MARYFIELD, DUNDEE – A quick note before we begin today. I’ll be hosting an online event tomorrow with a very special guest. He’s an American CEO with quite the investment tale to tell, and if you’re interested in streamlining your portfolio and your investment process, I think it’ll be right up your street. Click here to be notified when we begin the broadcast.
In Monday’s note, we explored how emotion can be the greatest bane of investors and traders alike. While one should always treasure one’s humanity, letting fear or greed cloud your judgement can ruin the greatest of portfolios.
Continuing on with that subject I thought I’d share a letter penned by my colleague Nickolai Hubble, which published it a little while ago in Southbank Investment Daily (Nickolai now writes Fortune & Freedom with Nigel Farage – click here if you’d like to read more like the below)..
It was all about investor biases, and how best one can avoid them. I’ll let him do the talking:
Humans are subject to all sorts of biases that undermine our ability to make good investing decisions. Academics seem to discover new ones all the time.
The most famous one is loss aversion. Investors are deeply irrational in that they fear losses more than they value gains. Or, as I think of it, they want to book their gains and hide their regrets. Rational humans would equally weigh the two because they counteract each other equally.
Loss aversion makes investors sell winning positions early and keep losing ones for too long, in the hope they’ll come good. The outcome, because markets tend to trend, is larger losses and smaller gains. That’s a recipe for underperforming the stockmarket over time.
Cognitive bias is another famous flaw. We focus on and remember what fits our narrative. More importantly, we ignore and forget what does not suit our preferred way of seeing reality. We explain it away.
This lack of objectivity means we hold on to investments we “like” for longer than we should. And we like what we buy. It’s a form of overconfidence.
Information bias is an especially acute affliction for investors these days. We focus on any information and overemphasise how important it is. Recency bias means we consider more recent developments to be more important than the more important developments. The 24-hour news cycle has done untold damage to investors thanks to these two biases.
There are plenty more such flaws in investor psyche. I’m sure you’ve heard of them before. How our various biases, instincts, emotive decision making and priming lead us to make the wrong decisions. Especially amongst investors.
In my view, the only people more prone to these flaws are the scientists who claim to discover them.
Their experiments are biased in the ways they claim to discover amongst others, their results aren’t replicable and the discoveries simply reflect how many studies were done, not whether the biases they claim to find actually exist. (If the same study is done 100 times over, several of those studies will find the result they’re looking for and only those false positives will get published in scientific journals.)
In other words, I’m very sceptical about whether those biases exist, whether they’re really a bad thing and whether the researchers aren’t just hypocrites.
But the real world offers clues about what it takes to be a successful investor. You don’t need academics’ confirmation bias-based studies to tell you.
Psychopaths make good traders, for example. As do women, who are better at controlling their egos and thereby biases. They admit when they’re wrong faster (in financial markets).
But there’s a far simpler explanation for yesterday’s revelation. And it doesn’t really need humans to be inherently flawed to demonstrate the need for a rules-based investment strategy.
Rules are useful because they are better than humans, not because humans are flawed investors.
Why are rules better at investing? For a lot of reasons.
It is easier to objectively evaluate whether rules work. A human who doesn’t follow rules is too volatile. They respond to the identical situation differently at different times – one of the reasons the studies I mention above are so flawed.
A human behaves very differently in a glass box with a scientist staring at them, for example. And yet, that is how many studies about humans are conducted. The differences between the lab and the real world are never accounted for.
Not to mention the habit of university professors to use students for their studies. I, personally, am not surprised that students are irrationally loss averse around their professors. They spend their lives trying to pass, not perform well. And they know those professors might never pay up the $10 they promise in the future as opposed to the choice of $5 now. It’s not as irrational as it may seem…
Back in reality, it’s obvious that investors behave differently at the top of a bull market, and after securing triple-digit gains, than they do after losing 10% on a position.
Then there’s the differences between people. There is no one average human who is subject to all the flaws scientists claim to have found. Different humans behave differently in the same situation. Some are more loss averse than others. Some are better at deluding themselves.
Which are you? Neither of us know. So how can you adjust to improve your returns?
Should you become a psychopath to improve your investment returns?
I’d suggest not.
My point is that rules can be studied properly because they’re consistent over time. Put them in a glass box and they do the same thing. Put them in a bull or a bear market and they don’t care. Whether you or I apply them doesn’t matter. They make the same decisions regardless of how juicy the gains are.
And you can test variations of rules easily. Adjust, fiddle and retest, until you get your optimum solution. This leads to, let’s call it evolution, over time. The rules improve by a process of figuring out what works and what doesn’t. And that evolution is a lot faster than amongst human beings, for whom trading the stockmarket is not exactly a survival factor.
So, as I see it, whether you’re a flawed human being or not, rules are likely to deliver better investing results. Or more measurable ones that’ll lead to improvement over time.
But I don’t suppose you want to have to go through such improvements over time. Learning things the hard way is painful.
I agree, especially because it’s unnecessary. You can use others’ tried and tested rules instead.
As Otto von Bismarck once said: “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others…”
Thankfully, when it comes the mistakes of other investors, there are many throughout history for us to choose from. We’ll be focusing on the most important ones – and how to avoid them – in this event tomorrow. Don’t miss it!
All the best,
Boaz Shoshan
Editor, Capital & Conflict
PS For more from Nickolai, be sure to subscribe to Fortune & Freedom here. I’ll be doing a lot more work on that side of the business in the near future, so if you like Capital & Conflict, be sure to sign up.
Category: Economics