Confidence, optimism and critcal thinking in the stock market kcchongnz
Author: kcchongnz | Publish date: Fri, 23 Dec 2016, 08:43 PM
Dear readers, this article is a discussion about issues, nothing to do with any personality, although the issues could be linked to some personalities coincidentally, but it is not intentionally. Kcchong
In my last article in i3investor with the link below,
I received many good feedbacks, 157 comments so far for this article. Thank you very much for your comments, including my toughest critic, Mr. stockmanmy. Your posts and comments light up my life in i3investor. I like critical comments. I used to tell my course participants not to have a cult mentality in investing, like always looking for positive confirmation of the stocks you invest in. The cognitive behaviour of confirmation bias is deadly in investing. I had seen it numerous times before, and talked about it in i3investor before. I told my course participants to always look for constructive criticisms of opposite views, which would curb their cognitive bias of over-optimism, and its cousin, Mr. Over-confidence.
Mr. stockmanmy, sorry about that, this article somehow touches on your latest article in your stockman blog, coincidentally on your “secret recipe” of optimism, confidence and critical thinking ininvesting.
But I guess it is good to have some opposite opinions on this, isn’t it?
Here are my opposite views on why do I advise on avoiding Mr. Over-optimism and Mr. Over-confidence when investing? I will provide some examples, but again, this is for sharing of knowledge and opinion, and it has nothing to do with personality.
The cognitive bias of over-optimism and overconfidence (OOOC)
Confidence is a quality personal trait for our career and whatever we do, well, almost all. When we have confidence, good results can be achieved easier. For example, if we are confident, we can do better in public speaking or networking and get things done easier. In investing, I believe one can do better too if he has the confidence to stand away from the crowd, provided he has the right experience, knowledge and the proper approach.
Overconfidence may be a healthy attribute too. It makes us feel good about ourselves, creating a positive framework with which to get through life's experiences. Unfortunately, being OOOC of our investment skills, but without critical thinking, can lead to some disastrous results in investing in the stock market, if what you have is just that “optimism” and “confidence”, and nothing else solid. Here are the reasons.
The most fatal oversight is negligence of the uncertainty of the stock market, the commodity market, the foreign exchange and various macro-economic issues. Take for example, palm oil price was high 3 years ago, and Jayatiasa had planted hectares of palm oil trees. Without even looking at its balance sheet, you are confident that its FFB would grow exponentially over the next few years, and that the palm oil price would continue to rise, and hence its earnings. You put in 50% of your investment into this company, some more with another 50% in borrowed money, and chased the share price all the way up to close to RM3.00 a share.
The share price of Jayatiasa closed at RM1.32 today on 23rd December 2016, for a loss of more than 50% in just 3 years, while the broad market is practically flat for the same period. Look how OOOC had serious detrimental effect on your investing outcome.
Instead, if someone possessed critical thinking, I mean the right way of critical thinking, he would have recognized the cyclical nature of commodity prices and the power of mean reverting, and would not had extrapolate the growth too optimistically. Ignoring the market uncertainty, the inherent risks in investing, the competitions from soya oil, and thinking that trees grow to the sky itself is a form of fatal OOOC.
Take for example XingQuan, another stock. It has a lot of cash in its balance sheet. Very good and persistent earnings. You have a relative who is an auditor of this company and told you nothing to worry, and you had visited its factories in China. Yet, it is selling at such a ridiculous price. So, you are confident, a little too over-confident by placing a huge stake with margin into this stock three four years ago. What happen to this OOOC?
However, if someone just bases on this OOOC, and without any knowledge of the business, and the language of business, how can he has critical thinking, the critical thinking on how to evaluate risk and return, based on its business?
Failure to diversify
Overconfidence also results in an investor feeling too bullish about a stock, or a sector and concentrate all his eggs in one basket. Consider these statements:
“About 80% of my total investment is on the plantation sector. I have Kulim, FGV, SOP, TH Plantation and Jaya Tiasa and their closing prices are Rm 3.40, 4.46, 6.40, 2.00 and 2.75 respectively.]
I did write a piece on FGVB 7 months ago, when FGVB was at RM4.14. I am not sure if anyone took any heed on it. But if he had, and he had a lot of FGVB then, it would have saved him a lot of money.
These are the closing price of those plantation stocks today on 23rd December 2016. Kulim had been privatised, FGVB 1.53 (-66%), SOP 3.70 (-42%), THP 1.14 (-43%), and Jayatiasa 1.60 (-55%). On average, more than 50% of their value had evaporated.
This is despite that palm oil price has risen close to its price then in Ringgit term.
