This post contains my personal notes from the book Think like the great investors by Colin Nicholson. This post is long but if you to read it, it will be useful.
Attributes of great investors
1. They are well-educated and continue to learn throughout their lives.
2. They have above average intelligence but are not geniuses(which may a handicap).
3. They have a lot of experience which means they ripen over time and not just burst on the scene.
4. They make counterintuitive decisions. They have a strong intellectual framework for making decisions and the ability to keep emotions from corroding that framework. They can do this because of better intuition and development of awareness of the various cognitive biases and an ability to avoid these biases
- The common cognitive biases in our thinking are very natural. They never feel wrong to us.
- We are all prone to these cognitive biases to a greater extent than we can imagine. It is not a criticism of us; it is just how we are made as human beings.
Behavioural finance explores the real world rather than developing theories based on unrealistic assumptions.
90 per cent of traders produce lower results than buy-and-hold. The problem is overconfidence — an overestimation of our trading ability. Another finding was that the more transactions a trader made, the lower their results. Both men and women are overconfident, but men are more overconfident than women.
Good decision-making requires two things. The first is fact-finding and the second is being aware of the limits of our knowledge. We need to confident but we are usually overconfident.We think this problem applies to others but not to us, yet that in itself is overconfidence. Some things that illustrate our overconfidence in general are:
- We think we know more than we actually do.
- We are absolutely certain that we know something, but this is actually untrue.
- We try to estimate something that is difficult to estimate.
- We use simple cause and effect relationships to deal with complex and difficult problems.
- We mistake correlation and causation.
There are some areas where overconfidence can easily manifest:
- Complex and uncertain situations.
- Atmosphere of general euphoria.
- Dealing with issues that are outside our own expertise.
- When we have excessive pride and self-confidence in ourselves.
The reasons why we develop the overconfidence bias are as follows:
- Illusion of superiority: We all tend to be unrealistically positive about our own abilities. We are tend to be unrealistically positive about our own futures. We should remember that half the people cannot be above average and that will help us mitigate this illusion.
- Illusion of control: We like to think we are in full control of our destiny. We all tend to have a strong belief in the superiority of our own decision-making relative to others. We should remember that luck, fate and destiny also are responsible for what happens to us and this will mitigate this illusion.
- Limited imagination: We think of only one possibility and we think that possibility is a sure thing. Reading history, taking the time to ruminate and tapping the imaginations of other people who are not involved in the situation can help. Also making a list of the worst things that can happen can also help.
- Confirmation bias: This means that we only look at views and ideas that are in agreement with yours and do not look at the contrary or opposite views. Looking for other choices and alternatives always helps in mitigating this bias. Remembering that there are always negative and positive aspects about everything and always alternative options or explanations will help us in avoiding confirmation bias.
- Selective memory: We selectively remember the good investments that we made and forget the bad investments. We do not keep good records.
- Certainty vs accuracy of our estimates: Our certainty always exceeds our accuracy. We all have the illusion of knowledge. More knowledge does not lead to better judgements. What leads to better judgment is to know what factors really drive the situation
- Availability bias: We tend to make distorted judgments based on three things-if something has happened to us personally or to people very close to us, if something was very shocking, or in some way graphic, and was repeatedly reported in the media and if something happened recently, rather than some time. These lead to poor judgements because our sample size is often small, we lack a sense of proportion and we do not stop to consider what the real probabilities are.
Strategies that can help you overcome the overconfidence bias are:
1. Do not make investment decisions based on small data samples. Ask yourself how many times this pattern or idea has worked in the past and how many times it has failed to work.
2. Examine the positives and negatives, the pros and the cons every time you make an investment.
3. Seek a Devil’s advocate if possible.
4. Focus on what is important to make a decision. Quality is more important than quantity. Choose the critical fundamental ratios and technical indicators. Then apply them to a large number of stocks and then choose the best and analyse them in depth.
5. Use the SWOT analysis( strengths, weaknesses, opportunities and threats)
6. Keep good records. Monitor your return against the benchmark return and the return goal you have set for yourself.
7. Keep a journal or diary of every investment decision that you make. Record the reasons for your buy decisions and sell decisions in real-time. Learn lessons from these decisions.
8. Do not forecast or listen to forecasts. Set our your investment objectives and strategy. Analyse the condition of the market. Fine-tune your strategy for the market you are in. If the condition of the market changes, adjust your strategy.
2. Mental accounting
There are three stages investors go through in becoming proficient:
- 1. Looking for an outside source to tell us what to buy and what to sell.
- 2. Realise the need to make their own decisions and search for the perfect system.
- 3. Understand that the path to successful investing depends on how we make decisions and not on some external system.
Since investing success depends on the quality of our decisions, to make good decisions we need a set of rules and guidelines in the form of an investment plan, and the discipline to follow those rules and to exercise sound judgement when applying guidelines. Our investment plan will have rules and guidelines for when to buy, when to cut losses, when to take profits and how much money to commit to a single investment. How disciplined we are in following these rules and guidelines depends upon whether the plan is aligned with, and compatible with, our knowledge, skills, experience, beliefs, risk tolerance and general personality. Most important of all, it depends on our decision-making skills, otherwise we may think we are following our plan perfectly when we are actually doing a poor job of it.
We mentally put money in categories or accounts in order to simplify problems. This is one manifestation of what is called mental accounting. In investing, common categories, or mental accounts, that we create for ourselves include ‘money I can’t afford to lose’ versus ‘money I can afford to lose’ and ‘my money’ versus ‘the market’s money’. Successful investors take ownership equally of all the money that they invest, including unrealised profits.
Strategies to prevent mental accounting:
1. Revalue every investment regularly to its current value if it was sold today. Do not focus on the price you paid or the amount you invested. Set up your records to make the price now and the current value far more prominent.
2. Each year, start your records again, taking the price and value of each holding at the end of the previous year as your cost. This helps you to accept that the gains made are really your money. If the price then falls in the new year, it will seem more like a loss and you will guard it more carefully. It also helps to orient your thinking towards this question: For how long does the price of your stocks have to go up before you take ownership of the gain? If you bought a stock 10 years ago for $1.00 and it is now worth $5.00, when does the $4.00 gain become your money?
3. Plot the total value of your portfolio daily or weekly on a graph so that you can see the level it has reached and how much it has fallen from the previous peak.
4. Take some profit off the table from time to time. I have a guideline that when a stock I buy doubles in price, I sell half of it, which takes my profit off the table and lets my original investment continue to run. There are other reasons for doing this relating to rebalancing the diversification of the portfolio, but it also helps to counter the mental accounting bias that unrealised profits are ‘the market’s money’ not ‘my money’.
