5.2 Part 2: Solutions to Addressing the Mental Pitfalls
“It is crucially important not to let psychological factors interfere with economic rationality in investment decision making”
Bill Ackman
Having discussed about how stumbling into behavioural pitfalls can lead
us astray, we can deduce that investing is more to do with the art – of
dealing with human emotions and behaviours – and less to do with the
science. Our emotions such as greed, fear, joy, pride, exuberance,
frustration, impatience and anxiety can be great obstacles to our
success in investing. Our swing of mood, irrational thoughts, biases,
fallacies, illogical decisions, illusions, paradoxes and self-defence
mechanisms can affect the outcomes of our investments. The combination
of the above-mentioned pitfalls is a perfect recipe for the devastating
outcome.
Although having the fundamental value investing and technical analysis
knowledge is important, mastering the art of managing our emotions,
behaviours and consciousness is the key to successful investing. The
stock market is really a jungle out there. You will be mauled by
“tigers” if you are not equipped with the necessary investing tools to
survive. Your survival in investing requires far more than analytical
skills. You need to have the right temperament, mentality, habit,
thinking and plan to succeed in the market. The market always swings
from one end to the other. In the long run, if you stick to your guns,
understand human behavioural biases, avoid falling into the
psychological pitfalls, follow some of the solutions I have outlined
below and managed to elude those unnecessary blunders I have discussed
earlier on, you should be able to do well with your investments.
“It is far safer to project a continuation of the psychological
reactions of investors than it is to project the visibility of the
companies themselves”
David Dreman
“The psychologist far more than the economist may be of help in deciding when to buy”
Phil Fisher
5.2.1 Learn to understand yourself
"To know thyself is the beginning of wisdom."
Socrates
People always ask me how I achieve such a spectacular performance in my
investments and if I have any supernatural abilities to accurately
predict the movements of stock price. Well, like many other investors, I
do not possess any crystal ball to foretell the future and am unable to
cast magic spell like Harry Potter. The only incantation I know –
Abracadabra – does not even weave its magic on my investments. However, I
do share a few important traits with other master investors that enable
us to outperform the markets. One of the traits is self-awareness. From
my observation, all successful investors have high self-awareness.
Having high self-awareness, in this case, is referred to knowing our
personalities, strengths, competency zones, limits, vulnerabilities,
objectives, self-interests and motivations. This is an essential step to
achieving unbeaten performance. By developing a deep appreciation of
ourselves, we are able to formulate suitable investing strategies and
golden rules that fit our characteristics and investing styles, enable
us to navigate our way through the up and down cycles of our investing
journeys, make us undeterred by temporary failures and enhance the
ability to overcome our behavioural biases. That’s why Bernard Baruch
once said “only as you know yourself can your brain serve you as a
sharp and efficient tool. Know your own failings, passions, and
prejudices so you can separate them from what you see.”
There are many ways you can do to get to know yourself better. One of
the methods to understand your persona is by taking Myers–Briggs Type
Indicator (MBTI) test. The test is specifically designed to identify
your preferences, attitudes and psychological functions (extraversion,
sensing, thinking, judgment, introversion, intuition, feeling,
perception and etc.) and help defining your temperament (sanguine:
enthusiastic, active, and social; choleric: independent, decisive, goal
oriented; melancholic: analytical, detail oriented, deep thinker and
feeler; and phlegmatic: relaxed, peaceful, quiet) Source: Wikipedia. In
general, extroverted investors, with thrill-seeking gene and
opportunity-oriented strategies, like Peter Lynch, Robert Arnott and
Mark Mobius, do exceptionally well in bull markets. On the other hand,
introverts like Warren Buffett, Jeremy Grantham, Charles Schwab and Bill
Miller, who are mostly contrarian, passive, thorough, careful,
risk-averse, calm and patient investors and enjoy in solitude, do better
in bear markets.
