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Monday 22 February 2016

7 Investing Lessons from Behavioral Psychology

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You could start by not wasting your time clicking on stupid clickbait articles, I suppose. But since you’re here you might as well learn something.

Investing should be mainly about hard work, slogging through accounts and trying to figure out where or why a company has a defendable competitive advantage. But that’s not much help if you have the self control of an octogenarian with prostate trouble.  Investing is 90% hard work and 10% mental discipline – but don’t even bother if you haven’t got the 10%.

1. Learn Self-Control or Buy Trackers

The research of Walter Mischel revealed that people who demonstrated self-control when small children had, on average, better life outcomes on almost every dimension – in terms of health, relationships, lifespan and investing.  The ability to delay gratification, to make a sacrifice now in order to benefit later on, turns out to be one of the key attributes for private investors.

Markets are broadly efficient, at least in the short-term.  Day-traders and people making short-term trades are almost guaranteed  to lose money unless they have some form of informational advantage. I know a few – a very few – people who do seem to make money in the short-term but they trade in specialized areas where institutions have little interest. For everyone else the main advantage of being a private investor is that we can wait.

Unfortunately, for a lot of people, waiting turns out to be something they’re very bad at. And, as Mischel found, this can be traced back to early childhood. Whether this is a genetic trait or is something learned at the breast isn’t clear, but it’s certainly the case that without it you’re going to struggle to make positive returns. So if you’re the kind of person who can’t wait to buy the latest must-have gadget, and would rather charge to your credit card than wait a month, probably best you stick to index trackers.

See: The Secret to a Healthy, Wealthy Life

2. Disconfirmation is Your Friend

Confirmation bias is among the worst of all behavioral biases. When presented with information that favors a specific position we find it almost impossible to consider alternative ideas. It’s to do with the way our brains process information, we only consider the options in front of us, we don’t go off searching for all the other options.

In real life this is generally fine, but in the fictional world of investing it’s dangerous, because we need to consider – and keep considering – the possibility that our favored stock ideas may actually not be as perfect as we’d like to think. Unfortunately confirmation bias drives us to look for information that supports our ideas and to ignore data that undermines them.

Learning to look for disconfirmation is hard, and there are no short-cuts. As part of the investing process, both before and after a stock purchase, we need to force ourselves to consider scenarios that play out badly. In fact we need to force ourselves to look at a range of options and we then need to try to assess the probability of each of these happening.

Now, oddly, the more we do this the easier it gets. And if we keep records of the options we considered and the probabilities we assigned to them we get even better. It’s a win-win for the main purpose of investing, making money.  And if you can’t do this, buy an index tracker.

See: Unrealistic Optimism and the Impoverished Investor

3. Mental Accounting is Lying to Yourself

As Richard Thaler has discussed at length, we have a nasty tendency to group our savings into different buckets – he calls these buckets “mental accounts”. Mental accounts allow us to differentiate between the low risk investments we expect to keep us safe in the long run and the high risk investments that we play for fun.

Unfortunately this type of thinking allows our deceitful brains to play tricks with us, as we accept losses in our high risk accounts that we never would in the low risk ones. And, if we’re pushed, we’ll move stocks between these accounts to make ourselves feel better. Mental accounting is also behind the idea that if a stock doubles we can sell half and let the other half run for “free”. Which is mathematical nonsense, but it’s the way our brains work.

Mental accounting is simply another way of lying to ourselves. We can avoid facing up to the painful reality of our pathetic failed investing ideas by subtly moving shares between our different accounts. Don’t do it. It’s one pool of capital, and if you lose any of it it’s gone for good. Absolutely avoid absolute losses; they will kill your returns.

See: Mental Accounting: Not All Money is Equal

4. Anchors are for Boats

Anchoring is the way our brains work. We don’t compare outcomes to some philosophical perfection, but to something typical that corresponds to the situation we’re interested in. Our analysis of any situation is always relative to some anchor point.

When we’re investing the anchor point is often a purchase price or a peak price. When we’re buying stuff we’ll compare offers to each other – and we can be gamed by clever corporations using biases like the decoy effect.

Because we can’t help anchoring we need to find better anchors than prices. Earnings, dividends, debt and return on capital are good starting points. If you’re going to anchor then do so relative to the market. But remember that if the decision is not a clear one you’re always better off doing nothing.

See: Anchoring, the Mother of Behavioral Biases

5. Loss Aversion Makes Trading Foolish

Our brains are wired to avoid pain and seek pleasure, but not in equal measure. Pain hurts twice as much: when was the last time you woke up and thought how good it was to not have toothache?

Applied to investing this equates to loss aversion, where we avoid selling loser stocks in order to avoid the pain of accepting that we’ve lost money. We also sell winning stocks in order to lock in gains. Given that, by and large, losers keep on losing and winners keep on winning this is simply a way of ensuring we underperform the market.

Trading is a negative sum gain for most private investors because of this. If you’re going to trade then selling stocks that are losing is better than selling those that are winning: but as “losing” and “winning” are both relative to the relatively random anchor of a buying price trading is something that should be done as little as possible. If you’ve bought a good company the short term price movements are irrelevant; it’s all about having the self discipline to control yourself.

See: Loss Aversion Affects Tiger Woods, Too

6. Time is Your Friend

Virtually all professional investors have to take time into account in their investing decisions. Performance and bonuses are paid out quarterly or annually, so they need to make sure they hit their targets. This can lead to some odd investing decisions, if you take a step back and analyze what’s going on. Private investors shouldn’t take their lead from the professionals, they’re operating in a different world.

Private investors don't need to make timing dependent decisions. In fact, if a private investor is constrained by time then they probably need to review their portfolios: borrowing money to invest is a mug’s game, because you may be forced to divest as markets go down, when probably you want to do exactly the opposite.

If you have to actively invest then making sure you’re not time constrained is critical; because quality stocks, bought at reasonable prices and held for long periods will generally produce a good outcome. Being forced to sell your best investments in order to raise cash just as the market tanks will not.

See: On the Invariant Nature of Investor Ineptitude

7. No One Knows Anything

Given the vast amount of information that flies about the investing world you’d be forgiven for assuming that there are a lot of people who know what’s going on. The truth is exactly the opposite – no one knows anything.  Everyone is speculating because that’s what humans do when faced with uncertainty – we try to make sense of it.

But investment experts pontificating on the latest or next market moves are simply the modern day equivalent of prehistory shamans, high on drugs and low on effective prophesy. They have as much chance of predicting the next market earthquake as their ancient counterparts did, and at least the shamans had the consolation of getting high. 

Diversification is the one free lunch in the market, and that’s not very exciting. But if you can’t control your spending habits, ignore the experts, avoid trading and take alternative views into account then you probably should stick your money in a few index trackers and go spend a bit more of your time with the kids.


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1 comment:

  1. This article is worth a read: Why We Consume: Neural Design and Sustainability It notes: "The brain’s key problem is not a conflict between greed and character. Rather, its problem is how to compute efficiently".