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Monday, 24 August 2009

Get An Emotional Margin of Safety

Businesslike Investment

Warren Buffett states, quite frequently, that the most important investment statement ever made was that of his mentor, the father of value investing, Ben Graham:
"Investment is at its most intelligent when it is most businesslike"
Now if you’ve ever wondered exactly what that means you’re not alone. But it’s really one of the most important business lessons any of us can ever learn. It encapsulates the idea that investment isn’t about individual subjective feelings but about general objective rationale. To be good investors we need to learn to control our emotions. Unfortunately it's got a bit more difficult since Graham first wrote those words.

Unemotional Investment

We find Graham’s statement difficult to understand because we don’t understand Graham’s – or Buffett’s – viewpoint. Although both men are amongst the best communicators the world of top-class investment has ever thrown up they still sit in the rarefied atmosphere of that elite group of investors who are able to step away from their own emotions when they come to investing.

By “businesslike” Graham meant “unemotional”. At the root of all good investment, he believed, was a focus on the underlying numbers. Graham, far more so than Buffett, was focused on the investment ratios and balance sheets of his investments. To be “businesslike” the individual investor needs to ruthlessly focused on the numbers, not the stories associated with them. Thus Graham and Buffett aim to remove the behavioural biases that affect most investors.

Of course, there’s no doubt that there are a select group of people who are more easily able to ignore the impact of group psychology than the rest of us. It’s possible – even probable – that the great investors of the world are simply psychologically unusual people who are capable of ignoring the impact of normal behavioural biases. These people are so rare that it would be interesting to take one of them and wire up their brain to a computer to see whether their responses are different from that of normal humans. Only trouble is they’re so rich that they can employ really big bodyguards and generally reckon their brains are their own concern.

Emotionless Delusions

Antonio Damasio has conducted lots of research on the effects on reasoning of damage to the areas of the brain implicated in emotion – probably best encapsulated in his book Descartes' Error: Emotion, Reason, and the Human Brain. The results are largely counterintuitive. What he shows is that emotion and reasoning seem to be linked at the hip, or at least at the prefrontal cortex. Emotion doesn’t make us irrational, rather it seems that it’s part and parcel of whatever rationality we actually possess.

In essence emotions are heavily tied into the business of decision making: you probably wouldn’t want to entrust your safety to someone whose emotional reactions were damaged. For instance there are a range of rather nasty syndromes associated with the loss of emotional arousal including Cotard’s syndrome where the person thinks they’re dead and the Capgras delusion which causes the sufferer to think that a person or persons close to them have been replaced by an identical clone. Although these may sound odd or even amusing they’re not: Capgras sufferers have been known to behead their nearest and dearest to prove that they’ve been replaced by machines and been found burrowing in the remains looking for the batteries.

Emotions and Decision Making

Human decision making is one of the main puzzles facing psychology. How do we decide what considerations to take into account and what to leave out? This is hard enough at the best of times but is especially difficult under conditions of ambiguity or uncertainty. Technically the problem of deciding what to take into account when making a decision is known as the philosopher’s frame problem – given limited time and limited intelligence how do we manage to do anything other than stare at our navels?

The philosopher Ronald de Sousa (who provides a good introduction to theories of emotion at the Stanford Encyclopedia of Philosophy) has argued that rational decision making is critically dependent on emotions - emotions are the way evolution has fitted us to focus on the important issues involved in any decision. Emotions are a rapid response mechanism to filtering out the unimportant features of any situation. When you're about to be eaten by a tiger then the colour of your kimono shouldn't really matter.

If de Sousa’s ideas are even roughly correct then we can’t simply become unemotional by choice, because emotions are implicit in who we are. However, we can learn to control our emotions in specific situations in order to restrict our behaviour: we can learn practical rationality. So, implementation of Graham’s mantra requires a real determination to ignore all the churned up feelings of the primordial ape within us and resolution to focus on the few certainties that we can latch onto in the investment world.

Brain Damaged Investors

Some research we’ve looked at before by Baba Shiv and others, including Damasio, into the impact of emotional centre brain damage on investor decisions suggests that a lack of emotion is actually a benefit to investors. While such damaged people might not be able to judge the danger of walking into a Hell’s Angel’s convention and disrespecting facial hair they are remarkably good at making sensible investment decisions. So while in real life a failure to take contextual information into account may be exceptionally dangerous it seems to be a benefit when investing.

Lest all of this seem to suggest that the great investors of the world are simply people who’ve been hit on the head one too many times let’s be clear that what we’re ultimately talking about is the ability to inhibit emotional reactions to investing situations, rather than advocating some process of self-induced brain trauma. So, it would seem that these emotional responses are getting triggered inappropriately in investing situations, leading to decisions that are simply stupid. Which suggests that learning to control these responses should make us better investors or, as Ben Graham would put it, would make us more businesslike.

Beyond Asset Value - Back to Rent Seeking

In Graham’s heyday this was simpler than today: his mechanical strategy looked for clear mispricing of stocks in terms of discount to net asset value. Most, if not all companies, were valued based on their assets. What Warren Buffett realised, earlier than most, is that this has changed. The corporations of today are valuable more for their future earnings streams than their assets. The most valuable companies are those successfully engaged in rent seeking – gaining value by extracting fees without making any contribution to productivity. It’s those companies who can make money simply by existing that are most valuable.

The trouble with this is that it’s far harder to value rent seeking corporations like American Express and Coca Cola than the traditional Graham-type discount to net asset value opportunities. Which brings us back to the messy business of emotions: we can’t simply put aside our emotions by running a spreadsheet. We have to engage in the difficult job of identifying the must-have rent seekers and then waiting for the price to fall to a level at which we can rationally judge it rational to invest.

Businesslike Under Uncertainty

Only when this point comes it’s most likely that it’s on the back of some dramatic and stomach churning market event. Most people can’t ignore their emotions at these points – the overwhelming evidence of mutual fund investment flows is that people buy at the top and sell at the bottom. Short of beating ourselves around the head regularly we have to learn to stop listening to our in-built emotional warning systems and embrace the uncertainty. Only then will be truly businesslike in our investment habits.

Related Articles: Investing Like Berkshire Hathaway, Is Intrinsic Value Real?, Unemotional Investing is Best

1 comment:

  1. I believe there is a simple solution to the problem being discussed here. Every time the DOW or the S&P number is reported, the valuation (P/E10) number should also be reported. The P/E10 value tells you how much of an adjustment you need to make to the S&P or DOW number to know the real value of the index at that time.

    Overvaluation and undervaluation are both the product of investor emotion. In a rational market, neither is possible. The reason why most investors are not able to rein in their emotions is that the topic of investor emotion is generally treated as taboo. We give the market numbers as if they were significant but then leave out the adjustment needed for those numbers to reflect reality.

    We will gain the ability to rein in our emotions when we talk openly about the effect that our emotions have on stock price. That all can be reduced to a number -- the P/E10 value that applies at any given time.