Another approach to understanding yourself better is by performing
self-assessment through the continuous experimentation and reflection of
your philosophy and strategies. The reflection on your philosophy and
strategies helps you identify your strengths and weaknesses. For
example, when you reflect on your decisions and actions in your
investments, it indirectly reveals to you your tolerance limit, mental
power, circle of competence, competency level, comfort zone and etc. You
will be a wiser investor as you reduce your blind spots and make better
decisions. Moreover, it allows you to determine your boundaries so that
so that you won’t go outside your zone of competence and are able to
minimise risk to an acceptable level.
5.2.2 Stick to your golden rule
“Sacrifice money rather than principle.”
Mayer Amschel Rothschild
“If you took our top fifteen decisions out, we’d have a pretty
average record. It wasn’t hyperactivity, but a hell of a lot of
patience. You stuck to your principles and when opportunities came
along, you pounced on them with vigor.”
Charlie Munger
Having a good understanding of yourself is a vital step to improving
your investing performance, but it does not provide you any guidelines
on how the stock selection should be made to meet your objectives and to
achieve your mission. Unfortunately, there is no “one-size-fits-all”
rule for everyone to score a home run in the market. Therefore, you need
to have a set of your own investing principles or rules, which is
developed based on your risk tolerance limit, personal traits, strategy
as well as your areas of competence, as a guideline to pick the right
stocks for your portfolios and adhere strictly to the rules.
Study shows that unemotional investors who stick to their golden rules
and game plans always walk-away with magnificent and covetable returns.
Moreover, sticking to your golden rules allows you to sense danger early
so that you don’t put your capital at risk. Your golden rules
indirectly provide you a strong defence system, in which the rules
usually dictate the conditions and criteria each stock must meet before
it qualities a place in your portfolio such as the potential of business
expansion, future earnings’ trajectory, enterprise and earnings
multiples, profit margins, cash flow trend, financial heath and
management’s integrity, so that you can be sure of the odds are not
stacked against you.
Further, following our golden rules can help to address terminal
paralysis – a syndrome of inability to pull trigger when an opportunity
arises – and to prevent us from falling into the trap of representation
bias – a tendency to judge the probability of an event or a hypothesis
based on the resemblance of the event or hypothesis to the commonsense
data and past memory. For example, in the case of representation bias,
turnaround companies are often stereotyped as doomed-to-failure
businesses. Their potential to revive is often overlooked by the market
and is regarded as an impossible miracle. However, that is an area where
enormous return can be expected if the turnaround company that we
invested in does exceptionally well. Had I not stuck to my golden rule
and allowed my vision be clouded by the cognitive bias, I would have
missed out many good opportunities.
Another example of representative bias is that people always associate
blue chip companies with winning stocks. They blindly believe that this
type of companies will do well forever and buying dear does not matter.
Long-term investors who bought British American Tobacco Berhad (BAT,
which is regarded as a blue chip stock) around Rm75/share definitely
have their fingers badly burned. In retrospect, investors should have
avoided the stock at all costs, had they studied the earnings growth
potential of BAT in 2014. The rampant and escalating contraband
cigarette trade had started eating into the market share of BAT in 2014
and would have a profound impact on its earnings. It was not difficult
to fathom the decreasing price trend of BAT if you had analysed its
sales and earnings from a business perspective. By sticking to my golden
rule – only buy undervalued good stocks with high profit growth
potential – I managed to spot many opportunities and dangers early, and
avoid the predilection for stocks with beautiful stories and other
cognitive biases.
“It remained true that sound investment principles produced generally sound results.”
Benjamin Graham
5.2.3 Deliberation and hard-work
“The only way to gain an edge is through long and hard work."
Li Lu
Despite our frequent stumbles on the above-mentioned biases such as
overreaction, over-optimism and framing effect, study shows that our
investment performance can be greatly improved if we have done adequate
preparation before any “war” breaks out. For instance, to avoid getting
caught up in a buying frenzy, we can spend some time to search for our
targets early when we are in a rational state, so that we won’t rush to
buy a stock in the irrational modes of thought just because all market
participants and pundits shout buy. Things we can do to search for our
targets include, but are not limited to, reading annual reports and
financial statements, performing a comparison study and visiting
companies.
