5.1 Part 1: The Biggest Behavioural Problems
“The most useful and practical part of psychology—which I
personally think can be taught to any intelligent person in a week—is
ungodly important. And nobody taught it to me by the way. I had to learn
it later in life, one piece at a time. And it was fairly laborious.
It's so elementary though that, when it was all over, I felt like a
fool. And yeah, I'd been educated at Caltech and the Harvard Law School
and so forth. So very eminent places miseducated people like you and me.
The elementary part of psychology—the psychology of misjudgment, as I
call it—is a terribly important thing to learn. There are about 20
little principles. And they interact, so it gets slightly complicated.
But the guts of it is unbelievably important. Terribly smart people make
totally bonkers mistakes by failing to pay heed to it.”
Charlie Munger
The followers of Efficient Market Hypothesis (EMH) believe that the
market is always efficient and stocks always trade at their fair value.
According to this group of investors, any changes in the fundamentals of
a stock will immediately be reflected in the price of the stock, thus
making it impossible for investors to outperform the market. However,
based on my years of experience, this is not always the case. If the
market is indisputably efficient, as advocated by the professors of EMH,
there would be no chance for investors like us to exploit any arbitrage
opportunities, gain in price difference from stock investments and beat
the market in the long run. In actual fact, the majority of my wealth
is amassed through the acquisition of substantial stakes in undervalued
companies with massive profit growth potential, and the disposal of
those overvalued ones with no (or low) profit growth potential in
visibility.
It should be noted that irrationality, delusional optimism, cognitive
illusions and other human emotions have been largely overlooked when
people assume that the market is efficient. In fact, the volatility of
the stock market is, very often, driven by the irrational psychological
factors. It is human’s uncontrollable emotions, biases, fallacies and
false perceptions that result in the deviation of a stock’s price from
its real business value. And the market is mainly driven by greed and
panicked by fear. Or put simply, the movement of stock price is dictated
by human emotions.
Of course, the changes in facts and fundamentals of a stock do play an
important role in the movement of its price. But, without stock market
participants bidding it up or selling it down, the price will always
stay flat. For those investors who think that fundamental analysis and
technical analysis (FA/TA) are the only knowledge needed to survive in
the stock market, I urge you to consider spending more time on studying
human psychology in investing too. This is one of the subjects least
studied by most investors, but extremely important in investing. It is
also the area where the largest chunk of gains can be obtained from
stock investments if you know human psychology well. Stumble into the
biases and mental pitfalls; on the other hand, will cost you a hefty
loss in your investments.
Below are some common behavioural biases investors always fall prey to in investing.
5.1.1 Allow emotions to take over rational thinking
“Eighty percent of the market is psychology. Investors whose
actions are dominated by their emotions are most likely to get into
trouble.”
George Goodman (pseudonym Adam Smith)
People always allow their emotions to take over rational thinking and
seldom use logical system to process information especially when they
are in emotionally unstable state. This situation is commonly seen when
people are in fear during bear attacks. When they are bombarded with
noise and mentally overloaded as price plunges, the risk level they
perceive will be raised, and their faith is wavering, even though the
facts remained unchanged. Their Amygdalae (according to the study of
neuroscientists at the California Institute of Technology, Amygdala –
two almond-shaped clusters of tissue located in the centre of the brain –
is a part of the human’s limbic system that supports the functions such
as behaviour, long-term memory and emotional processing) will induce
fear, thus causing them to be conservative and ignore bargains. They
will either avoid the stocks completely (even if the investments are
clearly high winning probability bets) or dump whatever they hold until
the feeling of fear subsides. The latter is akin to throwing the baby
out with the bath water, and in this situation value is completely
ignored. The over-reaction of hitting the panic button at every
Sen/Ringgit drop and disposing all their holdings at dirt cheap prices
is the reason why people always buy dear and sell cheap. And this
problem is commonly suffered by people who trade very often.
On the contrary, people become irrational buyers when they are in greed
and an extremely happy mood. They have a tendency to take higher risks,
buy aggressively and chase after hot stocks when they are in euphoria.