5. Write a report on your total portfolio every six months. Start with what the total portfolio was worth at the start of the six-month period as ‘My Opening Wealth’. Add dividends and imputed credits received/accrued. Add/subtract capital gains/losses. This will give a total, which you label as ‘My Closing Wealth’. This will help you feel that all of the present value of your portfolio belongs to you and none of it to the market.
3. Reinforcement and punishment
When we buy a stock, our goal is for the stock to increase in price and pay dividends interim. There are essentially two methods of investing:
- Buy high and sell higher( greater fool theory): high risk( works in market bubbles)
- Buy low and sell high( value investing)
Consider these scenarios:
- You notice a good stock but you see the price is not rising and therefore you do not buy. Then the price starts rising. We think that we are too late because the price has already risen. The price keeps rising and therefore we eventually feel that we are missing out and we buy. As it turns out we buy near the top and end up making a loss.
- We are often reluctant to buy stocks when they are cheap and do not sell when they are expensive.
- We buy what we think is a good stock, but at the wrong time or at a high price. Then it falls in price. We sell it at a loss. Later on we find this stock again at a lower price. However we do not buy the stock at this time because of our past experiences when we bought at much higher prices.
- You buy a stock at a low price and then it increases in price and you have a good profit. Then when we get some more money we invest it again in the same stock without considering whether the stock is undervalued or overvalued.
- We buy a stock and we make a quick short term profit on it. We will continue to buy the stock at any price hoping to make a quick term profit on it.
- You buy a stock. The stock falls down below your purchase price. Then it zooms and you make a 300% profit. You are more likely to buy similar stocks in similar industries and hold on to it even if the stock falls below your purchase price.
- You are tempted and buy stocks which others around you have bought and made profits on, irrespective of the price.
- You are unlikely to buy the same stock if you have sold it at a significant loss previously.
- If you have seen others lose a lot of money on the stock market, then you will also not invest in it, even though the stock market may be now cheap and there is a good chance of success.
In the above scenarios you can see how the rewards and punishments that you have experienced before can affect future decisions regarding investing.
Strategies to prevent reinforcement and punishment are:
1. The first step is to become aware of the way our experiences can reinforce poor investment behaviours. I have found it helpful to read biographies of the great investors. This will help to offset the way our poor experiences have set us up to repeat our inappropriate actions by observing the way different behaviours have worked for the great investors. This is all a part of getting inside their heads so we begin to think the way they do.
2. It is also valuable to read widely about the history of stock markets. This will give a perspective on current events. Even more importantly, it will give us a feeling for just how unrealistically high and unreasonably low prices can become in booms and panics respectively. Investors who are hurt in bear market crashes often remark that they never expected it could happen. Yet history is littered with examples. If we do not study history, we will learn the hard way from practical experience.
3. The most important single strategy for lifting our investment skills over time by learning from our experience rather than having our poor behaviours reinforced is to keep a journal or diary in which we record our investing decisions. In the journal we should write down what we knew at the time we made a decision and our reasoning in making that decision. Then, during the time we hold an investment, we should record any new information that has come to our notice about the company we have invested in and our thinking behind every decision we make, even if it is to do nothing. When an investment is sold we should try to work out and write down why the investment worked or failed. When our assessment shows that we made some poor decisions, we should examine what we knew and whether our thinking was faulty in some way. We can then think about what we should have done differently and resolve to avoid those mistakes in the future. In this way we can learn from poor experiences, rather than having them leave scars on our emotions that lead us to repeat the same mistakes again and again.
4. The central problem in the stories in this chapter was that the investors did not see the difference between price and value. Many of the great investors have pointed out that the price of a stock is what we pay for it, but this is not its value. Driven by emotions, the market can price stocks totally out of whack with value. When we study the great investors, we will notice time and again how they have a concept of what the value of a stock is. This is often called its intrinsic value, which is jargon for some method of valuing a company that is independent of the market price of its stock. One very common heuristic for assessing relative value is the price–earnings ratio, but there are many others. The great investors then compare the value they have assessed for a company’s stock with the price they are being offered in the market. If the price is far above value, they will not buy. However, if the price on the market is well below their valuation, they will consider buying. Our strategy should be to decide on a way to judge whether a stock is priced above or below our estimate of its value. If we adopt the discipline of the previous strategy and write this all down in our journal, we will less often buy stocks whose value is far lower than their price on the market.
4. Cognitive dissonance
Cognitive dissonance is the discomfort felt when there is conflict between the facts and our opinions or actions. Sometimes this leads to changed behaviour, but there is a strong tendency to redefine our opinions to justify our actions. A common impulse is to seek only confirming evidence and ignore disconfirming information. Avoiding these tendencies to mould our opinions to justify our investment actions is difficult, but being aware of the emotional dynamics behind cognitive dissonance is a first step to realising that we may be in danger of rationalizing what we want to do or being blind to the case against it. We need to focus on ways to avoid our tendency to make and hold on to poor decisions by changing our opinions or hiding from the facts to justify our actions or proposed actions.
Strategies that can counteract cognitive dissonance:
1. A technique for answering exam questions can be invaluable in dealing with cognitive dissonance. Take a sheet of paper and draw a vertical line down the middle. On the left side, we list all the positives about the situation. On the right side, we list all the negatives about the situation. Then we try to form an overall judgement of the importance of the pros and cons. This is very important when we feel that an investment is a near certainty; we must also be able to see why someone would sell the stock to us. If we cannot see the negatives in a situation, we should seek out someone who can help us to fill in the right-hand column. This leads into the second strategy.
2 Historically, when a proposal was made to make someone a saint in the Catholic Church, the Pope would appoint a Devil’s Advocate. The task of the Devil’s Advocate was not to consider the proposal as such, but to present the Pope with all the reasons why the candidate should not be made a saint. We can apply this technique by finding someone who has knowledge of the situation and asking them to argue against our proposed decision. Many people do not understand the true concept of a devil’s advocate, so it pays to explain it at the outset.
3. The previous strategy can be difficult for us because we may be reluctant to expose our thinking to others, or we may not know anyone who has the knowledge to fill that role. In this case, we can imagine we are on a debating team. Suppose that our opponents in the debate are trying to convince us that we should buy the stock we are attracted to (or to continue holding a stock that we own). Our task is to think of all the arguments we might use to refute their proposal. In other words, by putting ourselves in an imaginary situation where we pretend that we have to argue against something we believe or want to do, it is possible to become our own devil’s advocate. In no time we will have completed both columns on our sheet of paper and can start to form a balanced and rational decision.