After studying the business of a company, if the company is found to
have a bright earnings prospect, we should put the target in a list
called “wish list” or “watch list”. By doing so, we have screened out
all the stocks that do not meet our selection criteria. We then monitor
the price of the stocks in our watch list daily. Remember, we only have
to monitor them daily, not hourly, so that we have more time to search
for other good deals and for other matters (i.e. your day-job and family
matters). When it comes to buying, we only buy the stocks in our wish
list, not any speculative counters (or “goreng” stocks).
After buying the stocks, we then review their performance regularly.
The reason why we perform the review is to avoid getting trapped in a
crowded theatre when everyone yells fire in panic state later. When the
tide and facts change, we change our perceptions, price targets, and
decisions immediately to adapt to the new situations, so that we do not
steadfast to the old ideas which have become obsolete and to avoid
falling into the trap of anchoring bias. That’s why Lord Keynes once
said “When the facts change, I change my mind, what do you do sir?”
If we always stay abreast of a company’s development and progress, we
won’t be missing out any buying or selling opportunities and should be
able to seize the opportunities to “move every piece” ahead of the
market. In essence, we make hay whilst the sun shines.
Most important, never follow any tips from your friends, analysts’
reports or news blindly. You should maintain your intellectual
independence and rely on your research work. Your friends are more
likely to be wrong than right. Study shows that about 90% people lose
money in the stock market. Your friends may not be willing to come to
your rescue when you are “stranded” in the depressed counter later for
listening to their tips. Analysts, on the other hand, always report
something good to support their own interests. Don’t fall victim to
their traps. Additionally, their forecasts are seldom right. Be more
sceptical and take the reports with a pinch of salt. Some of them have
very little or no skin in the game. They are paid to write for the
companies. Moreover, some of the tips given by opinion makers and market
pundits are inaccurate ones. Whilst the news reported by media may not
be outdated ones, the positive factors may have already been priced in
when you buy the particular stocks. Traders will begin to dump their
positions once the news is released. Keep in mind that market
participants always buy the rumours and sell the news. Therefore, you
should be wary when you are dealing with the type of stocks, especially
those in a rigged market, that have gone up substantially before any
good news are released.
To avoid making any dubious moves, you should reduce the level of risks
to an acceptable level before plunking down your hard-earned money for
any companies you have never run before. The important thing is don’t
bury your head in the sand. Uncertainty is always there. You should
embrace it, not ignore it. Before buying them, try to understand as much
as you possibly can about the businesses, including the future of their
industries, their capacity for business expansion, profit margins and
profit growth potential. The uncertainty stems from missing information
can be reduced by devoting more time to conduct research (to search for
the missing piece of the puzzle). Noisy information can be eliminated by
filtering the unreliable and non-related information. Conflicting
information can be addressed by finding the discrepancies between the
two types of information and making an informed judgement. You should
also learn to handle the internal conflict in your mind and keep
focusing on facts. In the worst case, if you can’t handle any of the
uncertainties, especially when the uncertainty level is exceptionally
high, stake is high and reward is low, you should just give it a pass.
Study shows that our emotional intelligence can also be improved if we
put in more effort to manage it and to understand the behaviours of the
market. In order to avoid selling a stock in panic with the crowd when
everyone is terrified after a big drop, we can always prepare for any
unforeseen circumstances before the reversal occurs. For instance, we
can perform pre-mortem before executing a trade to find out what could
cause a decline in the price of the stock, anticipate the respond of
other market participants and learn from the simulated experience how to
react to a bad situation. This will prevent us from risking our own
money, prepare us better for any unforeseen developments and allow us to
control our emotions well. The second benefit is that when we devote
more time to empathise with other market participants, we will know
their objectives and feelings. Our stock market is made up of trading
and investing participants. We will be able to anticipate their next
move, deploy our plan and respond to the conditions better if we
understand their behaviours.
5.2.4 Maintain the discipline
“You must have the patience and conviction to stick with what is, by definition, an unpopular bet.”
