We are all, by nature, emotional creatures. This makes most investors unknowingly – use emotions to drive their investment portfolios. Of course, numerous daily decisions, whether we are consciously aware of them or not, are processed through our emotional thinking. However, these “gut feelings” are derived from a wide array of unsorted, un-weighted, un-organized, and sometimes just simply irrelevant subconscious data. According to various experts, this emotional decision making process is used more frequently than a purely logical approach because it’s faster and easier. When it comes to investment decisions, using a gut feeling is just as prevalent; and the outcome is often wrong and costly.
One of my favorite books on this topic is “The Little Book of Behavioral Investing”, written by James Montier. He describes emotional decision making as using the X-System and logical decisions using the C-System. In the book, he uses a quick test to determine where you fall on the spectrum using three questions. See how you do:
- A bat and ball together cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?
- If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
- In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?
Out of 3,500 people, only 17% got all three questions right. Further, 600 professional investors and fund managers took the test and only 40% got all three right, while 10% got none of them right. The commonly used X-System is what caused so many wrong answers. The correct answers are: 5 cents, 5 minutes and 47 days
According to Montier, the fewer correct answers you get, the more vulnerable you are to the behavioral investor biases, as loss aversion, conservatism and impatience. However, if you answered all 3 correctly, you aren’t completely out of the woods. Getting them all right, might actually be worse for you when investing because you would be at risk for over-optimism, overconfidence and confirmatory bias – the three major biases that can lead to the biggest portfolio losses. Further, Montier concludes that if a decision needs to be made and the situation is:
a) structured and complex
b) ambiguous or has incomplete information c) ill-defined with shifting goals
d) competing information exists
e) high stress is involved or
f) high stakes
Then the X-system is used to make the decision more frequently, which often leads to big mistakes. Of course, every now and then, simple random luck dictates that your “gut” will be right, which makes the overconfidence bias stronger, leading one to rely more and more on the x-system. It’s like being right for the wrong reason.
Many investors use the x-system for investment decisions without even knowing it. Yet it can be so blatantly obvious when examining bull markets that turn into bubbles. The emotions pour into the market with over confident gusto, and when it eventually pops there is denial, anger and then despair. Investors often have short memories and, unfortunately, learn expensive lessons. Bubbles almost always end similarly – when valuations are extreme, so are the reversals. The most dangerous words in investing are: “this time is different.” As Mark Twain so eloquently put it, “history doesn’t repeat itself, but it does rhyme.”
Let us now look at the polar opposite of X-system to the more logical C-system. In order to become proficient at using the more logical side of thinking, we must get rid of two other biases – self attribution and hindsight bias. These biases contribute to misunderstandings of why and how certain investments went right or wrong. When right, people often attribute it to skill, and when wrong, they attribute it to bad luck, instead of what the root cause may really be: bad analysis in the first place.
The C-system is about finding facts through research while rooting out the noise (bad research). There are five P’s to follow:
- Prepare (financial plan)
- Plan (investments)
The preparation stage, is to begin (or re-visit) what it is you personally want and need to achieve with your money. Is it attainable? Do you really need a 20% rate of return all the time? Are you insulated in the event of a “black swan” event? Do you have a back-up plan? Through financial planning sessions these answers are revealed and can offer incredible glimpses of the future based on the existing course an investor is on. Furthermore, it provides remedies or areas to focus on. A financial plan needs to be updated regularly (minimum once per year).
Planning the investments is the strategizing phase based on information derived from the financial plan. It starts with the asset allocation mix needed to meet the return requirements (risk/return), and the type of investments that would fit within the allotments.
The pre-commitment phase is doing the right kind of research on the investments that are merely potential candidates. This is, and should be, the most extensive and time consuming phase. You need to look at the data, be your own “devil’s advocate,” and not let other people’s personal biases influence the outcome by failing to consider the source of the research you are looking at. During this process it’s of paramount importance to keep a keen eye on your own biases.
The patience stage is emphasized over and over again. Considering that stock prices can be heavily influenced by a collective mass of emotions, they are often mispriced either too high or too low. If you can truly understand the financials of a company, you will know what price level is a good buying/selling opportunity and what isn’t – and having the patience to wait is the key; even if it means holding cash. As Warren Buffett says “holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”
Pounce when the opportunity presents itself according to all the planning, preparation, and research that has been done. Don’t hesitate. If the research previously done and reviewed still makes sense, and the investment is simply mis-priced and you second guess yourself when you shouldn’t, you are likely exhibiting several behavior finance biases that should be checked.