This is more apparent when the market is on the rise and stock market
pundits painting a rosy picture of an industry. At the same time, the
dopamine level in the nucleus accumbens of investors will be rising. It
will subsequently induce reward-motivated behaviour, lead to euphoria
and result in people taking a high-risk bet and ignoring danger, as the
irrational impulses get in the way and they become more optimistic about
the future of the stocks. Over-optimism is one of the worst cognitive
biases people always commit in the bull market. This type of optimism is
a spontaneous one and always results in share price shooting to the
moon as investors continuously bid up the share price. As you may
recall, the moment before the Asian Financial Crisis in 1997, the market
was filled up with over-optimism and the KLCI shot up to 1270. Within
18 months, KLCI fell 76% when the bubble burst. The Asian Financial
Crisis is an important historical event showing that market bubble is
caused by psychological problems and people overly react to both good
and bad news. As I am writing this, I notice that many steel stocks have
been making new historic highs every week, the people I meet everywhere
as well as the people I exchange opinions with in forums are optimistic
about steel companies’ future. When I advised people to be cautious, as
the oversupply of property in every city of Malaysia will affect the
earnings of some steel manufacturers, a few stubborn commenters even
asked me to shut up. This is a clear sign of allowing greed to take over
rational thinking. When the companies report decreasing earnings later,
their prices will definitely plummet and this group of investors is
vulnerable to a loss due to the oversupply problem.
“Everyone has the brainpower to make money in stocks. Not everyone
has the stomach. If you are susceptible to selling everything in a
panic, you ought to avoid stocks and mutual funds altogether.”
Peter Lynch
5.1.2 Hate facts, but like stories
“Too many people buy stories or trends - they don't buy businesses.”
Donald Yacktman
The human brain is hard-wired to understand stories better than data.
Thus, people tend to favour stories more than facts. According to
Jennifer Aaker, a professor at Stanford’s Graduate School of Business, “a
story is a journey that moves a listener, and when the listener goes on
that journey he or she feels different and the result is persuasion and
sometimes action.” That’s why stories have a powerful ability to affect human emotions.
However, in investing, allowing stories to influence your judgement may
not necessarily be good for you. Many of the sensational stories
created by the media are for viewership and have no “nutritional” value
to your investments. Unlike facts, which cannot be created or
manipulated easily, stories, on the other hand, can be twisted to meet
the objectives of manipulators. For example, some analysts would write a
fantastic story about a firm and capitalise on human greed to dupe
gullible investors into buying the stock, even though the company does
not have an earnings growth potential and many of its projects are low
profit margin work, so that the analysts could take advantage of the
market force to bid up the stock price to their target level and get to
sell the stock at an attract price.
In addition, analysts and media understand that common investors are
easily falling prey to framing effect, a cognitive bias in which the
outcome of people’s decisions is influenced through the way a situation
is presented. That’s why they would write a beautiful tale of a business
with framing effect embedded in the story to bamboozle naïve readers
into buying the stocks they intend to exit positions. For example, even
if a company has started to suffer some financial losses this quarter
and face some oversupply problem, the media may frame the situation
positively by just highlighting the positive development of the company.
They would frame it in a way that “despite the tough operating
environment and uncertainty, Company XYZ managed to sustain its
profitability for the current financial year and the management is
endeavouring to continue improving their operating efficiency. We
envisage the future outlook of the business to be positive.” Any
intelligent readers who assess the company’s profit growth potential
from a business perspective and study its financial reports should
notice that the recent quarter’s financial loss has been muted and
replaced with annual earnings in the statement. Further, they should be
aware that oversupply is a serious issue. In this case, clearly, the
analyst or media is telling a story with some hidden agendas. If anyone
gives the story the benefit of the doubt, he or she would be suffering a
loss in the investment when the price drops.
