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The Mind Does More Than Just Play Tricks On You
Obstacles in an investor’s thoughts.
This is a bit different from my usual format, but I hope y’all will enjoy it - YZ
KWR: Hello everyone, today’s broadcast is about how our brain sometimes works against our best investing interests, leading us to accept the wrong conclusions or make the wrong decisions. In a typical day, many of us make around 35,000 decisions- The sheer data and information that needs to be received, understood and analyzed for us to make these decisions is immense. Our brains have certain mechanisms that help us make many of these decisions almost instantaneously, with typically amazing accuracy, often using shortcuts and heuristics to aid in this rapid decision making. However, some of these shortcuts can lead to biases or skewed thinking, especially if some data is more nuanced than at face value. This can often impact our financial decisions, leading us astray.
Stories sell better
As people, we love stories. We love it when things have a beginning, middle and end. We especially love when things are explainable. Even when there is no obvious causal effect, or if there is no evidence for one, we automatically try to fill the gaps with the most plausible explanations ourselves. Our mind prefers to always assume that events happening were directly because of other events, when they may have in fact been due to simple regressions to and from the mean.
For instance, a CEO of a company may win an award in recognition for the firm’s great performance during the year. Some will think that the CEO is to some degree responsible for the improvement in the firms performance: The implementation of a better culture, good strategy, good leadership. But there are an incredible number of factors that lead to a good year for a firm, many of which the firm has no control over- increase in consumers’ income, improvement in trade relations among countries, improvement in supply chains. Sometimes, the firm does well simply due to randomness- the firm got lucky this year. However, it is more popular and easier to digest the idea of a causal story that led to the improved performance of the firm.
Let’s stay on the idea of the CEO winning an award. After receiving these awards and recognition, the CEO’s ego is likely to have been inflated. They may start to believe they have ‘expert intuition’ and start to believe in their instinct more and more in decisions- this only allows biases and heuristics to have a greater and greater impact, which isn’t necessarily a good thing. Managerial hubris can lead to suboptimal decisions or actions, such as an opting to go for more aggressive or risky M&A, believing that his managerial skills will make it work.
YZ: “A little bit different spin to this would be the euphoria of 2020 bull market run up (although based on past history, we can say this about all stock market bubbles). Originally investors would be buying equities based on strict rules and thorough due diligence with result being (most of the time) positive returns as the stock market kept going higher and most great companies would get “bid up”, most investors had to “relax” their standards and ease up the process to keep up with speculators who would be making money on pretty much anything and everything which resulted in original investors with strict rules getting sucked into thinking that based on their new rules and (example 2020) this being a new paradigm, they can keep making money forever based of their new standards which do not require as much due diligence or patience…
Resulting in some of big/famous investor names blowing up (Archegos Capital Management), some closing their funds (Tiger Cubs, the hedge funds run by Julian Robertson’s proteges), or drastically under-performing (The ARK Innovation). The caveat I must provide is unless the fund got blown up there is (technically) still a chance that the remaining funds can go on to outperform (vs their peers or stock market) over the longer time frame… for that time will tell…”
Therefore, as a result, not only may a firm’s performance regress back to the mean with the same CEO, but it has been found that firms with ‘superstar status … subsequently under-perform beyond mere mean reversion’(Malmendier and Tate, 2005).
Confirmation bias and the Halo effect are two aspects which may also impede one’s ability to invest. Let’s assume that someone went to a conference or to an event, and met the founder of a new start up firm. They strike up a conversation, and the person leaves the conversation with a high opinion of the founder. At home, they begin to do research about the firm, seeing if they should invest into it. The positive conversation with the founder leads to the Halo effect, where the firm may be seen in a more positive light and therefore less objective light, which leads to the instance where a single conversation has a large influence over the person’s decision to invest or not, which is not optimal.
Additionally, the person may look for information which confirms their ‘belief’ that the firm is a good investment with good prospects- the research tends to be confirmatory, rather than exploratory. The decision to invest may have subconsciously been made, and the research is only there to confirm that intuition. Furthermore, regardless of what the person may learn about through the conversation or through research, one thing should be the most important- Base rate, the probability of something in the absence of any information(Davenport, n.d). The base rate of a start-up firm become a great investment is very very low- and this probability should be the starting point of the person’s decision to invest in this firm. However, the person is likely to either overweight specific information about the particular start-up firm or neglect the base rate, and as a result may believe that the likelihood of the investment being successful is much higher than in reality.
