Some good
books/ resources on the topic are listed below
Poor
charlie’s almanacThinking fast and slow
The psychology of influence
The art of thinking clearly
Seeing what others don’t : The remarkable ways we gain insight
Professor
sanjay Bakshi’s website (here)
and all his lectures (here). I
would encourage everyone to read the lectures multiple times.
Lets explore
a few more baises and how one can avoid themSunk cost fallacy
This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted, then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.
I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.
Story bias
Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.
It is however
dangerous to get seduced by a story stock or company. Unfortunately you can
find investors buying into stories all the time and overpaying for it. The
stories change, but the basic theme is always the same. A new or exciting
development comes to the attention of a few investors (IT stocks, real estate
stocks or consumption stocks). These smart investors have the insight of
investing early at attractive valuations. This ‘story’ is soon picked up by the
media and now others follow blindly into the story at astronomical valuations.
The ‘story’ feeds on itself and everyone looks good as long as the price is
rising. At some point investors start realizing that the valuations are too
optimistic and the selling begins. The ‘story’ is discredited and investors
wonder how they got sucked into it
How does one
avoid getting sucked in? There is one word for it – valuations. Never overpay
for stocks, no matter what the story. If something is obvious to everyone, then
the price reflects it and it is ‘overconfidence and hubris’ on part of most
investors to assume that they are smarter than the market.
Base rate
neglect
If you ask
someone an unpleasant question – are you more likely to die in an airplane
crash or heart attack, what is the more likely answer? I can bet in the
majority of the cases, it would be the airplane crash (heart attacks are a more
common cause). An airplane crash is more vivid and comes on the front page of a
newspaper, whereas heart attack deaths are almost never publicized.
Almost everyone
tends to neglect the base rate – statistical probability of an event. Investors
tend to do the same. Let’s consider some examples – 90% + options expire
worthless and various studies have shown that IPOs tend to underperform market
over the long run. Inspite of these statistics, investors believe they can do
better, mostly because they are not even aware of the low success rates.
How does one
take advantage of base rates? One needs to focus on areas where the odds favor
you. It is far easier to do well with companies and industries where the
underlying business has a high rate of return. In such cases, unless one pays
too much, the investor is likely to do well over time.
In summary,
know where you have an advantage and work on exploiting it. For example – I
know for a fact that I cannot beat a full time trader in the short term and
hence I will never invest in a stock or option where the odds are stacked
against me.
Over optimism
and overconfidence
One needs a
level of optimism or confidence to do well in life. At the same time, there is
fine line between confidence and over confidence. How do you know you have
crossed it?
If you find
yourself, attributing all the success to your intelligence and failure to bad
luck and other factors, you may be crossing the line. As an investor, if your
performance is not above average (after several years) and you still think that
there is nothing wrong with your approach and think that it will all work
itself out, then you need to dial down your confidence and optimism.
What about me?
I have had the reverse problem – I have always been underconfident and that has
been harmful too. I have underallocated to equities in the past and created
smaller positions in my top ideas. As a result, my opportunity loss has been
far higher than my actual losses.
In my case,
the actual results have given me the confidence to be more aggressive, though I
still finding myself doubting all the time.
No silver
bulletsWe have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.
The first
step in overcoming these biases is to recognize them and acknowledge that we
are often influenced by them. The next step is often to build routines to
reduce their impact or negate them completely. Some shortcuts I try to use
- Do not look at the stock price when analyzing a company to avoid getting ‘anchored’ by the stock price
- Never buy a stock which is hitting upper or lower circuits. There is a lot of emotion around the stock/company and it is better to let the dust settle down, before one can analyze the situation calmly and make a balanced decision
- Try to look for at least three reasons which could cause the idea to fail
- Do a probabilistic analysis of the stock, to evaluate the downside. How low can the price drop?
- Avoid IPO, options and current fads
- Never listen to tips – especially from TV. If it is recommended on TV, everyone and his uncle knows about the company and the price already reflects the prospects.
- Analyze the stock from a 2-3 year perspective where I have a strength over the other short term players in the market.
- Don’t tell about your losses to your wife. She will think that you are smarter than you really are J
- Do not look at the stock price when analyzing a company to avoid getting ‘anchored’ by the stock price
- Never buy a stock which is hitting upper or lower circuits. There is a lot of emotion around the stock/company and it is better to let the dust settle down, before one can analyze the situation calmly and make a balanced decision
- Try to look for at least three reasons which could cause the idea to fail
- Do a probabilistic analysis of the stock, to evaluate the downside. How low can the price drop?
- Avoid IPO, options and current fads
- Never listen to tips – especially from TV. If it is recommended on TV, everyone and his uncle knows about the company and the price already reflects the prospects.
- Analyze the stock from a 2-3 year perspective where I have a strength over the other short term players in the market.
- Don’t tell about your losses to your wife. She will think that you are smarter than you really are J
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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.
2 comments:
Great article! Thanks! How does one know that one is stuck in the sunk cost fallacy? And how do you act when you consider that you are in one? You sell it? You leave it as it is?
To me I have the opinion that the biggest problem there comes when the company starts to issue more shares and start to live not on revenue but on the shareholders. In every other case I always consider that it can/should turn around.
Am I wrong?
I have however learned that a share can continue much further down also when averaging down on the way and the unrealised losses can indeed become huge. My new rule therefore became that I am not allowed to add more in a dropping position until they have minimum one quarter report showing good results.
Well... I have another problem. The more I tell my wife about my winners the worse she thinks of me for not booking the profits :-)
Good dose in the last few posts. I have never found myself lacking on aggression and have paid for it quite a bit.
Now I have come to realize that the market offers you many more opportunities than you can afford to take. So it's always better to be sure now than sorry later.
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