In addition, you should take note of some groups of stocks with
inherent beautiful stories. The groups of stocks I refer to include, but
are not limited to, blue chips stocks (with a hope to thrive
continuously), rapidly expanding companies (with a straight line
extrapolation of earnings forecast), IPOs (with a hope that the
companies would take a quantum leap in its earnings), ACE market stocks
(with a hope that they would be transferred to the main board),
high-tech stocks (with potential to get high earnings multiple),
government-linked companies (with a hope that they would get contracts
without needing to go through any competitive tendering process) and
other thematic stocks (with the likelihood of their prices being pushed
up). These groups of stocks are always found with many beautiful stories
created to trick ignorant investors into buying them up. That’s why
people tend to love blue chip stocks that generally have good stories
and to shun undervalued stocks with profit growth potential. Bear in
mind that most of the blue chip stocks are relatively expensive and
produce lower returns than value stocks, as the irrational Mr. Market
has bid them up to an astronomical level without bothering about the
risk and reward of the investments. Lo and behold, as I am writing this,
Nestle is shooting through the roof and is selling at P/E multiple of
57.3X. Also, I see a lot of jubilant investors rejoicing and
congratulating one another in forums everyday. They do not seem to know
what the multiple signifies and the danger of bidding a stock up to an
overvalued level. It implies that if the company were to pay out all its
earnings to the shareholders every year, it will take each shareholder
57.3 years to recover the cost of buying the share. If you buy a share
of Nestle today, you can only expect the earnings yield of 1.75%. That’s
why stocks with beautiful stories underperform undervalued stocks with
promising earnings growth potential more often than not.
“The fallacy is associated with our vulnerability to
over-interpretation and our predilection for compact stories over raw
truths. It severely distorts our mental representation of the world.”
Nassim Taleb.
5.1.3 Herd behaviour and follow others blindly
“Frequently the crowd is mistaken because they are not acting on
the basis of any superior information but are reacting, themselves, to
the principle of social proof.”
Robert Cialdini
Animals have a natural tendency to flock together as a group for
security purposes and other self-interests. And just like animals, human
too like to live in a group and act in the same way. People feel
insecure when they are going in the opposite direction that the crowd is
moving. In the study of Amygdala, Gregory Berns, a neuroeconomist of
Emory University School of Medicine, also discovered that “social isolation activates some of the same areas in the brain that are triggered by physical pain”. In other words, following the crowd generally makes people feel emotionally safe and avoid the feeling of pain.
In investing, people also always exhibit herd behaviour. The reason why
most investors always follow the crowd is that most of them do not have
an independent point of view. They prefer to follow the tips given by
other people such as their close friends, relatives, remisiers,
investment bank analysts, columnists and other market “experts”. In
addition, they have the fear of missing out. They would rather be wrong
than to miss out any opportunity to win together with their friends.
They always believe that if everyone is buying the same stock, other
people must know something that they don’t. That’s why market
participants always chase after hot stocks blindly in a group. Even if
some of them may sometimes go against the crowd, they are unable to stay
firmly on the ground when facing peer pressure. They do not know how to
handle the social pain and stress when being criticized by their
friends. In the end, they succumb to the pressure.
As much as following the crowd makes investors feel safe, the herd
behaviour won’t help them much in investing. It is impossible for you to
achieve an exceptional result by following the crowd. Most of investing
ideas shared by the group members are inferior in quality. Even if the
investing idea that you follow is a terrific one, you can only expect an
average outcome since the prize has to be shared by so many winners.
Further, studies show that investors who follow the crowd buying in
euphoria (when the market at its peak) and selling in panic (when the
market at its trough) always end up with a disastrous investment
outcome.
Also, you should be wary of any investment professionals who claim to
have an ability to predict short-term stock price movements. If you buy
or sell on their advice, you are literally trading blindly. Bear in mind
that these professionals do not know the market movement more than
anyone. They do not a crystal ball either. In fact, most of them
underperform the market index – KLCI – more often than not. History has
demonstrated again and again that most economists too failed to foresee
crisis arriving when the market was still in euphoria.
5.1.4 Impatience
“Successful investing takes time, discipline and patience. No
matter how great the talent or effort, some things just take time: You
can’t produce a baby in one month by getting nine women pregnant.”
Warren Buffett
From my years of observation, most of the stock market participants are
short-term investors who simply take a punt with short-term orientation
and without having an edge. They usually invest with a very short time
frame – about a week or two. Many of them do not have the patience to
wait for at least a year for their investments show some improvement in
earnings. They get in and out; back in and back out of particular stocks
frequently when there is news or rumours about the companies’
development and when they believe that the stocks’ prices will move
soon. Even if the stocks they hold are growth stocks, when their
investments show some gains they would immediately cash in without
waiting for the growth being reflected in the stock price.