It really pays to diversify, a humility in investing, rather than OOOC. Don’t you agree? Or is it still wise to put 80% of one’s investment in just one sector? What is the cost of OOOC in investing?
Diversification is a main topic in finance and investing in the academic study. It is a maxim in investing too, sine decades ago which most fundamental value investors follow very closely; super investors like Walter Schloss, Joel Greenblatt, Mohnish Pabrai, Howard Marks, Seth Klarmen, etc. All these are billionaires from investing, and investing for their clients. They always tell those wannabe investors to guide against OOOC.
“We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.” Seth Klarman
“It is not an algorithm. It is a mindset. I think that we always try to stress the danger of overconfidence. I forget if I put it in the book, but it is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind. The most dangerous thing is to think you got it figured out, or that you can’t make a mistake, or that your estimates are right because they are yours. You have to always recheck your information, bounce your ideas off yourself and others.” Howard Marks
The cost of overconfidence
We have seen that OOOC cause one to concentrate investments in a single stock or a single sector and fail to have a diversified portfolio of stocks in various sector in case he may be wrong as the investment world is full of uncertainties. OOOC causes one overly optimistic assessment of one’s knowledge and ability or control over a situation, and buying risky investments because he believes he will make big money, without looking at their risks. OOOC also causes one to seek only evidence confirming his own views and ignore contradicting evidences, and worst of all ridicule others for giving some good contradictory opinions which may be good for him.
Worse still, the OOOC is accompanied by confirmation bias, and refuses to hear, and scorn opposite opinions, without the right critical thinking, and without the knowledge and hence the ability to do that.
Leverage, the fatal blow
What about if one combines OOOC with leverage, say 50% in margin finance, because it is perceived as a sure-win purchase? He will lose all his equity and still left with some debts to pay the investment banks.
When you combine OOOC and leverage, you get some pretty interesting results.
"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious," explained Buffett in his 2010 shareholder letter.
"But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."
Response to stockmanny
This is my response to the various comments of stockmanmy in my article below here which have been posted thousands of times by him in i3investor everywhere and in all his articles. This is as a mean of sharing my point of view:
12 formulas and 20 accounting ratos do not make one a better investors.]
That person with CFA who has lost a lot on money in a short time as mentioned by stockmanny, is not because of the fact he has a CFA title. If he followed his CFA training, I am 100% sure he wouldn’t have lost a lot on money. Rather I wold think he would have avoided losing any money in the last few years. He lost a lot of money was not because he used “12 formulas and 20 accounting ratios”, because if he used that, like what Mohnish Pabrai, Guy Spier, and other super investors do, he would have made some money, instead of losing a lot of money. I only used two ratios in Magic formula, and I have shown with published records in i3investors that I have done well too as shown in this link below:
Joel Greenblatt of the Magic Formula did that too making billions for himself and his investors. Oh yes, Joel Greenblatt is not only a fund manager, he is a professor in finance too. Please be reminded, again.
Well, I have shown these published records many times, and I hope I don’t have to show you I must have made multi-million in investing, then only I can talk. I opine that that CFA lost a lot of money because of OOOC, for example thinking that he got so much insider information and bet big in a single or just a couple of stocks, hoping to gain big time, in the fastest way, far from the fundamental value investing (FVI) way, which he should had embarked on. Or he thought someone was so damn good in investing that he followed to buy all the stocks recommended by him, with all his money,without using his accountng knowledge.
Regarding your seeking of excitement in the stock market, this is my advice to the newbies and young investors, using the wisdom of Paul Samuelson,
“Investing should be more like watching paint dry or watching grass grows. If you want excitement, take $800 and go to Las Vegas.”
In my opinion, it pays to have humility in investing, rather than OOOC. We must recognize our shortcoming that we are far from invincible and could be wrong, and get the free lunch in diversification, as a defence against uncertainties, because investing is full of uncertainties, something we can never foresee. Generating superior return is certainly an important aim, but safeguarding assets and protecting them from losses is just as crucial.
Critical thinking is of course required, or else you would just follow blindly; buy when others ask you to buy, and sell when others tell you so, and thus, lost money. I am sure you have learned your lesson too.
In order to have critical thinking in investing, one must have the knowledge of the business, as investing in a stock is akin to investing in a part business, not just a simplistic or rudimentary “golden rule”, vague “business sense”, or fuzzy “pivotal moment concept”. Otherwise, any Tom, Dick and Harry can be a multi-millionaire.
I sincerely hope this article is viewed in a positive light as a mean of learning from experience, for all of us. Seriously, I do hope newbies in investing take heed of what is written here.
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