Whitney Tilson
In order to avoid being swayed by other’s errors or ill-intentions, and
to achieve satisfactory performance in investing, it is important that
we maintain our discipline in investing. Once we have established our
golden rules and devised our investing plans, we should follow our own
systems closely, not the crowd. For example, you should use the
investing strategy that suits you the most, not the complex financial
models and strategy used by some fund managers. Instead of buying
hot-stocks of the month, you should only buy the stocks the meet your
selection criteria.
People will feel nervous when their holdings plummet in price or get
greedy when their holdings are in winning positions. They always
overreact to noise. When their friends shout “buy the stock before it
shoots up”, they have a tendency to go big into the stock. Instead of
following your friends, you should maintain a level head when the market
is in the state of panic or jubilation. Study showed that level headed
investors always make wiser investment decisions than people who are
less emotionally intelligent. Also, price volatility is a part of the
investing game. If you can ignore price fluctuation and the noise and be
prudent when making important decisions, you will do well in your
investments.
Based on my observation, people also always fail to pull trigger on
their investing ideas as they spend too much time to think about the
company’s future when opportunity arises. Likewise, they will be
hesitating to sell their holdings or cut loss when the fundamentals of
the business have changed, as they gamble on with a hope that their
losses will be recovered when the share prices rebound. To prevent
procrastination, you should buy immediately when a stock meets your
criteria and sell immediately when its fundamentals have changed. Do not
hold on the losers when their business fundamentals have changed. For
example, when companies report decreasing revenues or sustained losses
due to supply glut issue, you should sell your stocks immediately. Limit
your loss will ensure that you stay out of the companies. Bear in mind
that the first loss is the easiest loss. You need a 100% gain to recover
a 50% loss if you do not follow your cut-loss rule when the market
slices it.
In addition, you should maintain your discipline – to be patient if you
have nothing to buy or to sell. Very often successful investors get
paid for doing nothing. This is one of the best strategies in investing.
Charlie Munger calls it sit-on-your-ass investing. On the contrary, if
you trade too frequently, your wealth will be dwindled by the
commissions charged by your brokerage house for your in and out
activities. If you feel bored, instead of getting in and out, you can
use the time to search for more targets and prepare some dry powder for
the subsequent round of bargain hunting.
5.2.5 Concentrate on the facts
“You need to probe a whole raft of numbers and facts, searching for confirmation or contradiction.”
John Neff
To avoid falling trap into the common behavioural biases, disciplined
superinvestors usually pay more heed to the facts of a stock, not the
beauty of its story. They look for stocks selling substantially lower
than their business value. They look at the earnings growth potentials,
current earnings, earnings trend, dividend yield and cash flow of a
company, so as to make an informed judgement and to exploit the emotions
of Mr. Market.
If you follow the principle of those superinvestors of focusing on the
numbers, use logical thinking coupled with business sense to analyse
opportunities and buy stocks with tremendous profit growth potential and
with low downside risk, you are less likely to be penalised when the
stocks are not performing for a couple of quarters, as the pessimism has
already been priced in. In addition, your hard-work will be paid off
when the companies report increasing profits as the positive earnings
surprise will help lifting the share price. Further, if you make
judgements based on the facts, it is not difficult to spot a bubble in a
stock.
Even if you do not have strong financial acumen to accurately assess
the value of a business, the least what you should do is to have an
unbiased perception of the market, stick to the facts and avoid
following the irrational behaviours of the others. And most importantly,
you should ignore the estimates based on straight line extrapolation
and take those research reports published in online forums with a grain
of salt. Some of the reports are written with ill-intention to hoodwink
us into buying the stocks at inflated prices from the syndicates when in
fact the companies have been found with rats infested in the engines.
Whether or not you find the reports sensible, you should perform your
own due diligence before buying into the stocks. In many cases, the
morsels left may not be worth your money.
“What I try to do is focus on the facts of today.”
Bruce Berkowitz
5.2.6 Tap into your powerful intuition
“Intuition is more than just a hunch. It resembles a hidden
supercomputer in the mind that you’re not even aware is there. It can
help you do the right thing at the right time if you give it a chance.