5. Representativeness bias
The representativeness bias occurs when we use something superficially similar as a basis for a decision. We tend to see similarities where they do not exist or are not meaningful. This leads us to misjudge probabilities and risks because we are ignoring the base rate. Whenever we come across situations in which we have little or no meaningful information about a choice of any kind, we avoid the representation bias by falling back on our common sense and trying to imagine what the mathematical likelihood or probability will be. Where possible we should seek out relevant statistics on which to base the probability.
Strategies to counteract representativeness:
1. Now we are aware of the representativeness bias, we can make it a habit to always ask ourselves: What is the base rate? Developing a habit requires a lot of effort and concentration and is not easy. We could make a note and stick it on the edge of our computer screen: ‘Have I asked myself what is the base rate for at least one thing I am working on today?’ Leave it there for a month and try to make it happen.
2. It is much easier to see representativeness in others than in ourselves. In developing our sensitivity to representativeness errors it can be very useful to listen for them in what is said around us. It may not be a good idea to point it out and lecture others on it, although we might subtly wonder aloud about the base rate by asking how many other examples there are of something used to justify a decision. The main thing is for us to make an effort to recognise when others are ignoring the base rate, because it will help us to start seeing when we ourselves are doing it.
3.We should try to develop a habit of quantifying things. Suppose we want to start a new business. The first step is to find the statistics, which governments keep, of how many new businesses succeed or fail in the first two, five or ten years. That is the base rate. Then look for the reasons why they fail and try to understand and avoid them. In another example, suppose we see a number of newly floated companies doing well and think that it might be a good plan to invest in some. First seek out the facts. In particular, ask: How many new floats in the past have succeeded and how many have failed? Also ask: Is the success to failure ratio the same in any market conditions? Yes, it is hard work, but the great investors do this work and develop judgement skills that are above average. If we invest in ignorance of the base rate, then the market will teach us what it is. The fees the market charges are called losses.
6. The gambler’s fallacy
The gambler’s fallacy mistakenly applies the law of large numbers to small samples. Investors do this when they wrongly assume that any period of strength must be followed by a period of weakness. Invest in great companies and remember: the trend is your friend.
Strategies to overcome the gambler’s fallacy
The best strategy to use to work towards overcoming the gambler’s fallacy is to look at markets the way the great investors look at them. Ben Graham, who is regarded as the father of security analysis, always looked back at least 10 years when assessing a company. If a company has been listed that long, look at its earnings and dividends back that far.
In charting and technical analysis, most people look only at the short-term picture. The great investors always start with the longest-term picture they can get. Get the longest term picture of your stock market. Then look at the 20 year chart. Then look at the 5 year chart. Then look at the one year chart.
When we see a very strong rise in the one year chart, this may easily set us up for the gambler’s fallacy, because we intuitively think that after such a strong rise the market will go down as it reverts to the mean. However, we are only looking at one year of data and this rise may not be great historically. Sure, there will be short-term corrections along the way and one may well be due at the end of the chart. However, there is nothing on this chart to say that the next year will not see the market go significantly higher.
That is why the strategy of starting our analysis with as much history as we can muster and working down from there to the present is so valuable in giving us the perspective that will help us to avoid the gambler’s fallacy.
7. Random reinforcement
Random reinforcement occurs when someone is rewarded unpredictably, by chance or randomly. The person expects a payoff for their actions, but never knows on which occasions it will occur. Random reinforcement lies behind the gambling addiction and many superstitions. It is also part of the nature of investing. Knowing about it is the first step to avoiding it.
Strategies to counteract random reinforcement:
1. We start by learning useful behaviours in investment or trading, which we want to foster. In doing so, we need to recognise destructive behaviours, so we can identify better behaviours to put in their place. Many of these destructive behaviours are based on the cognitive biases described in this post.
2. We need an investing or trading plan that is firmly based on useful behaviours. We will have tested the plan so that we truly believe it will work if we persist with it. There is no single right approach. There are many ways to make money in the markets. Even more importantly, each one of us is different in many ways. We have to feel comfortable with the various elements that are in our plan. If not, we will be unable to follow it. Finally, we need to execute all the rules and guidelines that make up our plan with as much discipline as we can muster.We should have some procedure whereby we must monitor our actions against our plan. We must also assess honestly how faithfully we followed our plan. Some people like to devise some reward for themselves for when they follow their plan.
3. It is a valuable discipline to write a journal for every investment that I make. In it you should record what you know at the time you make a decision to buy. Then, as you manage the investment, you record your reasoning behind each decision. When you close out an investment, you should assess it against your investment plan and identify anything you find that you need to work on doing better in future.You have to journal in real time (to avoid hindsight bias). It is also worthwhile monitoring your annual returns. This is a superb discipline for you. Showing our journal to a trusted person is confronting for most people, but could be of enormous benefit in learning to be a better investor. That said, such confidants are few and far between. The important and achievable step is to keep a journal of all investments, recording things as we go along.
Anchors are information, opinions, targets or prices that act as an unconscious starting point in estimating, assessing situations or judging values. We then make adjustments from the starting point of the anchor. Those adjustments are typically insufficient. The better approach is to establish a base level that is unaffected by the anchor and make carefully justified adjustments from that. As with all cognitive biases, the most important first step is to try to be aware of anchors, which are pervasive in all aspects of our life.
Strategies to counteract anchoring
1. Before we consult others about a decision, we need to try to think it out for ourselves. The sheet of paper with a line down the centre headed pros on the left and cons on the right is a very powerful tool here. Then, when we consult others, it is best to show them both sides of the question using this summary and avoid saying what we think. Ask them what they think about your judgement on each point in the pros and cons sheet. Also ask them if there are any aspects that you seem to have overlooked on either side of the decision.
2. We should avoid acting on the opinion of only one other person whom we have consulted, especially if they simply agree with us. We should make a point of seeking out the views of people who hold different views to ours and stressing that we value their opinions. Then we test their opinions against any objective measures we can find.
3. It is vital that we do our research before negotiating something. For example, we should write down what we think is the market or reasonable price based on the most objective measures we can find. If our opponent sets an initial anchor price, we should reset the anchor by asking or offering our predetermined reasonable price and try to focus the negotiation on justifying variations from our price. Of course, if we ask or offer a price first in the negotiation, we can set an anchor price in our favour, but it should still be reasonable and able to be justified by argument.
4. In the stock market, we must have a sound method of calculating an intrinsic value for a stock. This may be an absolute price that we calculate, or it may be a formula for determining the relative value of a stock using a ratio of some kind. Then compare the price in the market to the intrinsic value and only consider buying when the price is reasonable. Because intrinsic value is not a precise amount, it can be a valuable discipline for us to employ more than one method of estimating intrinsic value and then use the range of estimates in our judgement.