Most of them do not aware that the cost of trading in and out actively
is so expensive that it could reduce their investment return
substantially if they don’t control their behaviour. In addition, they
have to pay a higher price for a stock since they are not willing to
wait for the right time to buy it. Likewise, they will miss the
opportunity to win big since they sell their stock too soon before the
price reaches its peak. If you are a patient investor and can empathise
with market participants, you can definitely get it at a fire sale price
and sell it near its peak. Patience is the key to successful investing,
but not many people realise it. That’s why Charlie Munger always says “the big money is not in the buying or the selling, but in the waiting.”
5.1.5 Hesitate to seize opportunity
“You have to have the courage of your convictions. That’s what you
are getting paid for. This is the time when I really earn my money.”
Bruce Berkowitz
We always see people blame fate for having no opportunity to grow and
prosper. But, in actual fact, I always see people hesitate to seize
opportunities when they are given chances to buy good stocks at fair
prices. They have a proclivity to procrastinate when opportunities
arise. When the stocks in their watch list have met their selection
criteria, instead of scooping up the incredible bargains, they spend too
much time pondering over the companies’ survivability, thinking if they
should still buy the stocks and calculating how much money they should
allocate for the investments and so on and so forth. Also, sometimes
they would wait for the companies to show a few consecutive quarters of
earning growth before they are prepared to buy the stocks. Eventually,
when other investors gobble up the shares, the value quickly vanishes
into the thin air and the opportunities are gone. That’s why Buffett
said in 2008 that “if you wait for the robins, spring will be over.”
Another reason why people fail to grab opportunities is that they fall
prey to anchoring bias. Investors always anchor their decisions to an
outdated analysis, all-time low or all-time high price, and their
previous buying or selling price of a stock. For example, if a stock’s
52-week low is Rm0.50/share, most conservative investors would not be
willing to buy the stock at Rm0.70/share, even though the value of its
business is Rm1.00/share (apparently undervalued) and it has a
tremendous profit growth potential. They would still fix their target
buying price at Rm0.50/share – the price they had missed out last time.
Likewise, people are very likely to buy a stock when it touches its
52-week low – Rm0.50/share, even though its earnings have been
decreasing, the value has dropped to Rm0.20/share and there is no reason
whatsoever in buying the stock which may put a dent in their portfolio.
Another interesting finding I discovered is that if people sold a
fast-growing company at Rm1.00/share a few years ago, it is very
unlikely that they would buy back the stock above Rm2.00/share even
though the stock is extremely undervalued at the price.
Also, people are averse to loss and hesitate to pull trigger after
losing money in an investment. According to Kahneman and Tversky, “the pain of losing is psychologically about twice as powerful as the pleasure of gaining.”
Their self-defence mechanism will kick-in when dealing with the same
stocks they have suffered some losses before, even though the stocks
have a great upside potential. For example, after losing money in a
stock a couple of years ago, some investors will hesitate to buy back
the stock, even though the fundamentals of the business have improved
and the company has reported increasing earnings. When I bought
Eversendai last year, many of my friends advised me not to touch the
stock as some of their friends have lost money in the investment. They
have got a phobia to invest in the company and would ignore the profit
growth potential of the stock even though the fundamentals of the
business have shown some improvements.
In addition, people tend to avoid buying stocks immediately after
seeing blood in the streets or experiencing huge losses in the bear
market, even though the prices are dirt cheap. The recency bias results
in people overestimate the probability of event happens in the recent
past (that the recent market crash has rendered a sharp rise in
bankruptcy rate) and give lesser weight to the event that happens in a
distant past (that the last bull run rewarded many contrarian investors
generously). If you are an intelligent investor, you should be aware of
the bias, make your judgement based on facts, focus on the long-term
objective of your investment, pay attention to the companies’ profit
growth potential, and look at the long-term trend of the stock markets,
not the short-term movement of stock price. Statistics show that stocks
are relatively cheap every time after the market crash. The worst is
always behind us when the markets bottom out. And the best time for
bargain hunting and accumulating fast-growing stocks is when they turn
the corner, and when there is blood in the streets. If you hesitate for a
minute, your reward will be gone in no time.
5.1.6 Refuse to cut loss
“Letting losses run is the most serious mistake made by most investors.”
William O’Neil
Another behavioural bias people always stumble upon is their refusal to
cut loss when they discover that they have made some mistakes in their
analysis work, and when the situation has changed and the reason to hold
a stock is no longer valid. The reason why investors refuse to sell the
losers is due to disposition effect (“the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value.”