In fact, over time your own trading experience will help develop your
intuition so that major pitfalls can be avoided.”
Michael Steinhardt
Intuition is a powerful tool that provides us a cue accessing to the
vast amount of information stored in our memory and to protect us from
dangers. Unfortunately, intuition is very often ignored by maladjustive
investors and is always deemed as a noise that impedes their valuation
of companies by this group of investors. A good decision making process
should not be depended solely on the deliberative mode of thought or
reflective mind; intuition too should be made use of in order to achieve
a better performance in investing.
In investing, you certainly do not want to have your lifetime savings
stuck in a stock that has been hard hit by the industry downturn or with
a serious oversupply problem, even though it has a very low debt level,
high net working capital and a healthy balance sheet. When you analyse
the company’s business and financial health, your deliberative thought
could only tell you that the balance sheet is clean and that the company
is less likely to get into financial distressed problems, but it
doesn’t tell you anything more than that. It is your intuition, which
formed through years of learning and experience, could help you judge if
it would be a value trap and could tell you that you need to hold the
stock for many years, if not decades, for you to see the light at the
end of the tunnel. For instance, currently there are many property
developing company shares selling below their NTA (net tangible assets
value) due to the oversupply of properties in every town and city in
Malaysia. Yes, it is safe to buy some of them as their balance sheets
are clean. But my intuition tells me that their prices will remain
depressed for many years until the property market turns the corner. If I
make my judgement solely based on fundamental or technical analysis,
most likely I will get trapped in the stocks for many years.
In an interview at the University of California, Berkeley, Daniel
Kahneman told his host and audiences that intuition is also critical to
the careers of many people, including firemen and nurses. He further
shared the findings of his research partner, Gary Klein, that “a
fireman on the roof suddenly yelling to his company, let’s get out of
here, just before the house explodes, and then it turns out he wasn’t
aware of when he was doing it, but his feet were warm and that was the
cue that triggered the sense that something very dangerous was going on
just underneath them.” According to Professor Kahneman, even
experienced statisticians use intuition and heuristics to solve simple
problems generally instead of the complex mathematical models they have
mastered.
Similarly, in investing, most of the successful investors do not buy
stocks based on the discounted cash flow of the stocks. What they
normally use is a set of heuristics called the rule of thumb or criteria
(some simple calculation) coupled with intuition to judge if a stock
will make a profitable investment at a particular time. Based on Charlie
Munger’s observation, “Warren (Buffett) often talks about
these discounted cash flows, but I’ve never seen him do one. If it isn’t
perfectly obvious that it’s going to work out well if you do the
calculation, then he tends to go on to the next idea.” Intuition
comes from our recognition of patterns such as trends, similarities and
differences. It is built through years of hard-work, focus and
experience. On the other hand, Wikipedia defines heuristics as simple,
efficient rules which people often use to form judgments and make
decisions. These information and rules form a mental map, which seasoned
investors always use to match with the current development and make the
best decisions. That’s why superinvestors can make judgements fairly
quickly and invest with conviction without having their performance
being compromised.
Superinvestors like Michael Steinhardt, Bernard Baruch and George
Soros, always rely on their instincts (some call them “animal
instincts”) for important investing decisions. One of the ways how they
tap into their intuitions is by monitoring their body response. Acute
back pain, rapid heartbeat with anxiety, throbbing headache or nausea
with disgust is perceived as a signal of impending peril by some of
them. The signals are stored as somatic markers (feelings associated
with emotions) in probably their ventromedial prefrontal cortex. The
signal is usually triggered in their brains when they went through
something unpleasant they have experienced in the past or they encounter
something in stark contrast to their objectives. That’s how their
nervous system responds to their emotions – by triggering an acute pain
to the physiological system, as both of which are inextricably
connected. The claim is attested by the findings of a group of
psychologists of the University of Virginia that “when we feel
heartache, we are experiencing a blend of emotional stress and the
stress-induced sensations in our chest—muscle tightness, increased heart
rate, abnormal stomach activity and shortness of breath.”