9. Hindsight bias
Hindsight bias affects us in two main ways. First, we reconstruct history by mistaking when we knew things. We believe that we knew them earlier, when we actually learned them later. This leads us to think we were smarter in our decision-making than we actually were. Second, our memory is selective because it magnifies our recollection of good decisions and suppresses our recollection of poor decisions. This leads us to think we are better decision makers than we are, so we become overconfident and take more risk than is warranted by our real ability.
Hindsight bias is easier to see in others than in ourselves. Even when we recognise it in others, it is still very difficult to deal with in ourselves because our reconstruction of history and selective memory are largely unconscious.
Strategies to counteract hindsight bias
1. It is essential to keep good records of our investing. All the great investors know that good records are essential and they put a lot of effort into record keeping. At any time our records should tell us what our return is for the year to date and for past years. Beyond that, we should summarise our investments in a way that gives our investment performance a good grounding in reality. Keeping a tally of the number of profitable and unprofitable investments is important. However, far more valuable will be also to know the total profit from the successful investments and the total loss from the unsuccessful investments. This is because it is a basic rule in investing to let profits build in successful investments, but to quickly close out the investments that do not work out. Therefore, it is likely that there will be more losing investments than winning ones, but the gains made in the smaller number of winners should greatly outweigh the total loss from the ones that did not work out and were quickly sold.
2. Keep an investment journal or diary for every investment I make. Start it before you buy a stock and write down what you knew when you made the decision and what my reasoning was. It must be done at the time, because trying to do it later leaves us open to hindsight bias. Our memory will have been reconstructed unconsciously, so we cannot be sure what we really knew and did not know at the time. Then, as we manage the investment, we record at the time all the decisions we make and what we knew when we made them.
3. When we have closed out an investment, we need to assess it. Do it in writing. Resist the urge to think that we knew anything that is not in our investment journal. Providing we are honest with ourselves, this is the most powerful investment learning tool I know. It counters hindsight bias because it enables us to recreate what we knew and thought when we made the decision. Then we will be on the way to defeating hindsight bias.
10. The disposition effect and prospect theory
The disposition effect is the tendency to sell winners and ride losers. The reason for it lies in the ideas behind prospect theory. Three ideas explain the disposition effect:
• mental accounting: seeing each investment separately. So we do not sell investments that are losing and hold on to them because we do not want to lose.
• seeking pride and avoiding regret: we regret taking losses and have pride in making profits. So we hold on to our losses and take profits very soon.
• self-control: the planner versus the doer in us. If we plan what we should do, then we will not take profits soon and hold on to our losses. Those of us who just do without planning often end up taking profits soon and holding on to losses.
Understanding opportunity cost can be very helpful in making the decision to cut losses and switch to better investments. This leads into what we can do to avoid the disposition effect.
Strategies to counteract the disposition effect:
1. Become a more rational decision maker. The first step is to have a written investment plan. The plan should spell out what we expect to happen when we buy a stock. While it is happening successfully, we should have a rule in our plan that we continue to hold it. The plan should also spell out how we know that what we expected is not unfolding, and we should have a rule in our plan that we sell it and invest the proceeds in a better prospect.
2. Pre-commitment statements can help us avoid the disposition effect as far as taking losses quickly is concerned. Setting stop-loss levels before we make an investment is probably the most important of them. Just before we buy a stock is the last time that we are not emotionally involved. At that point, we have the best chance of rationally deciding on a price level such that, if the stock fell to it, we would be wrong about what we were expecting to happen when we buy the stock.
3. It can be very helpful in lessening the effect of mental accounting if we focus our thinking on congratulating ourselves on following our plan, rather than on the result of any one investment, so avoiding the mental accounting bias.
4. Another strong strategy is to utilise this idea from Leroy Gross to avoid mental accounting and at the same time add the power of the idea of opportunity cost: see selling losing stocks as switching to better stocks, rather than as taking losses. A good way to do this is to regularly review each stock in our portfolio. . Twice a year may be ideal.
Then we should go through the portfolio one stock at a time. It is a useful discipline to write down our thinking stock by stock. There are only two questions to ask about each stock: (1) Is it performing satisfactorily? (2) If it is not, what is the opportunity cost of continuing to hold it?
To answer the second question we need to do our research and identify a number of alternative stocks that we could invest in. For the non-performing stocks we hold and the alternatives we have identified, we make our best estimate of their future prospects. If the prospects of the alternatives are better than the non-performing stocks we hold, we should switch out of the non-performers into the better prospects. The power in this procedure is that we make ourselves identify the non-performers in writing and then we make ourselves consider the alternatives. Unless we do this, sitting in non-performing stocks is too easy and amounts to hiding from the opportunity cost of doing so. Think of it as hiding from better opportunities.
11. The sunk cost fallacy
The sunk cost fallacy arises when we make an irrational decision in the present because we are fixated on a cost that we have incurred in the past, rather than take the best option that is now open to us. We cannot change the past; it is done and gone. However, we can select an optimal course for the future.
The first step in dealing with the sunk cost fallacy is to be aware of it and how destructive it can be in terms of poor investing decisions.
Strategies for counteracting the sunk cost fallacy:
The best strategy to deal with the sunk cost fallacy in investing was described previously in the disposition effect. This is to conduct a regular review of our portfolio after each reporting season. This review process is best done as a formal written report, because it makes it more difficult to push losers out of our mind and not consider the other options that we have. Identify the non-performers and make a search for and evaluate several alternatives compared with the existing non-performing holdings. This will highlight the opportunity cost of continuing to hold the non-performers, taking our attention away from the sunk cost. Then it will be easier to make the switch because we are focusing on the best way to use the value that is in the non-performers, rather than what we invested in them, part of which is gone. We do not have to make it back the way we lost it. In fact, we are likely to do even better if we switch into a superior stock.
12. Availability bias
The availability bias affects our decision-making skills adversely when our intuition and memory are based on events that were very graphic, recent or affected us personally. The bias comes into play because the ready availability of only a small sample of all similar occurrences means that we may ascribe great importance to one particular cause. The availability of only a small sample in our memory means that we make poor decisions because we do not see the base rate. The base rate is established from the data covering a very large sample of similar events and the proportion of them that can be attributed to the cause we remember.
Strategies to counteract the availability bias:
1. If we read a positive article or hear a tip about a stock, we should never act on it without research to see if there are any other views. We should be particularly wary when any recommendation or tip about a stock is based on a purely short-term factor or a trend over only one or two years. We must search out the data on the stock over a longer period, like a decade, which will give us a far wider perspective and cover the stock’s performance in both expansions and contractions in the economy.