Source: Wikipedia) as well as the fear of missing out. Further, they
don’t want to feel shame and get the pain for booking a loss. Therefore,
they tend to hold on to their losers for a very long period and sell
the winners very fast. They believe that as long as they do not realise
their loss, the paper loss is not considered a loss and they will not
miss the chance to win back when the tide turns. The worst is that some
of them have a tendency to take a greater risk after devoting so much
time, energy and money in the investments and are still suffering some
losses. They will add to their losing position by buying more of the
down-trending stocks at lower prices. This fallacy is called sunk cost
fallacy.
Also, investors always forget that share price seldom declines
continuously for having no reason. Price plunge related to fundamental
business problems such as oversupply issue and increasing operating
costs will linger a very long time, and very often may continue to
depress the stock price until the issues cease to have a significant
influence on its earnings. When a business’s highly profitable go-go
days are gone, it will take a very long time for the stock to regain its
former glory. The best you can do is to dispose the stock as quickly as
possible before its price collapses (so that your investment won’t be
affected by the decreasing revenues and the earnings disappointment) and
then use the proceeds to buy stocks with better earnings growth
potential (to avoid falling trap into the bias of loss aversion).
Holding on to the losers will only deteriorate your portfolio
performance and make you feel more depressed.
5.1.7 Invest with wishful thinking
“Never act upon wishful thinking. Act without checking the facts, and chances are that you will be swept away along with the mob.”
Jim Rogers
Just like gamblers, some investors too have a tendency to invest with
wishful thinking. Many of them do not invest with realistic expectations
and focus on facts; rather this group of investors lives on wishful
thinking. They follow their friends falling for the popular myths that
everyone believes. Further, they pay high prices for non-performing
assets, and wish that the stock prices would go higher and expect other
fools to acquire the trashes from them generously. They must know that
this type of situation is untenable and the trend is subject to reversal
when the market wakes up one day to realise that the stocks are
unworthy of their money. Another scenario is that they buy some good
stocks at attractive prices and then set their expected return
unrealistically high, and they wish that the market would reward them
lavishly for the investments. Whilst the market may sometimes be
irrational in their willingness to pay for the good assets, very often
having a disappointment for investing with unrealistically high
expectations is evitable.
Also, the investors who take a greater risk after suffering some losses
(discussed earlier on) always invest with wishful thinking. They will
buy more shares with a greater sum of money after losing money in a
stock in the hope that they could win back the money they have lost in
the previous investment. As they increase the sum of their investment,
they are actually taking revenge after getting clobbered by their failed
investment, let their anger influence their judgement, and wish that
the stocks reaching new lows will rebound. That’s why they buy even more
shares and up the ante as the price keeps falling. And they wish that
the rebound will occur soon. They are definitely unprepared for the any
unforeseen circumstances. If the stock price falls lower, they will
definitely be in financial trouble if they buy on margin. Bear in mind
that what goes up must come down, but what comes down may not necessary
go up. Making judgements based on a false notion and without having
evidence to support your hypotheses is a dangerous move. Stocks seldom
fall to their historic lows for no reason. The companies are either
suffering from financial distressed or facing oversupply problem. Never
expect a troubled company to pull a rabbit out of its hat, unless there
is sufficient evidence showing that the problem has been addressed with
business expansion and earnings growth in the pipeline. In investing,
there is no magic dust to bail you out for your mistake – wishful
thinking. Do not take a greater risk after a loss. If you insist on
doubling your stake in your failed bet when the stock price falls, make
sure that you know the root cause of your failure and that the odds are
now stacked in your favour prior to committing more capital to the
investment.
5.1.8 Value stocks in possession unrealistically high
“……people are more likely to keep what they start with than to trade”
Richard Thaler
People have a tendency to value things in their possession higher than
the prices quoted in the markets and higher than the things they have
not yet own just because they own the things. This bias is called
endowment effect. Again, this shows that people do not always look at
the facts and live in their dream. They are inclined to value their own
properties higher than their market prices. For example, if a house is
for sale at Rm100,000 and the market value of the property is also
Rm100,000, the potential buyer would find it pricey before buying the
property. But, after purchasing the house, he or she will think
otherwise. He or she will claim that the property is undervalued and can
easily fetch over Rm150,000 or more.
