, as analysts anchor their expectations to previous information, then surprises that happen are even larger in the end. This failure to adjust expectations can then lead to value stocks and large price jumps. Psychology and limits to arbitrage Arbitrage refers to a situation where investors are able to gain a riskless profit due to the market mispricing an asset. By buying an undervalued asset and cashing the profit when prices have returned to normal. In reality the risk is that the market can continue to misprice the asset even further. This is called as the “Noise trader risk”, introduced by Long, Shleifer, Summer and Waldman. Noise trader risk happens when irrational investors keep moving the price of an already mispriced asset to the same direction, despite the actions of one or more rational investors. Also transaction costs add more risk to the equation therefore limiting arbitrage behavior. Mental accounting A typical investor does not see every euro that he possesses as being identical. Mental accounting theory helps to explain why it is quite typical for investors to divide their money to “safe” money invested in low-risk assets, while investing their “risk capital” very differently. Once money has been placed in one mental account, it no longer is a direct substitute for money in another mental account. Mental accounting theory tries to understand this psychology of decision making. Mental accounting has three components, according to Thaler. First, outcomes are apprehended and experienced. Based on this, decisions are made and later evaluated. Second, activities and sources are categorized. For example to invest or to save and also the use of these funds for spending such as housing and food. Lastly, these accounting activities are rebalanced daily, weekly, monthly or so depending of that person’s personal preferences. Gross claims that in cases where a client’s investment is at a loss a stockbroker can keep its customers by using words “Transfer your assets”, instead of referring to selling and buying. Selling would lead investors to acknowledge their losses, but now they merely transfer their money from one mental account to another. Myopic loss aversion People have stronger reaction to losses in their wealth, than they do to increases even if gains are bigger than losses. Psychologically losses are taken approximately twice as heavily compared to gains. A myopic investor is defined as a person who tends to make short-term decisions over long-term ones, and often evaluates his/her losses and gains. An example of this would be to follow a myopic and a non-myopic investor. Myopic investors would likely avoid stocks and invest in assets such as safe and stable government bonds. If he had stocks, he would constantly check the market and, in case of a loss, feel it emotionally as very painful. Therefore, myopic loss-aversion leads investors to choose portfolios that are overly conservative. While a non-myopic investor would not check the market as often and would be comfortably unaware if his wealth happens to take an occasional downhill. Therefore, he prefers long-term investments with better returns over safer government bonds. (Thaler, Kahneman, Tversky and Schwarz) Framing As defined by Tversky and Kahneman, the term “decision frame” means the acts, outcomes and contingencies that a decision maker associates with a certain choice. This one frame depends on personal characteristics, norms, habits and also on how the problem is presented. As problems can be presented in many different ways, that can also change the outcome of framing. According to Tversky and Kahneman, “Individuals, who face a decision problem and have a definite preference, might have a different preference in a different framing of the same problem, and are normally unaware of alternative frames of their potential effects on the relative attractiveness of options.” Prospect Theory Developed by Tversky and Kahneman, it is an alternative theory to analyze decision making in situations that contain risk. Prospect Theory (PT) focuses on gains and losses instead of wealth. Also, instead of using probabilities and risk aversion, PT uses decision weights and loss aversion. An outcome is called a prospect, and a prospect includes a decision with some level of risk. Decisions are made in two levels: The editing and evaluation levels. In the editing level, possible outcomes are put in order, according to some heuristic. This can be explained by people looking at the outcomes and they make a mental note of an approximate and possible average outcome. By using that average as their reference point, they’ll then categorize lower outcomes as losses and higher ones as gains. So Tversky and Kahneman state that humans prefer focusing on gains and losses instead of their final wealth. The Bandwagon Effect This is a form of group thinking. With stocks, it refers to a situation when more and more people start to buy a certain stock, the more will follow, therefore increasing the demand more and more. They might do this despite their individual beliefs and opinions, simply because other people are doing it. As more and more people join, those that are still out are under group pressure to “join the fun”. The expression, “hop on the bandwagon” is typically used when this kind of a group effect is happening. Bandwagon effect has two sides to it, according to Shefrin. First, it is believed that a crowd must know something. Second, losers don’t want to be alone. In the case of negative returns, the pain of regret is eased by the knowledge that many others made the same mistake. This theory helps us to understand why growth and value stocks perform as they do. As more and more people abandon the stock, it becomes a value stock when enough people have “left the bandwagon”. Growth stocks are the opposite until they reach their peak when the first people start jumping off. The most rational investors should be the first ones to jump on and off the stock. Conclusion The world is full of information to learn. The hard part is learning to control yourself. When you understand and remember these behavioral barriers, you are above the average investor and closer to greater wealth. The bandwagon effect is one of the most basic ones, but also the most important one, in my opinion. It explains the market behavior during the most critical times, during a bubble and a crash. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.