2. And that is only the first step. The next thing is to search out several alternative stocks both in the same industry and in a number of other industries. Weigh them all up using a few important ratios or key measures. This will better expose us to the base case. Our stock may shape up well and it may not, but whichever way it goes, we will avoid a mistake and may make an even better decision than just acting on the article about one stock.
3. Whenever we read about, or someone states, large round percentages, such as that something happens 80 to 90 per cent of the time, we should be on high alert. Politely ask or research the base rate. Questions to ask or research include the following:
• Over what period was the frequency calculated?
• What was the nature and size of the sample measured?
• How was the trigger for the event defined?
• How was ‘happened’ defined?
People who make round number assertions like this are often basing them on their memory, which is corrupted by availability bias: their sample is too small and too graphic to give the perspective needed.
13. Small numbers and reversion to the mean
We assume that reversion to the mean applies to one or a small number of stocks. Reversion to the mean does not apply to small samples; this is known as the law of small numbers. Reversion to the mean applies only to very large samples or a great number of situations on average. Also, the past may be no guide, because the causes and circumstances may have changed. We should never assume that simply because something happened before it must unfold the same way again. Search for the reasons behind things then and now. Look for statistics from large samples of cases to establish a base case probability.
Strategies to counteract small numbers and reversion to the mean:
1. Read history. I particularly recommend the books Two Centuries of Panic, The Money Miners, The Bold Riders and Six Months of Panic, all by Trevor Sykes. It has been said that those who do not study the lessons of history may well learn them the hard way in their lifetime. Not all history repeats itself exactly, so good histories focus on the causes based on the evidence, which makes it easier for us to see the extent of similarities in the present situation. A very salutary 10 minutes can be spent visiting http://www.delisted.com.au and running through the lists of delisted companies for how many we can remember. This gives some idea of the base case.
2. If a stock’s price has fallen a long way, there is always a reason. We should never assume that it will automatically rise again. This is what we should do before deciding to buy it:
- Research the stock to understand why the price has fallen so far. Look for concrete reasons, not just opinions.
- Look for evidence that the problems are being put right or are behind the company. The best evidence is that the price has stopped falling and is starting to rise. If it isn’t, we are either too early or there is something the smart money knows that we don’t know.
- Form an understanding of the future of the company and its industry. Is it a growing industry or a mature to declining one? Was the all-time high price established in a time of boom and irrational exuberance about its industry or business and unlikely to be repeated?
- Also, some industries are cyclical (they do well in time of economic expansion but badly in economic downturns).
- How does the stock compare with other directly competing firms in the same industry or business?
Then, we should remember opportunity cost. Have at least six other investment opportunities to compare the stock with. Invest in the stock only if it is assessed to be better than these alternatives.
Overreaction occurs when investors place too much weight on recent information. Research confirms the theory that bad news leads to overreaction. In particular, a wide portfolio of stocks that have low PE ratios is likely to outperform over the next three years, which is a large part of the rationale behind value investing. However, this effect is valid only for a wide portfolio of low PE stocks, not for any one or a small number of low PE stocks.
Strategies to counteract overreaction
1. Look to take advantage of unwarranted overreaction. If a stock is sold off sharply on some bad news, ask whether the reaction is overdone by focusing too much on the very short-term picture rather than the longer term picture. If we think it is, and that the stock is relatively undervalued, we might buy it or buy more of it if we already own it. However, it is also important to recognise the risk that we could be wrong on our assessment. Markets can behave irrationally for longer than our capital will hold out. Therefore, it is important to set a level below which we are no longer willing to allow the stock to fall and to sell promptly if it happens.
2. Construct portfolios of undervalued stocks rather than follow the soaring trends of momentum stocks that tend to be overvalued. The important thing is to hold diversified portfolios of undervalued stocks. Spread the portfolio across a number of industries and avoid holding too many stocks in any one of them. Of course, some undervalued stocks will not rise. For them, there is a need to be disciplined in selling if their price falls to a level at which we are no longer prepared to continue to hold them. Even more important is the understanding that the value investing research applied to a large, widely diversified, portfolio of undervalued stocks. The law of small numbers discussed in the previous chapter does not apply: they will not all rise, but the portfolio as a whole is likely to rise more than the market. Most of us will not have enough capital to hold a wide portfolio of stocks. Therefore, the value investing style is only a rough starting point. It is reversion to the mean for a large sample. No matter how undervalued stocks are, it does not mean that any one of them, or any small number of them, will outperform the market. In selecting which small number of undervalued stocks to buy for our portfolio, we need to bring to bear many other disciplines.
3. If we have bought an undervalued stock and after a few years its fortunes turn around magnificently and its price soars, we might take advantage of the tendency to overreaction. Suppose the price has risen such that the stock is now no longer undervalued, indeed no longer even fairly valued, but greatly overvalued, then we might consider that the risk on the downside is now very high. It may be a time to capture the excess price that is due to overreaction, and so will not last, by selling and switching to a new undervalued stock.
15. Inertia bias
The inertia bias arises when we choose the status quo over making investment decisions because the result is uncertain and the choices are too complex. By dodging making decisions, we do not have to take responsibility, which means we protect our ego and avoid regret.
Strategies to counteract inertia bias:
1. Have a written investment plan. If either of them does not have the skills to draw up such a plan, they should seek out and pay for the assistance of a professionally qualified financial planner. Any cost to create a financial plan will be a bargain if it will get you started on building retirement funds. The cost of having a plan drawn up for yourself also reduces sharply your need to seek peer reassurance when making decisions: you now has a professional to advise you.Once you have a plan you can carry it out effectively. Given a good plan to follow, you will not look back in her investing. Should you encounter problems making decisions, you consult the plan or go back to your financial adviser.
The plan will also help you with selling non-performing investments quickly. This is because your plan should have a target return. If you are not achieving it, you need to look for the reasons. The plan should tell you that, if an investment is not performing, what you should do about it — namely, to find better alternatives.
2.When struggling with a decision whether or not to sell a non-performing stock, we should sell it. Then, having done so, we should ask ourselves whether we now want to buy it back? In my experience the answer is invariably not to buy it back. The trick here is to have changed the status quo from owning a non-performing stock to having cash to invest. In the unlikely event that we decide to buy the stock back, it costs only the brokerage out and in again. We may also have the advantage of crystallising a tax loss for the current year.
3. Having people remind us of mistakes is actually an easy problem to attack. It is as simple as resolving not to talk to others about our investments before we make them or while we are holding them. In fact, it is best not to talk about them afterwards either, to reduce a number of other cognitive biases that tend to distort our memory.