To prove this bias, Daniel Kahneman, Jack Knetsch and Richard Thaler
conducted an experiment by distributing mugs to half of their students
and ask the students to sell the mugs to the other half of the group who
did not have the mugs. They found out that those students with mugs had
a tendency to overvalue their possession and placed a higher selling
price for their mugs than the price offered by another group of students
due to the mere ownership effect called “endowment effect”. In another
experiment, Kahneman and his colleagues distributed mugs to half of
their students and chocolate to the other half of the group, each with
the same value. The students are then asked to trade with their
possession. In the end, they found out that only a small group of
students were willing to part with their original possession.
This divestiture aversion behaviour is also commonly seen in investing.
People always fall in love with the stocks in their portfolio, assets
they inherit or something they are familiar and comfortable with, and
are inclined to believe that the stocks they possess are worth more than
their market values, regardless of their real values, and have a
tendency to remain at the status quo. Therefore, they refuse to sell the
stocks in their possession then use the proceeds to buy other stocks
with better profit growth potential, even though the reason to keep the
original stocks in their portfolio is no longer valid. For example, if
an investor bought stock A last year at Rm1.00/share, he or she expected
the stock to rise to Rm2.00/share in a year, but so unfortunate that
the business faces some headwind, the EPS of the stock fails to increase
and the stock price hovers at Rm1.50/share level for a year. At the
same time, stock B, an undervalued stock selling at Rm1.50/share, seems
to be a better investment for the investor. Do you think the investor is
willing to sell stock A for stock B? The most probable answer to the
question is “NO”. Behavioural bias theory tells us that it is very
unlikely that the investor will sell stock A before their expected value
is reached, so that he or she could use the proceeds to buy stock B. As
he or she sticks with his or her original possession, he or she will
eventually miss out a good investment opportunity.
5.1.9 Overconfidence
“Overconfidence is a powerful force.”
Richard Thaler
People have a tendency to overestimate their own ability, efficiency,
intelligence and knowledge level. Most of them believe that their
investing skills, knowledge and strategies are superior to other market
participants. Whilst having confidence is important to your personal
success, overconfidence on the other hand may hurt your investment
performance and be detrimental to your continuous learning.
Overconfident investors always believe that they are better than other
people in stock picking. Therefore, they are not well-prepared for what
may go wrong with their investments and won’t be prepared for any
unforeseen circumstances that may stack against them. For example, if an
investor believes that a company has a bright future or that he or she
has found an investment which would provide him or her an exceptional
return, he or she then bet big on the stock without identifying the
possible threats that may jeopardise the business, or listening to the
critical comments of people in the opposite camp, he or she is prone to a
shock when the stock price and earnings take a hit and he or she may be
unable to get out safely.
In addition, people have a tendency to feel overconfident and wager
aggressively after winning a few small bets. It is very normal that
after a few consecutive of winning games, we will take it for granted
that the odds will still be in our favour in the next few trades and we
will be getting very greedy in the pursuit of more rewards. But staying
in the game with an exaggerated swagger is a deadly mistake. Again,
shock always occurs when we fail to foresee what may go wrong with our
investments, and we are susceptible to a huge financial loss if we
insist on moving ahead in foggy situations with overconfidence before
the vision gets clearer.
Whilst both genders generally exhibit the same trait, studies show that
overconfident is more prominent in men than in women. Male hormone
always leads men to be more confident and to make high-risk gambles. In
comparison, men trade more frequently (and often excessively) than
women, and men suffer lower returns with higher trading costs. They
always believe that the investing decisions they make are right, even
though sometimes they may not know what exactly are they doing, and may
not be aware of the presence of some blind spots and the consequences of
their decisions. Women, on the other hand, are more likely to
acknowledge their ignorance if they do not know anything about a company
and are more risk-averse in making any investing decisions.
5.1.10 Reject opposite view
“We were also well aware of the dangers of what social
psychologists call confirmatory bias, in other words the tendency to
collect all the information that agrees with your position and to ignore
the information that doesn't. Behavioural theory teaches that the best
antidote to this bias is to listen to the opposite side of the case and
then dispassionately to identify the logical flaws in the argument.”
Barton Biggs
In investing, people do not like negative comments about their stocks,
and always search for evidence to confirm their investment decisions.