That said, in some situations, relying solely on our intuitions can
lead to some cognitive biases. For example, an investor who relies
heavily on his or her intuition, refuses to pay heed to counterfactual
analyses and contradictory views (which will mar his or her hypotheses),
and insists that his or her intuition indicates that the same patterns
will be repeated again are highly susceptible to overconfidence bias,
which may result in a mediocre performance. Therefore, my advice is to
avoid making judgements purely based on gut instinct or purely use
heuristics as a solution to your problems (as heuristics can sometimes
turn into harmful biases). You should guard it with logical thinking as
well as with adequate research and analysis. Experience can only help us
to a certain extent; it can’t solve all of our problems. The most
important thing is to avoid extrapolating unrelated experience to our
decision making process. It will result in pareidolia.
Also, despite the fact that the combination of intuitions and
heuristics works well under general circumstances and help investors
make sound decisions, new investors are not encouraged to follow their
intuitions. Their experience in this field is too little to help them
make good decisions. It takes effort and years of experimentation and
experience to form the database in their minds and reliable intuitions.
Therefore, new investors are usually advised to perform due diligence –
by conducting sufficient research and analysis – prior to placing their
wagers on stocks and should continue doing so until a massive wealth of
experience and expertise in this area are accumulated to enable the
reliable intuitions be formed.
5.2.7 Close the empathy gap
“Successful investing is anticipating the anticipations of others”
John Maynard Keynes
Merely knowing how to read tapes and financial statements or value
companies is not enough. You need to have a good grasp of the market
participants’ “heartbeat”. Even if you have an MBA or a PhD in finance,
you can only use your finance knowledge to a certain extent, to estimate
the intrinsic value of a company as guidance and to look for ballpark
figures of a company’s earnings, not the precise numbers, let alone the
exact price of a stock. In investing, you need to know that apart from
the value of a business, greed, fear and other psychological factors
have also been largely embedded in its stock price. This is the area
where the largest chunk of gain can be expected, but it is basically
ignored by market participants. Keep in mind that stock price is
dictated by human’s animal spirits. If the spirits are low, fear and
pessimism levels are high and confidence levels plummet, it’s highly
likely that the stock price will fall. This is more evident in turbulent
markets.
To have a good grasp of the market participants’ emotions, we need to
have a combination of good cognitive empathy and emotional empathy.
Being good at cognitive empathy means we are able to put ourselves in
someone else’s shoe, experience what they are going through and see
problems from their perspective without necessarily feeling their joys
or pains. Being good at emotional empathy, on the other hands, means we
can feel the emotions of other people so that we understand the feelings
and reactions of them but without having ourselves overwhelmed by their
emotions. By being good at both, we are able to simulate the same
problems people encounter and the same emotions they have, know what
they are thinking, understand their states of mind, and anticipate the
responses of the crowd in the market when reading their comments and
analysing the trade volume and chart pattern of a stock.
Having the ability to close the empathy gap is also helpful in
interpreting data stated in financial reports, knowing the direction of a
company based their corporate strategy, getting more hints on the
hidden agenda of management’s actions and having an appreciation how the
market perceives the strategy of the company. For example, when a
company proposes a private placement, it probably signifies that the
company is raising funds to expand the businesses, repay loans or for
other purposes. Upon reading the announcement, the market will naturally
sell it down at a loss without investigating the objective further, as
it is deemed diluting the existing shareholders’ interests. To be a good
investor, we must be able to control our emotions, gather all relevant
information, read between the lines in the proposal to get a hint and
perform a thorough analysis of the proposal before arriving at the final
conclusion. If you find out that the private placement is beneficial to
both the company and the existing shareholders, and you are in a
resourceful state of mind (calmed, centred, confident), you should be
able to exploit social awareness to your advantage for the emotional
blunders committed by other people. Moreover, the ability enables us to
find out if a management team is running the company only to set
themselves up for life without creating value for shareholders. It also
allows us to get rid of a troubled stock after going through its reports
and analysing the management’s actions so that we are not there when
the shit hits the fan.