YZ: “This is a topic that is debatable in the investing circle, some investors swear by the fact that because they speak to the management (as their due diligence process) it gives them an “edge” against those who do not, while other investors take an opposite view as discussed above stating that speaking to the management creates confirmation bias.
My personal take is that (like anything in life) a good balance must be found, which I learned the hard way after 2020ish run. It took me sometime to realize that whenever you hear a CEO or anyone speak about their company they (themselves) are already biased toward their company and for most part do not / will not say anything negative about the company, at least not while they are on company’s payroll.
Example: me listening to the podcast / interview of one publicly traded company’ CEO talking about himself and the company, as you can imagine not much negative was said, the information that was provided about this newly publicly traded company was either rosy or vague (and its much worse when its vague, because we as listeners can interpret the information in many different ways and a lot of those could be not even anything that CEO might of meant aka Halo effect, creating a false picture in our minds).”
Statistics, Damn Statistics
Another aspect that our mind has deficiencies in is in the interpretation and understanding of statistics- a person much more easily interprets raw figures rather than percentages. Hearing that 0.01% of retail investors lose most of their entire starting investment in the first year does not evoke the same emotions as hearing that 10 out of every 1,000 retail investors lose most of their starting investment in the first year.
Another indication of people’s inability to fully understand statistics is the possibility effect- when events are possible, but not probable, people tend to either overweight or completely disregard that event in their decision-making(Capital, n.d). This bias is often worse if the event can be easily imagined(Capital, n.d). This effect is what makes lottery work: The chances of a person winning are incredibly remote, but ones ability to imagine how much money they could win and what they could do with that money is so powerful, many take their chances. Another example are black swan events. The chances of these events happening in a given time or given time horizon are very low, but not zero. But many people do not know how to account for such low probability events, which often leads to investors either disregarding this event, or often over-weighting it to the point of missing out on returns.
YZ: “Here, Long-Term Capital Management (LTCM) comes to mind. LTCM was a highly leveraged hedge fund. LTCM was created by a group of Wall Street veterans and Ph.D/Professors from Elite Colleges and yet none of them could of seen the black swan events of 1997 (Asian financial crisis) and 1998 (Russian financial crisis). Resulting in bailout from a group of 14 banks, because otherwise LTCM’s collapse could of caused another black swan event.”
This last example ties in very nicely with the availability heuristic: That events can be judged to occur more frequently than they are if able to think of many instances of that event occurring. For instance, if in late march of 2023 I asked someone how often do banks collapse, instances of the Silicon Valley bank declaring insolvency on the 10th of March, the Signature bank a couple days later, and the First Republic Bank collapsing(Rodini, 2023). As someone would be able to quickly remember multiple instances of banks occurring, they may give an answer that is likely to be much higher than they might normally give in a given year.
YZ: “In investing we can not know everything. No matter what anyone tells you, we always make decision based on incomplete information and this is why margin of safety is so important!
Margin of Safety (MoS) was coined by Benjamin Graham and David Dodd in their Security Analysis and was also emphasized by Seth Klarman with his book called Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.
MoS comes in different forms: (standard form) buying something for “less than its intrinsic value”. Informational MoS (having more information vs other buyer/seller), Reputation, speed, etc.
Basically with MoS, you have room for error, because we are not perfect and sometimes (a lot of times?) things will not go perfect (the way we wanted), MoS gives us “extra” room in whatever that we are doing.”
Another inadequacy in our minds is the ability to deal with small numbers, or small samples. Small samples naturally lead to larger possibilities of variation, but often we try to find causal explanations for this variation rather than attributing it to simple variation that occurs with small samples. For instance, you may conduct a small study on 10 potential firms, and may find some startling conclusions- your first instinct may be so find some sort of causal explanation, maybe some firms have better cash-flow statistics, when what may be the case is that your sample size is too small, and you would find more meaningful and typical results when using a larger sample size.
Two Sides of the Same Coin
One feature that is almost universal in people is the idea that losses cause stronger emotions than gains. As a result, people tend to be risk seeking when facing losses and are risk averse when facing gains. Here’s a classic example of this in action:
Here are two sets of choices, and you have to pick one of the two choices in each set:
1A) Face a sure loss of $740
1B) Accept a gamble where you have 25% chance of losing nothing, but 75% chance of losing $1,000
2A) Get a sure gain of $740
2B) Accept a gamble where you have 25% chance of gaining nothing, but 75% chance of gaining $1,000
When looking at these choices, one can see that for the first choice, accepting the sure loss is the better option (Expected loss of $740, compared to an expected loss of $750 [0.75 x $1,000]) and for the second choice, accepting the gamble is better than the sure win (Expected gain of $750[0.75x$1,000], compared to an Expected gain of $740). However, many studies have shown that people often go for choice 1B and 2A, even though they aren’t the utility-maximization option, as instinctively people often look for any chance to avoid losses, while also wanting to secure gains. This can lead to situations where sub-optimal decisions are taken. For instance, a company with a struggling project may decide to double down, pump more money into the project in the hope that it will turn around, rather than cutting losses on the project -This example is also the illustration of the sunk cost fallacy. While it is possible to train oneself to not fall for this over-weighted loss aversion, it can be difficult to maintain this awareness consistently.