This type of bias is known as confirmatory bias (or confirmation bias).
According to studies, investors are twice more likely to look for
information and interpret ambiguous evidence in a biased way to support
their decisions rather than to look for flaws in their original
hypotheses. At the same time, they ignore the impact of contradictory
facts on stock price. For example, in 2014, when OPEC (Organization of
the Petroleum Exporting Countries) ramped up their production to 30
million barrel per day of oil and was in a price war with the shale oil
producers of the United States, the price of oil started plummeting,
people who are optimistic about growing global oil demand did not only
refuse to sell their oil and gas related holdings and ignore the fact of
increasing crude oil inventory and the impact of supply glut, they kept
finding reasons such as depleting oil reserves and surging demand of
oil from China, India and emerging countries due to GDP growth to shore
up their argument. In the end, those investors who refused to listen to
the opposite view and clung on to their beloved oil and gas stocks
eventually suffered huge losses when the prices of their oil and gas
stocks tanked, as the price of crude oil plunged to the level below
USD30 per barrel.
When like-minded investors get together in a group, they have a
tendency to form a stereotype view. They will reject those opposite
opinions, alternative views and disconfirming information, and ignore
warnings. They then strive for unanimity. To achieve their goal, they
also impose pressure on and angry with the dissidents or people in the
opposite camp. They distort facts and information to justify their
hypotheses and decisions. At the same time, the group will use mind
guard to prevent their group members from accepting any opposite
opinions. Independent thinking is lost when everyone is indoctrinated
into believing the distorted stories and trusting the philosophy which
may be composed of false notions, and unable to think for themselves, as
they are afraid to be criticised by the group members. The groupthink
or group polarisation, whilst seems to help the members to stay
confident, is actually a curse in disguise, which very often does more
harm than good to investors and will lead to over-optimism and
overconfidence.
“For if we are uncritical we shall always find what we want: we
shall look for, and find, confirmation, and we shall look away from, and
not see, whatever might be dangerous to our pet theories.”
Karl Popper
5.1.11 Overly focus on short-term performance
“When an investor focuses on short-term investments, he or she is
observing the variability of the portfolio, not the returns - in short,
being fooled by randomness.”
Nassim Nicholas Taleb
Our market is mainly dominated by short-term oriented investors who
concentrate too much on short-term price fluctuations and noise, always
aim for quick profits and exit a stock position after holding the
counter for a few days, regardless of its earnings growth prospects.
They will rush to buy a stock when there is a rumour about the company
and feel the urge to sell it when the holding starts showing some gain.
They call themselves serious investors, but their average holding period
is only less than a week. They prefer speculative stocks with higher
volatility to stocks with good long-term earnings prospects. They are
unable to see the term long-term earnings potential of a company. In
investing, we call this a problem of short-sightedness or Myopia.
This group of overambitious market participants also devotes too much
effort to predict the short-term price movements of a stock and ignore
the underlying business and its profit growth potential. They think they
have the ability to predict the market and to beat the market
short-term, but their portfolios always end up underperforming the
market averages, if not with a horrendous loss. Again, this shows that
people always overestimate their own abilities and underestimate all the
competitors – including those sophisticated investors who are not only
knowledgeable and experienced in investing, but can access to the latest
news within seconds, are able to predict the short-term earnings quite
well and outmanoeuvre the market.
In order to increase the winning probability of their short-term bets,
sometimes they are willing to pay lofty service fees to investment
consultants for hot-stock tips and investment advice. However, those
tips are mostly inaccurate ones and the returns of their products always
underperform the market. Even if those products are really magnificent
ones, after deducting the consultation fees, brokerage commissions and
other transaction costs, only a paltry gain is left over. In the end,
they still get beaten by the market. Keep in mind that these investment
consultants do not have a crystal ball too. Just like you and me, they
do not have the “supernatural ability” to accurately predict the
short-term stock price movement either.
That said, it is not hard to beat the market in the long-haul game. As
the active investors, such as professional money managers, day traders
and other short-term oriented market participants (who constitute a
greater proportion of the market) are overly focused on the short-term
performance of a stock, the long-term earnings prospect of the company
has been largely overlooked. This is the area where smart contrarian
investors with fortitude and patience can outperform the market and be
handsomely rewarded if they only concentrate on investing in undervalued
companies with bright earnings growth prospects.