5.2.8 Maintain humility
“You keep an open mind, keep trying to learn, stay humble and keep trying to learn from your mistakes and other people's mistakes.”
Ken Shubin Stein
“I would recommend being humble. Be open-minded, and do not be conceited.”
Sir John Templeton
People always fall prey to self-serving bias. They ascribe their
success to their own talents and hard-work and point the finger at
external factors for their failures. For example, some of the managers
always push blames to their subordinates for their teams’ poor
performance in order to avoid accountability. This type of cognitive
bias is not just commonly seen in the workplace, but it is also
typically observed in the field of investing. It is a sad but true fact
that all of us are imperfect. Nonetheless, people simply refuse to own
up to committing their blunders, when they have erred in their
decisions, due in part to their big ego and embarrassed perception.
To be a better investor, all of us must be willing to recognise our
limitations and weaknesses and continue to learn. As we are not
infallible, we should look for flaws in our hypotheses and spend time to
think what can go wrong with our hypotheses. To prevent being
overconfident, we must be more open minded, always listen to second
opinions or opposite views and seek for constructive feedbacks and
advice before making any judgements. If we have a tendency to make
investment decision from a more emotional perspective, we should
identify the biases and fallacies we always stumble upon and correct
them immediately.
Whilst all these efforts seems to humble us, they prevent us from
repeating the same slipups and pave the way for us to be successful in
investing. Further, humility, which encourages us to avoid distorting
facts and evidences to conform to our views or justify our errors and
make inference and judgements based on facts, indirectly make us a
rational investor. Also, it prevents our decisions and investments to be
ravaged by our ego, harmful emotions and other psychological biases.
For example, I noticed that people often refuse to admit their slipups
and feel embarrassed to buy back the stocks they have sold by mistake
earlier on, even though the growth of the companies is still intact. In
addition, status quo bias also prevents them from buying back what they
have sold earlier on. If they can see their cognitive bias, are willing
to admit their mistakes and buy the stocks back immediately, they should
be able to capitalise on the opportunity and make a heck a lot of money
out of it.
“We think humility is essential, especially concerning the ability
to know the future. Before we act on a forecast, we ask if there's good
reason to think we're more right than the consensus view already
embodied in prices. As to macro projections, we never assume we're
superior.”
Howard Marks
5.2.9 Keep an investment journal
“I’ve come to believe a personal investment diary is a step in the
right direction in coping with these pressures, in getting to know
yourself and improving your investment behavior.”
Barton Biggs
Some of you must be wondering why investors are advised to keep a
journal (or diary) of their investing activities, even though investing
has got nothing in connection with quality management, and yet it is a
non-productive task. Sure, keeping a record of your investing activities
doesn’t produce any direct positive return to your investments. But
human is sometimes forgetful and vulnerable to mood swings. Our
fluctuation of mood involuntarily changes the way we perceive the market
and have an influence on our trades. For example, when our investments
produce some gains, we tend to become happy and allow the emotions to
overcome our rationality. Hence, we tend to take a higher risk and buy
more shares when the price goes up. Don’t forget that our mood is
contagious. The crowd will also be elated and buy even more when the
price shoots through the roof. When the price takes a nosedive later we
regret our decisions. If we don’t keep a journal of our investing
activities, where do we get the recollection of how the blunders were
made when we want to review our past decisions in future?
In your journal, you can jot down your investment ideas, research,
buying and selling price for each stock, reasons of buying or selling
the stocks, emotional expressions or feelings and physical responses
when you buy them. It should be noted that the journal should not be
served reporting functions or be used to vent your frustration. If
managed wisely, a good journal does not only allow you to review your
decisions, know your states of mind, spot patterns, examine your
competency, reflect on your mistakes and prevent you falling into the
same snares in the future, it also helps you discover yourself through
the “psychological mirror” and connect you to your inner world,
including your wisdom and objectives in life, and enhance your learning.