4. Another possible strategy tackles the situation where we find it impossible to avoid the subject of our investments within or outside our family. We should try to focus on our overall investment plan rather than on individual investments. Whenever we feel we have to talk about a stock, we should do so in the context of our diversified portfolio, focusing our remarks on its contribution to the overall objective. If someone points out to us that a stock we own is not doing well, we might say: ‘It is only 2 per cent of my portfolio. All stocks do not go up together. This one is lagging, but I am letting it run for the moment. I am keeping it under review and know where I will get out of it, if it deteriorates further.’ Don’t ever say where that point is. Then always volunteer something like: ‘By the way, my portfolio is on track to beat the target in my investment plan if things continue the way they are out to the end of the year.’ This brings the focus back to the overall portfolio and our plan, rather than a specific stock.
5 A great strategy for overcoming inertia bias in our existing portfolio is to review it stock by stock after each reporting season. Before we start reviewing our portfolio, though, we should have found at least six good alternative investments. Then, as we review each stock in our portfolio, we measure it against the six alternatives using a specific set of key ratios or financial measures. Make our non-performing stocks battle for their place against the six alternatives. If they do not measure up against the six benchmark stocks, switch out of the non-performers into some of the better alternatives.
6.A variation on the previous strategy to adopt to avoid the status quo bias is to diarise to review every stock one year after we buy it. If it is not now worth more than we paid for it a year ago, something is wrong. Then invoke the six alternatives strategy outlined above and make it justify its place compared with the other choices we have.
7. From time to time I have employed an even more drastic, but very effective, strategy. If the stock market has been going up well for two or three years, sell any stock that is worth less than we paid for it, provided we have held it for at least a year. This switches the status quo to cash, as described in the chapter. I have never then bought one of those stocks back again. There were always better stocks out there that I had not bought due to inertia. By the way, this is a good cure for the non-performer that lingers in our portfolio because of past association or other reasons for us to regard it as an old friend. Friends enrich our lives in many ways, but stocks should be made to earn their friendship or the opportunity cost of keeping up the friendship will hurt our financial lives.
We feel regret when we make a decision to buy a stock that leads to a loss. The more we take responsibility for our decisions, the greater our feeling of regret. Regret is commonly avoided by blaming the loss on someone else, or on circumstances that were beyond our control. We may also be in denial that we made a decision at all when we allow a situation to continue without doing anything about it. However, if we do not take responsibility for our decisions, we restrict our ability to learn from our poor decisions and do not develop the skills to make better decisions in the future.
Strategies for dealing with regret:
1. A very useful method of identifying the decisions we make is to draw up a decision flow chart. This should capture the steps taken to decide on an investment and to manage the investment through to closing it out. At first, our flow chart will be quite simple. Nevertheless, it will identify when in the process we have to choose between alternatives or to take some action.
Then, as we go about investing, try to be increasingly aware of just how many decisions we do make. This will include the trickiest ones of all to identify as decisions: when we just let an existing situation continue. Remember that every day there is new information available in the form of prices or news. Mostly, we will quickly consider it, but not take any action. Become very aware that, in so doing, we have made a decision. Not taking any action is a decision not to change the status quo. It is a decision not to take any action.
Over time, if we build all these decision points into our flow chart, we will significantly raise our awareness of how many decisions we make and can start to take responsibility for them.
2. The way we take responsibility for all the decisions we make is to incorporate them into a written investment plan. Our investment plan should include a description of every kind of decision we need to make and how we will make that decision. This is a hugely powerful tool. When under pressure in managing an investment, our plan should provide us with rules and guidelines for how we should make that decision. Because the plan will have been written before our self-worth was involved in an investment, it will be a well-grounded basis for making better decisions.
3. A very powerful adjunct to this is to keep a special journal or diary for one of our investments. To learn just how many decisions we make unconsciously, for each day we own the stock, we should write in the diary two items: (a) any new information that has come to hand and (b) what decision we made and why. If there is any new information, we have to make a decision and we must write a reason for it. Remember that doing nothing is a decision and we should have a reason why we decided not to do anything.
This is a tough discipline, but if kept up for a year or more (from my experience it needs to be that long), it will greatly heighten our awareness of the decisions we make all the time, but do not tend to notice making.
At the same time, we should keep a journal for all our other investments. These journals can be far less detailed and record only significant new information that causes us to make a decision. When that happens, we record what the information was, what we decided to do, including to allow the status quo to continue, and the reasoning behind the decision.
4. Having to make a decision about an investment when it is under pressure in the market is very difficult. Possibly the most important decisions we have to make in investing involve preserving our capital — in other words, cutting losing investments early, before small initial losses run away from us into huge losses from which we cannot recover. The key here is to know that the last moment when we are likely to be able to avoid regret is just before we place the order to buy a stock. When we buy a stock we should have some expectation of what is likely to happen and that it will yield us an income stream and capital growth. We must be able to define when that is happening. Once we can define when it is happening we can define when it is not happening. That is when we will be wrong about our investment decision and should cut our losses. Most commonly, this should be a price level; if the stock falls below it, we will cut our losses and look for a better alternative investment. We should write this price level in our journal before we place the order to buy the stock. We may revise it upward later, but never lower it. It is a good idea to also pin the list of selling points for all of the stock we own on the wall where we do our investing work, so that it is difficult for us to ignore them.The powerful idea behind this strategy is that we can pat ourselves on the back for cutting a loss, and therefore following our plan, rather than simply seeing the original decision as a mistake.
17. Confirmation bias
Confirmation bias is a common cognitive bias. It happens when we seek assurance about an opinion by looking for more and more confirming evidence. We do not make an effort to understand why someone would sell to us at the price offered. We are in the greatest danger of confirmation bias when we are most certain of our opinion.
Strategies to counteract confirmation bias:
1. The best approach is always to make a list of the pros and cons of the stock we are thinking of buying and then weigh them up for a balanced view. If we can see only the pros and very few, if any, cons we need to seek out the negatives. If we have to ask others to help us work out the reasons against buying the stock, we should avoid starting by telling them how much we think of it, and nor should we ask for their overall opinion of the stock. Instead, we should ask specifically for the points against buying. Ask them to argue the other side of the case to you, taking the role of a devil’s advocate. Finally, also ask them to challenge all of your points in favour of buying.
2. Avoid seeking opinions from people who have an interest in you buying the stock. The management of the company, the house broker’s analyst, journalists who have written favourable articles about the company, employees of the company, and anyone who is a supplier to or does business with the company should be avoided. It is far better to ask the management or employees of a competitor or someone who is knowledgeable about investing and can take a totally disinterested view.