5.1.12 Refuse to admit mistakes
“There’s obviously a balance to maintain between confidence and
humility. You have to be humble enough to recognise when you’re wrong.
I’m willing to look silly.”
Bill Ackman
Would you admit your mistake when you do something wrong? In most
cases, people are just unwilling to admit their blunders. There could be
many reasons why people refuse to admit them, but the most obvious one
is due to egoism. In general, big ego hinders self-assessment, affects
visibility and ruin investing performance. People with the
self-importance problem always seek glory, crave for credit and
compliments, boast achievements and are unwilling to recognise their
weaknesses. In addition, they have too much pride to accept the advice
of other people. Even if they make bad decisions, they would give all
sorts of justifications for their errors. In the end, this group of
people always sticks to the wrong hypotheses, flawed philosophies and
the poor perceptions of their investments. They are predisposed to
repeat the same old mistakes again and again.
In investing, it is easier to make mistakes than to make perfect
“moves”. That’s why we make so many mistakes every year. From a
psychology perspective, these failures will cause emotional pains and
kill our self-esteem. But from a learning perspective, these mistakes
(be it misjudgements, misinterpret data, misestimate earnings or
mistimed shots) make us grow and stronger. In other words, if we are
willing to accept the embarrassment, take responsibility for our
incompetence and correct the misconceptions, our investing skills will
improve significantly. Unfortunately, many stubborn investors are simply
unwilling to admit their fallibility, so as to avoid feeling shame.
Keep in mind that people who are reluctant to control their emotions and
refuse to admit their mistakes seldom learn, and hardly will they see
much improvement in their investment performance.
5.1.13 Poor self-awareness
“The first thing you have to know is yourself. A man who knows
himself can step outside himself and watch his own reactions like an
observer.”
George Goodman (pseudonym Adam Smith)
Very often the failure of people in investing has been stem from not
having a good understanding of themselves. How can anyone formulate a
viable investing plan, rule and strategy for him or herself if he or she
does not even know his or her own personality, strengths and weaknesses
well? I always hear people call themselves long-term investors, but
they behave like traders. They trade so frequently that their portfolio
turnover ratio is very often greater than 1 and the transaction costs
will eat into their lifetime savings. Some of the people wanted to
follow those über-investors like Warren Buffett and Charlie Munger to
put all their eggs in only one basket and watch the basket closely, but
they don’t have the stomach for concentrated investing. They do not have
the discipline to perform due diligence, devote effort for soul
searching, unable to demonstrate the abhorrence of action and cannot
hold stocks for long-term. After building a substantial position in a
stock, they become unable to sleep well and intend to exit their
position as soon as possible. As they dispose their holdings hastily
when the stocks are declining in price (or selling below their buying
prices), their portfolios are vulnerable to a loss.
Also, having a poor understanding of oneself is the reason why people
cannot see their own bias blind spot. They always think they are less
subjective to some cognitive biases than the other market participants,
but in actual fact they are also the victims of the biases. For
instance, people always overestimate own ability and underestimate the
other people’s talents, and they claim that they can control their
emotions better than other market participants. But they eventually turn
into panic sellers when the market crashes and join the crowd buying
aggressively when a stock is selling like hot cakes.
Poor self-awareness is also one of the factors leading to
self-attribution bias. People often give credit to their own skills,
talents and knowledge for their success, but they blame others’
mistakes, market conditions, environment, government policy, price
volatility, bad luck and other factors for the poor outcomes. They must
understand that other than disavowing responsibility and avoiding
feeling shame, the externalisation – blaming others for causing their
loss – will not benefit them for their own growth. To be a better
investor, they should identify their strengths and recognise their
weaknesses, and learn continuously to improve their investing skills and
philosophies.
Chapter Summary (Part 1)
- The Biggest Behavioural Problems:
- Allow emotions to take over rational thinking
- Hate facts, but like stories
- Herd behaviour and follow others blindly
- Impatience
- Hesitate to seize opportunity
- Refuse to cut loss
- Invest with wishful thinking
- Value stocks in possession unrealistically high
- Overconfidence
- Reject opposite view
- Overly focus on short-term performance
- Refuse to admit mistakes
- Poor self-awareness
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