YZ: “If I was randomly asked these two choices, I will say that I would personally go with 1B and 2A… to me it just make sense and it can be seen in the way I invest. I have no problem with double downing on a position that gets cut in half (caveat) if I believe that the company is undervalued which means I believe that the market is wrong and I am right, that in-it-self is a big IF.
Sometimes you can buy something that you believe is undervalued but due to market irrationality it can go even lower which creates more of a Margin of Safety, again I will say…all this being said is because there was work done before on the company and since we are buying companies and not stocks the lower the price the better the returns in the long run.
The most recent and easy example is Bank OZK ( OZK 0.00%↑ ) during Silicon Valley Bank run on the bank or Bank crisis of 2023 (if you can call it that). OZK had nothing to do with start ups/cryptos, OZK is (among other generic bank things) in real estate business with big chunk of money for the projects coming from the sponsors, they were net buyers during 2008 crisis and client-tell at OZK is the complete opposite of Silicon Valley Bank, yet when SVB (and couple of others) failed lots of (regional) banks got pulled down (including OZK) as if OZK was similar to SVB… spoiler alert OZK was (and is) not.”
The Bigger Picture
Another issue that sometimes afflicts people is the idea of narrow vs broader framing. Narrow framing is when events or particular instances are seen as independent, while broad framing is recognizing that one event is part of a larger whole. As an example, when I gave you the two sets of choices above, did you judge each choice in isolation and then go onto the next choice, or did u look at all the combinations of all four possible options? Experienced investors will recognize that individual investments are part of a whole, and should not be seen as separate instances.
YZ: “This is assuming you had known in advance that both questions will be asked, a lot of times whenever you are asked these type of questions you do not know the following question(s) when you are asked the first one, so as with real world and investing, you judge based on the given current information and then you adjust as you get more new information available to you.”
One effect that stems from narrow framing is the ‘disposition effect’-‘ a preference for selling winners rather than losers’(Kahneman, 2011). This is where for each investment, the investor has set up a mental ‘account’(Kahneman, 2011). Naturally, if the investor would need to sell some of this investment for cash, the investor would have a tendency to sell an investment where they had earned money on-in the mind seeing this as closing that investment on a win, while maybe holding onto an investment that is losing. This decision could be made regardless of the future prospects of both investments: the already ‘winning’ stock may have better prospects, and be an even bigger win in the future, but many investors would prefer avoiding having to close a losing position, and have that ‘loss’ branded on them. More experienced investors are not afraid to close a losing position, knowing that in the uncertain world of investing, you are sure to win some and lose some.
YZ: “This is something that I’m still working on myself, but a great example of investors who can do just that are Stanley Druckenmiller and George Soros. During dot-com bubble, Mr Druckenmiller was short tech stocks and started losing a lot of money, realized that the “bull run” is not over, covered his shorts, and went long on tech stocks… the crash did come but couple of years later, but the point is that Mr Druckenmiller would do these type of trades all the time and he learned it from his mentor, George Soros.”
“Soros is the best loss taker I've ever seen. He doesn't care whether he wins or loses on a trade. If a trade doesn't work, he's confident enough about his ability to win on other trades that he can easily walk away from the position.” - Stanley Druckenmiller
While it may seem like our brains are working against us while we try to invest, these same things enable us to function and make thousands of tough decisions every day. Although it may be impossible to have a completely rational mind, one can take steps to ensure their decisions are of the best quality they can reach. While investing, ensure that certain pieces of information are not over-weighted or neglected, and if you have an intuition about a certain investment, take some time to determine if this is as a result of valid data and conclusions or due to something else. These biases often have a greater impact on decision making when one is more tired, doing other tasks simultaneously, or even when one believes they are in a position of greater power (Kahneman, 2011). Therefore, one can try to ensure they have a clear mind with as little distractions as possible, and making sure that one’s ego never inflates too much.
That’s all from us for now, but stay tuned for future broadcasts,
This has been Kunga’s Written Radio and YZ with From100Kto1M.
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