3. When we have money to invest in a new stock, it is best never to consider only one stock to buy. Have a list of four to six stocks and assess them against reasonably objective measures in weighing up which is the best one. We are likely to be surprised quite often that our original fancy does not stack up as well as we thought when it was the only one we were considering. This strategy of considering alternatives also helps avoid opportunity cost: the better return from an alternative that is foregone by investing in the stock that was our sole original focus.
18. Impulsiveness and immediate gratification
Rats and people prefer instant rewards to larger rewards later. The result is that the average investor is impulsive and impatient rather than disciplined and patient. We have a deep-seated need for positive reinforcement. This leads us to grab quick, small profits, but leave losses to get worse. We should be doing the reverse, allowing our profits to grow and cutting losing investments while the losses are still small.
Strategies to counteract impulsiveness and immediate gratification:
1. We should all have a written financial or investment plan. The starting point in the plan should be our long-term goal. This long-term goal should be broken down into shorter-term intermediate financial objectives. We should actively review how we are progressing toward our long-term goal by calculating and recording our progress. This focus on our long-term goal will help reduce our need for immediate gratification by encouraging a stronger need for long-term gratification. Many people find it useful to keep a graph of their progress toward their goal.
2. Our investment plan will also outline in detail how we aim to meet our financial objective and our intermediate objectives. If we keep a journal in which we record how we are managing each investment compared with the detailed tactics set out in our plan, it will be easier to sit and let profits build, while only cutting those losses that are necessary to protect our capital.
3. As far as cutting losses is concerned, this is a key objective. However, there is a danger that we become overly zealous in doing so and do not give our investments time and room to come good. We should have set a price at which we would be wrong about what we expected to happen when we bought the stock, which was the last time that we could assess this without feeling any emotional heat. Our plan should be to let a stock run as long as it is trading above our trigger price, but to sell the moment that price level is crossed. We should regularly review each stock we hold (once a week might do) and record in our journal that we are holding on to it still because it is above our predetermined failure level. Likewise, if it falls below the price where we must cut our losses, we record that we sold it. This focuses us on following our plan rather than on the day-by-day price level relative to our buying price that may cause us to seek immediate gratification by selling prematurely
Many things in life and the financial markets happen by chance. We are uncomfortable with random or unexplainable events and tend to invent reasons that are not soundly based in evidence. If we act on patterns that we have invented to explain random behaviour, especially in stock markets, we will do damage to our account and will have placed a hurdle in the way of our learning to deal properly with random or inexplicable events.
Strategies for dealing with randomness:
1. We should be on high alert when someone offers an explanation for why something happens in the market. They may simply have thought up a possible explanation, when the event may be pure chance or have no known cause. A possible explanation is not a fact. We should ask ourselves whether there is any hard evidence for the explanation, or whether it simply cobbles together some possibilities into a story that sounds convincing. Might this evidence have nothing to do with what is being explained? In short, we should be sceptical and question everything.
2. We should be especially wary when a commentary on why events happen morphs into a prediction. In this case, we must start with the assumption that the explanation for events is suspect and therefore the prediction that follows from it is equally suspect. Generally humans are very poor at predicting the future. My philosophy here is to ignore predictions, or at least to be highly sceptical.
3. We all naturally seek predictions, even in the face of strong evidence that it is impossible to accurately and consistently predict even near-term events. A far better approach is simply to assess the conditions we are investing in. Having done that, we set a strategy that is appropriate to those conditions and carry it out. If the conditions in which we are investing change, we modify our strategy accordingly.
20. The normalcy bias( analysis-paralysis, state of denial, behaving like an ostrich)
Normalcy bias is our natural impulse to freeze in the face of danger. We deny the danger is real because it has never happened before or because it is outside our experience. We underestimate the risk. We may huddle together in physical or mental groups as the catastrophe overwhelms us.
Strategies for dealing with the normalcy bias:
1. By reading history we can know what has happened before in financial markets and the corporate world. However, something simpler than that is to familiarise ourselves with the long-term charts of stock markets. Don’t just glance at them, study them. Look at how big each fall was in percentage terms. Look at how often they occur.
2.A very powerful strategy is to force ourselves to imagine something one level of magnitude worse than the greatest market catastrophe that we know about. Then think through its implications and devise a strategy to protect our capital, so that we are ready to act decisively and effectively should it ever happen. Mentally rehearse seeing it happen and executing the strategy.
3.Likewise, we should read histories of corporate crashes and form in our mind scenarios for how a corporate crash may unfold. What will the stock chart look like? What are the key signs to watch for? Clearly, the most important thing is to have got out of the way early. However, if we think through the implications of being caught in one that we did not see coming, we can set diversification and stop-loss strategies that will mean that even a corporate collapse that takes us down with it will not destroy more than a manageable part of our capital.
4. Preparation is the key. We should have a series of written action strategies for the investment disasters we can reasonably think of. However, we must be realistic. Some events may be so unlikely that we can exclude them. The purpose of a disaster strategy is to prepare us so that we are not overwhelmed. It should impose a focus on the priority actions we should take. In this way we will avoid trying to do everything at once, actually achieving nothing except confusion. After every financial disaster, stories emerge of how many people did not have a disaster strategy; or, if they did, they did not implement it because of normalcy bias. Most of them lost most of their wealth or became bankrupt. We can greatly increase our chances of survival if we are the ones who remain alert and we implement our financial survival plan.
People will act differently when they are in a crowd to the way they behave when they are on their own. We must understand crowd behaviour, lest we become one of its victims. The most powerful method for us to counter the power of the crowd over us is to develop the art of contrary thinking. This consists of learning to be a sceptic and to question every belief before accepting it on face value, especially when it seems that everyone believes it is true and sees no other possibility.
In his book Contrarian Investment Strategies: The Next Generation, David Dreman sets out four general principles that he has distilled from the study of financial manias:
- An irresistible image develops in thousands of people: that they can become instantly wealthy through speculation. They become what we call a crowd.
- A social reality is created in which simple opinions form in the minds of the crowd. These opinions are accepted as facts, even though there is no clear evidence supporting them. So-called experts approve the wild valuations and encourage the crowd by validating higher and higher prices.The crowd becomes increasingly overconfident and blind to all past standards of value. They ignore the experience built up over generations.
- Something happens to cast doubt on, or to change, the prevailing image. Overconfidence is replaced with anxiety, leading to fear and panic. Prices fall rapidly.
- Most people do not learn from these episodes. They accept the idea that it is different this time. Of course, it isn’t different at all: the dynamics of crowd behaviour are the only constant
People in crowds often act irrationally. Markets are crowds in the sense that there is mass contagion of ideas. We need to understand crowds and to work at retaining our independence.