By understanding yourself better, you can refine your investing rules
and formulate a suitable strategy and form a comprehensive checklist
that could guide you better in your investing journey.
“Keep an investment diary and re-read it from time to time but
particularly at moments when there is tremendous exuberance and also
panic. We are in a very emotional business, and any wisdom we can
extract from our own experience is very valuable.”
Barton Biggs
5.2.10 Build your mental strength
“Have the courage of your knowledge and experience. If you have
formed a conclusion from the facts and if you know your judgement is
sound, act on it – even though others may hesitate or differ.”
Benjamin Graham
By now I am sure you know the importance of having good investing
principles. But not everyone has the ability to stick to their golden
rules. People always find themselves having difficulty resist to the
temptation of following the crowd to buy hot stocks when the market is
in great excitement. Unless you intend to jump off the cliff with other
lemmings, you should impose self-control in investing. Stop the gambling
behaviour. It is akin to playing Russian roulette. You will get
“killed” in investing if you don’t control your involuntary behaviour.
The important thing is to avoid falling prey to hot-hand fallacy. In
investing, winning the first and second bets does not guarantee further
success in the next attempt. You will ruin your financial life if you
place your wagers without ensuring that the odds are in your favour.
When the market takes a nosedive, you must use your mental power to
control your emotions, remain upbeat and stay calm even after suffering
some losses. Stick to your golden rule and keep improving it. Your
golden rule is the only weapon that can help you make a killing and
accumulate wealth in investing. Paying attention to the fluctuation of
stock prices will not make you rich. Of course, you still need to have
the courage to pull trigger when opportunity arises. The ability to
execute a trade timely with conviction is essential to successful
investing.
In addition, you should resist to trade when you are in emotionally
unstable mood – be it thrilled, regret, angry or depressed. For example,
in a rising market, you may be elated when your holdings are in a
profitable position and you will have an inclination to buy more stocks
regardless of their value. The influence of your emotions, which always
hinders your investing success, will be put in check if you learn how to
handle them well. Have a nap when you feel tired and take a deep breath
when your brain is starved of oxygen or when you feel stressed. You
will have difficulty to make rational investing decisions if your brain
is overloaded. If you learn to tap your body’s self-healing mechanisms
to help you stay clear headed before you make any important investing
decisions, the likelihood of making high risk investments will be
greatly reduced.
Whilst people are generally financially prudent when handling their
hard-earned money, they have a tendency to spend extravagantly with the
dividends and capital gains they earn from the stock market. No matter
how good your performance is, the mental accounting pitfall would render
the snowball effect futile if you do not control your mental properly
by keeping the dividends and gains. Thus, you should not spend the
dividends and gains that you earn in stock investments, unless you trade
for a living. Keep the proceeds for the next bargain, so as to let the
snowball effect creates its astonishment.
Last but not least, you should keep learning, reviewing your past
investments and focus on improvement. Read more investing-related books
when you are free. Benjamin Franklin once said “an investment in knowledge pays the best interest.”
By continuing to learn, you understand yourself better. You will
discover more of your weaknesses. Additionally, it expands the arena and
façade areas of your Johari window and reduces your mental blind spots.
Keep in mind that your learning does not end when you leave college.
According to John J. Ratey, a clinical associate professor of psychiatry
at Harvard Medical School, “The human brain’s amazing plasticity
enables it to continually rewire and learn – not just through academic
study, but through experience, thought, action and emotion.” And “genes
and environment interact to continually change the brain from the time
we conceived until the moment we die. And we, the owners – to the extent
that our genes allow it – can actively shape the way our brains develop
throughout the course of our lives.” And with the determination to
continue learning and the perseverance for continuous improvement, you
too can become a superinvestor!
Chapter Summary (Part 2)
- Solutions to Addressing the Mental Pitfalls
- Learn to understand yourself
- Stick to your golden rule
- Deliberation and hard-work
- Maintain the discipline
- Concentrate on the facts
- Tap into your powerful intuition
- Close the empathy gap
- Maintain humility
- Keep an investment journal
- Build your mental strength
