A Dozen Things I’ve Learned About the Psychology of Investing

1.“The best example of narrow framing that I can think of is the use of pro forma earnings. Essentially this is a company turning up and saying, hello I’m lying to you, these are the earnings I didn’t make, but I’d be jolly grateful if we could all just pretend I did.” (Framing bias) James Montier http://www.investmentpostcards.com/2010/03/11/interview-james-montier-on-value-investing/ Our brains only have so much cognitive capacity so humans suffer from in-attentional blindness. If we are told to focus on the basketball going back and forth we can miss a gorilla that appears in the video being viewed. When people are told to focus on EBITDA (A.K.A. “bullshit earnings”), they often don’t see a lack of genuine profit and awful cash flow.

2.“Denial Ain’t just a River in Egypt.” (Denial bias) Mark Twain. Charlie Munger writes “sometimes reality is too painful to bear, so you just distort it until it’s bearable.” Victims of Nigerian Internet schemes who keep sending more and more money to the fraudster despite existing big losses are an example of this bias. Richard Feynman put it this way: “The first principle is that you must not fool yourself–and you are the easiest person to fool.”

3. ”We’re really crummy at forecasting the future.” (Hindsight bias) http://www.fool.com/investing/general/2013/06/28/an-interview-with-dr-daniel-kahneman.aspx Daniel Kahneman. Arguably the best thing you can do to overcome this bias is to write down your investing results in a notebook. If you just keep track mentally you will inevitably exclude your mistakes. I know a number of people who used notebook approach and subsequently converted to index funds zealots. If you carefully write them down numbers don’t lie. As a profession economists are hindsight bias practitioners extraordinaire. No other profession even comes close to believing that explaining the past enables them to forecast the future. Economists who are very certain about their predictions are the most popular with the public, but are no more accurate.

4.“People are really crazy about minor decrements down.” (Loss-Aversion bias) Charlie Munger. People hate to sell stocks at a loss so they hold them too long. While what is in the past is what an accountant calls “sunk, it is hard for people to think that way. I’ve watched people let a stock price drop to zero since the more it dropped the harder it became for them to sell. Losses can have long lasting impacts. For example, investors financially burned in 2001 and 2007 are spooked by the experience in a way that is similar to people who lived through the Great Depression.

5.“What a man wishes, so shall he believe.” (Confirmation bias) Demosthenes. In doing due diligence and research on a stock people see what they want to see. We all need friends who can tell us when we have objectivity problems. Michael Maubousin’s book Think Twice http://www.amazon.com/Think-Twice-Harnessing-Power-Counterintuition/dp/1422187381 identifies ways to deal with this bias.

6.“A careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives.” (Overconfidence bias) Charlie Munger. The primary problem with this bias is that people who should be buying index funds think they can be successful active investors. A retiring Morgan Stanley executive recently described overconfidence bias as what drives Wall Street “sell-side” profits (if investors were not overconfident Wall Street profits would plummet).

7.“Most of us view the world as more benign than it really is, our own attributes as more favorable than they truly are, and the goals we adopt as more achievable than they are likely to be.” (Over-optimism bias) Daniel Kahneman. http://mobile.bloomberg.com/news/2011-10-24/bias-blindness-and-how-we-truly-think-part-1-daniel-kahneman.html Over-optimism leads investors to do things like take on too much debt which can end up crushing their financial returns. To deal with this nothing works better than having a margin of safety. Especially as you grow older, “returning to go” financially is a risk well worth avoiding.

8.“[People] think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” (Cascades/herding bias) Charles Mackay. https://en.wikipedia.org/wiki/Extraordinary_Popular_Delusions_and_the_Madness_of_Crowds People are social creatures and in the absence of information or time to make decisions they follow the herd. As Benjamin Graham once said: “You are neither right nor wrong because the crowd disagrees with you.”

9.“In the absence of any solid information, past prices are likely to act as anchors for today’s prices.” (Anchoring bias) James Montier. Anchoring is a tendency of people to grab on to inputs just because they are available. For example, financial analysts often fail to revise their estimates since they get anchored to prior numbers. (they revise too late to be useful).

10.“If people want high numbers, they’ll roll the dice really hard, but when they want lower numbers, they roll them very gently.” (Illusion of Control bias) Michael Mauboussin. http://cobrands.morningstar.ca/article/printArticle?articleid=341146&culture=en-CA&cobrandid=50 As an example of this bias, once people pick a stock they immediately become more certain that the pick is wise when logic should tell them otherwise. This can result in a failure to sell a stock when an opportunity cost analysis logically would call for the stock to be sold.

11.“Let us eat and drink; for tomorrow we shall die.” (Present moment bias) Isaiah Old Testament. Companies like Starbucks know people will pay several dollars for a coffee even though on an annualized basis it eats up a big share of after-tax income. People like benefits that are available NOW—which is why they don’t save for retirement and eat too many calories. The investor too often says: “To heck with the 401(k), let’s buy a waterski boar with a disco ball.”

12.“Never try to teach a pig to sing; it wastes your time and annoys the pig.”

http://25iq.com/2013/07/01/a-dozen-things-ive-learned-about-the-psychology-of-investing/

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