Becoming rational

I personally think that being rational is extremely important in becoming an above average investor. So how does one become more rational?

There is a book called – predictably irrational by dan ariely which talks of the irrational behavior in most of us. The more interesting part of the book however is the ‘predictable’ part. It means that most of us are consistently irrational. The good thing about this predictability is that if one can identify these patterns, then there is a possibility of reducing the irrationality (I don’t think it can be completely eliminated)

The first step in reducing the irrationality is to name and classify the various behaviors which impact us negatively as investors. I started exploring the various biases which affect us in the previous post and will continue with a few more in this post.

Authority bias

You may seen this bias in others (most people think they are themselves immune), when they  purchased a stock based on a recommendation by some TV presenter or commentator. In other cases, the recommendation may be from a broker or some sales person in a bank.

I have personally avoided this bias in the above form by having a simple thumb rule – TV presenters are actors and should be watched for entertainment alone. As far as brokers and sales people are concerned, I refuse to listen to them.
The above comments may imply that I am immune to this bias – but I am not. I follow a few other bloggers and top investors. In the past, if one of them was invested in a stock, I would develop a much more positive view of the stock and even went ahead and invested in the same.

The biggest source of my bias has been from the top thinkers in the field of investing (Warren buffett, Ben graham etc). It is not that their teachings are not worthy of following, but I have followed them blindly without understanding the context.

Case in point – Warren buffett talks of the buy and hold philosophy. A lot of people miss out that they he does not imply buy and forget and certainly not buy and hold bad companies. The pre-requisite condition is that one should buy a good company at an attractive price and then hold it for a long time. I have bought duds and then held it for some time, thus compounding my mistake.

How does one avoid this bias – As in all other biases, it is not easy. I have found one approach which works for me a bit – Never accept blindly what others say (including your idols). I  try to analyze the context of a statement or idea and try to think of a scenario where that idea is not true.

First conclusion bias
This is a very common bias and we know it by another name – First impressions. We tend to form opinions of other people in the first few seconds of meeting them and then any interaction tends to re-inforce the impression. This bias has a lot of implication in job interviews, but that is a separate topic.

In the case of investing, this is closely related to the commitment and consistency bias. As an investor, I have found that when I am looking at a company and its financials, I tend to form a fuzzy view of the company in the first few minutes – such as looks worth of investigation (may even buy) or maybe this company is junk. Once I reach this view (often subconsciously), my subsequent analysis and thought process is influenced by this first conclusion. In addition, if I make a token purchase the commitment and consistency bias kicks in. Once this happens, my decision is kind of locked (even if i think it is not)

How does one avoid it ? For starters, I look at a company and form a view (even if subconscious) and then just drop further analysis. I make a note of the company and then move on to something else – allowing for a cooling period. I will usually come back to it after a few days and then read up on it further – making notes as I go along.

The final decision to buy comes usually after a few weeks and even then the position is a small one. I am not sure if I have been able to reduce the bais, but it prevents me from buying a stock when I am in heat. The downside is that the stock price may run up before I can buy a full position, though in balance I would rather loose the upside occasionally than make a foolish decision.

The next post will the final one on this topic and I will explore a few more biases and discuss how it is important to build routines in your investment process to reduce their impact.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.