Caveman brain and variable cycles

Almost everyone claims to be a long term investor, but few truly are.

A person’s real attitude toward investing only becomes obvious with time.  One person initiates an investment approach and sticks to it for 20 years, while another switches after it doesn’t “work” over three.  The result is almost always good performance for the person who sticks to one approach, and terrible results for the person who changes course every three years.

In my opinion, the cause of this short-term-orientation is twofold.  

First, human psychology really does a number on us.  Our caveman brain evolved to handle different problems.  You don’t need more than three years of data to decide whether you should run from a hungry lion or a pack of wolves.  But, hunter-gatherers and farmers need to think longer-range to survive.  Unusually bad winters and poor rainy seasons don’t happen every year, but when they do, you’d better have enough food and clothing stored, or you won’t survive.  On an evolutionary time-scale, this thinking is pretty new to us.  As a result, we make lots of mistakes when our caveman emotions take over from our long-range, reasoning mind.

I’m as prone to this difficulty as everyone else, much to my distaste.  My biggest investing mistakes are seldom a refusal to sell something bad, but impatiently selling something too soon.  I, too, have suffered from short-term-orientation with investments that weren’t “working,” only to see them take off shortly after selling.  

I sold Berkshire Hathaway in November 2009 (having held it for 3 1/2 years) shortly after Buffett bought the Burlington Northern Santa Fe railroad.  Buffett was clearly signaling that his company would never grow like it had in the past.  The stock then jumped 21% in four months.  I was right about underlying growth, but wrong to have sold at a low price to fundamentals.

I sold UnitedHealth in November 2010 (3 1/2 year holding, also) after company management had repeatedly described how new health care legislation could rapidly change their business model.  The stock proceeded to climb 44% in the eight months after I sold.  Once again, I was right on the fundamentals of the business, but wrong on the decision to sell when price to fundamentals were still too low.

My purpose in giving these examples is not to highlight what a moron I am (I’ve actually gotten many more right than wrong–no really!), but to illustrate that even someone aware of the psychological traps of investing can still fall into them.  The solution is better process, which is fertilized with a thorough, rational analysis of past mistakes.

The second reason I think short-term-orientation sets in has to do with the fundamental nature of investing and business cycles, which are wildly variable in amplitude and duration.  Just as you can’t decide the quality of farmland without considering weather cycles, so you can’t decide what’s going on with an investment without considering investing and business cycles–and that makes analyses more difficult.  

Investing cycles are caused by the boom and bust mentality of investors.  One year investors eagerly pay 20x earnings for an investment, and another year they won’t pay 5x.  This boom-bust cycle is caused by the psychology of investors as a herd.  They go from euphoria to terror and back again over time, and no one can predict how long the cycle takes or when it will reach its zenith or nadir.

Business cycles, which are less psychological than investing cycles, are caused by a variety of things (including government policy, fads and fashions, competitive dynamics, just to name a few).  Like investing cycles, business cycles follow unpredictable paths that can distort the information investors need to make good decisions.  A rational analysis of long-term sales and margins over the full cycle is required, as is an in-depth analysis of industry and company dynamics.  Is a downward cycle permanent, or temporary?  Has a paradigm shift occurred that makes the business model defunct?  Only time will tell.

Investors generally have a hard time handling investing and business cycles.  Its easy to panic and “throw in the towel” when the future is unknown, but it rarely generates good investment returns.  People would love to know if their investment approach is working by seeing results right away, but the world is too complicated to say one, three or even five years of data are enough.  It depends, and each cycle is different than the last.  It’s more constructive to look at long data samples, but few have the patience or desire for such work.

Given that, what’s the solution?  

First, you’ll only stick to an approach over the long run if you really–deep down–know it works.  If you’ve looked at the long term data, you’ll know that value investing crushes growth investing over the long term.  If you spend enough time picking the right approach (or the right manager), it’s possible to ride through periods of under-performance that can last as long as a decade.  If not, you’ll panic and abandon ship at just the wrong time.

Second, you’ll have to do battle with your psychology.  You will feel emotions when your investments tank.  You will want to throw in the towel when something isn’t working for several years.  Be ready to fight your emotions with reason, data, analysis, or whatever else helps you.  I’ve found temporary distraction works, as does exercise, deep breathing, meditation, reading.  Do what you must to hold emotion at bay and focus on the facts.  Only then will you stick to your approach.

Our caveman brain and variable cycles make sticking to an investment approach very difficult, but not impossible.  The rewards, however, are truly extraordinary and well worth the time, effort and intermittent anxiety.  

Find the right approach, and stick to it!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Caveman brain and variable cycles

Don’t invest with your heart, invest with your head

Emotions make us lousy investors. People, as humans, tend to act in emotional ways during tough or exciting times. When people give in to emotions–investing with their hearts instead of their heads–they get lousy results.

If you’ve refused to sell a losing investment, bought because everyone else was, sold because a stock’s price went down, picked investments because they seemed safe, or sold because the economy looked dreadful, then you’ve invested with your emotions. Don’t feel bad, everyone fights and succumbs to this at some point.