Gustave Le Bon has some fascinating insights on crowds: You can read his book here.
The crowd of investors tend to be correct most of the time, except at turning points in the market. If almost everyone thinks something, it is usually wrong. The key is to be an independent thinker. Search out the other side of every important argument. Find and test the evidence. This book discusses many strategies that can be usefully applied in addition to contrary thinking in the pursuit of a balanced view by standing apart from the influence of the crowd.
Keys to successful investing
There is no Holy Grail investment method. The nine keys to the kingdom of successful investing are:
- The long view: the ability to see beyond the noise and look at the long-term trends in the market and think independently about the world around them.
- Flexibility: Question everything. Be flexible enough to adapt to changing market conditions.
- A plan: Need to have a well written investment plan.
- Learning: Never stop learning and seek to understand the world around you.
- Advice: Seek out the best people in various fields and take their advice.
- Humility: Be humble. Accept that you will make unsuccessful investments.
- Self-confidence: Think deeply about investment and how your personality interacts with the market environment. Think out in advance what we are trying to do and how we will go about it. Then test your ideas. Then you will have true self-confidence, developed from thoughtful knowledge and experience. This will take time to develop
- Intelligence: Investing requires an average amount of intelligence, at least
- Persistence: To be a truly successful long-term investor you have to be patient and persistent. Trees do not grow in a day.
Failure traits in investing
Just as it is more important to manage losses than profits, it is important to learn to manage our personality weaknesses. The first step is to recognise which of the 11 weaknesses we have in our make-up, then we work on strategies to counterbalance our weaknesses. The 11 weaknesses and the ways to counteract them are:
- Arrogance: Write down why someone will want to take the opposite side of our transaction.
- Melodrama: Resist discussing your trading or investment decisions with others.
- Volatility: Keep things in perspective and think before acting. Avoid making decisions when we are emotionally off-balance.
- Excessive caution: Develop a sound investment plan and stick to it.
- Habitual distrust: Write down both sides of the situation-both positive and negative.
- Aloofness: Have a written investment plan and stick to it. Talk to someone whom you really trust.
- Mischievousness: Have a clear investment plan and follow it. Do not deviate.
- Eccentricity: Same as above.
- Passive resistance: Make an investment plan and execute it without seeking peer support. Rely on your tested plan, rather than the validation of others.
- Perfectionism: Prioritise the key trading and investment tasks and work hard on them. Then learn to accept the uncertainty about the lesser aspects of the situation.
- Eagerness to please: same as for passive resistance.
Dealing with loss
Beginners often start by making big losses on stocks that they rode down from high prices to low. They want to know what to do now.
- First they need a clear investment plan.
- Second, they must assess each holding against the plan and alternative opportunities and make rational decisions to rearrange the portfolio.
- Thirdly, they must try to follow their plan, cutting losses, while letting profits build.
- Fourthly, should also remember that uptrends will have corrections and therefore we should sell too soon.
- Finally, you should also be well diversified, so that if one investment fails, your loss is not catastrophic.
Plan to succeed
Exercising the discipline needed to follow a sound plan is the most important and difficult part of investing. If you are not succeeding, you may have developed financially destructive habits and behaviours. Identifying them is difficult, but not as difficult as changing them.
The two things that are necessary for an investor to succeed are:
- Good decision making skills
- Discipline under pressure
The way to develop this is as follows:
- Write down your investment plan. Make the plan as complete as possible.
- Test your plan over many years of historical prices and many stocks.
- Find a helper to whom you will report regularly.
- Begin an investment journal. Write down the reasons for every decision that you make. if something happens and you do not do anything, then that is also a decision. Write down how you assessed a situation, what your plan indicated you to do and what you actually did and why.
- Reward yourself each week if you followed your investment plan.
- Write an affirmation: I have stuck to my investment plan and it is paying off for me even in the face of short-term difficulties.
- When you slip up, acknowledge it, write what happened in your diary, forgive yourself and start the process again.
- Have a diversified portfolio
- Do not talk to others about your plans unless they are going to be supportive.
Seven investing sins
The key to investing is to buy when stocks are cheap. This is not easy. The seven mindsets to overcome are:
- Thinking someone can predict the market: Forget prediction and devise a strategy that will work irrespective of what anybody predicts.
- Trying to be perfect: Have a plan and follow it. You will lose and you will win sometimes in the short run, but if is a good plan, you will most likely win in the long run.
- Fear of being wrong
- Inability to act independently
- Lack of patience:Successful investing takes time
- Having unreal expectations: Warren Buffet had a return of 20% annual compounded from 1965-2011. That is the greatest investor. Anything half that amount in US dollar terms is great.
There is no way to predict the perfect time to start investing. We always have to manage uncertainty. We need a plan and then we carry it out, making modifications if necessary to manage market conditions. It can help greatly to manage uncertainty if we diversify over time using some variant on dollar-cost averaging and to diversify over many companies so that if one stock collapses, it will not be catastrophic for the portfolio.
Capitulation is a new idea: it describes the phenomenon that occurs when the mass of investors bail out around the same time, ending a bear market in a climactic sell-off. Capitulation is an idea based on two delusions: that there is only one simple answer to how the bear market will end and the desire for a quick resolution. Bear markets can end in various ways, only one of which is a capitulation or panic plunge on high volume. Sometimes markets can go down slowly for ages.
Professional investors tend to do better than small investors in difficult markets. While it can be difficult to survive in falling markets, small investors can stand aside. The really tough markets for small investors are sideways markets. Some guidelines for sideways markets:
- Have a plan specifically for sideways markets.
- Decide the level of participation. It may be better to be only partially invested.
- Keep an equity curve and ruthlessly evaluate performance.
- Keep an investment journal and interrogate it for lessons: especially whether the plan is being followed.
- Have realistic expectations for difficult markets.
Bull markets start before the news turns from gloomy to positive. This is because people invest on expectations, not current news. Most of us have difficulty imagining a future that is different to the present. Gurus, with their false certainty, are not the answer. One key is to understand history and look for parallels and trends. The other is to read widely and never stop thinking, hypothesising and testing the present against the possibilities.
The interplay of fear, regret and ego can lead to inappropriate decisions. The stock market is a leading indicator because people invest on expectations. Have a sound plan. Practise discipline and patience. Maintain perspective.
Investing involves losses as well as profits. We cannot know in advance which investments will pay off and which will fail. Build positions in investments that are succeeding. Quickly sell out of ones that are failing. Mastery is reached when you know instinctively what to do and do it with no hesitation and minimal emotion. Investing is a business.