The field of behavioral finance has clearly shown that we humans suffer from several biases that lead us to make unwise investment decisions.

For example, there’s anchoring bias. If you hold an investment waiting for it to get back to the price you paid, you’re suffering from anchoring bias. If you wait to buy an investment until it declines back to the price you could have bought it at (and regret not having done so), that’s anchoring bias again.

Another bias is called recency bias. This is the tendency to think that recent events are more likely than they are (and that distant events are less likely). Someone who buys hurricane insurance because a bunch of hurricanes seem to have hit recently is suffering from recency bias. Someone who drops earthquake coverage because an earthquake hasn’t happened in a while has been hit with recency bias.

Loss aversion is one of the most common biases. It happens when people refuse to sell an investment because they don’t want to “book the loss.” People feel losses more keenly than gains, and they usually need twice the gain to make up for a given loss. This can lead people to make bad investment decisions by holding on to something they should sell.

Then, there’s the endowment or halo effect. This happens when one particular good attribute overwhelms all other attributes. Many people still see GM as a great company because it was in the past, even though there’s a lot of evidence it isn’t anymore. It can also happen the other way around, when one particular bad attribute overwhelms all good attributes. Many assume a company whose stock has gone down a lot must be bad, even though it may have many excellent characteristics. The price drop seems to overwhelm everything else.

Finally, there’s overconfidence. When asked, we all claim to be above average drivers, kissers, and investors, but this isn’t Lake Wobegon and everyone can’t be above average. It’s hard for us view ourselves objectively, and so we make unwise investments when we feel more confident than the facts suggest.

The way to fight these biases is simple, but not easy: discipline. If you use strict criteria to buy and sell investments and act on that criteria, you can fight these emotional biases and win. This will greatly improve your results. Even better, If you’d prefer to let someone else be disciplined for you (I’m not unbiased on this suggestion), then unemotionally select an advisor that can act with discipline on your behalf.

Invest with your head instead of your heart, and you’ll get dramatically better investment results over the long term.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“Reasoning correctly from erroneous premises”

The quote above is from John Locke, but I found it second hand from Nassim Taleb’s The Black Swan. Supposedly, it’s Locke’s definition of a madman.

In my opinion, this quote accurately describes the state of the art in academic finance and economics.

Although it may be hard to believe, the Nobel prize has been given out repeatedly to very smart people who are exemplars of the above quote.

As a result, the field of finance, economics and investing is populated with folks who seem to unquestioningly follow such teachings.

That’s why most people are over-diversified and think risk equals volatility. The result is that most investors are under-protected from low probability, high impact, negative events and over-protected from low probability, high impact, positive events.

When a couple of Nobel laureates who exemplify the quote above followed their own advice, they lost almost all of their investors’ money and nearly caused a temporary collapse in the world’s financial system (if you think I’m exaggerating, read When Genius Failed by Roger Lowenstein).

Despite this paradigm shifting result, most market participants go right on assuming that erroneous premises can be followed with rigorously correct reasoning (and lots of higher math and Greek symbols).

Which reminds me of an apt definition of insanity: “doing the same thing over and over again and expecting different results” (Albert Einstein).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A bird in the hand is worth two in the bush

I listened to an interesting lecture last week on behavioral finance by Mier Statman. He presented an interesting question that really has me thinking.

Behavioral finance is a specialized field that studies how people make human choices when it comes to financial issues. You see, economists have theorized a “rational man” that makes choices based on pure reason, without any real emotion. Most economists use this “rational man” to figure out how the economy works. Unfortunately, for the economists, real people just don’t act that way.

The example Mier Statman gave, offhandedly, in his lecture was this: if you were given the choice between $1 million guaranteed or a 50% chance for $3 million, which would you choose?

According to economic theory, “rational man” would calculated the expected value of the two options and pick the larger one. Or, 100% chance of $1 million is less than 50% chance of $3 million (or an expected value of $1.5 million), so you should choose the second option.

Usually, I scoff at such examples because I almost always pick the “rational man” option, and pity the poor mortals who can’t aspire to be “rational man.” But, in this case, I quickly chose the guaranteed $1 million. “You mean, I’m mortal!” I seemed to think.

Even after thinking about it a bit, I still would chose the guaranteed $1 million. Why? Because $1 million would really make a big difference in my life, and I wouldn’t want a 50% chance of ending up with nothing.

After thinking about it a bit, I realized that the scale of the reward madea big difference for me. Give me the same bet on a 100% chance of $100 or a 50% chance of $300, and I’d happily take the 50% chance at $300. Same goes for 100% chance of $1,000 versus a 50% of $3,000. For me, I’d still rather a 50% chance at $30,000 over a 100% at $10,000. Around $100,000 is where I start to waffle, though.

I think I’d take the guaranteed $100,000 over a 50% chance at $300,000. Why? Because, once again, $100,000 would make a big difference in my life right now, and I’d much rather have a bird in the hand ($100,000) than 2 in the bush (a 50% chance of $300,000).

Where’s your break point? $30, $300, $3,000, $30,000, $300,000, $3,000,000? At what point would you chose the guaranteed 1 over the 50% 3?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.