5.1 Part 1: The Biggest Behavioural Problems
“The most useful and practical part of psychology—which I personally think can be taught to any intelligent person in a week—is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool. And yeah, I'd been educated at Caltech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me. The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important. Terribly smart people make totally bonkers mistakes by failing to pay heed to it.”
Charlie Munger
The followers of Efficient Market Hypothesis (EMH) believe that the market is always efficient and stocks always trade at their fair value. According to this group of investors, any changes in the fundamentals of a stock will immediately be reflected in the price of the stock, thus making it impossible for investors to outperform the market. However, based on my years of experience, this is not always the case. If the market is indisputably efficient, as advocated by the professors of EMH, there would be no chance for investors like us to exploit any arbitrage opportunities, gain in price difference from stock investments and beat the market in the long run. In actual fact, the majority of my wealth is amassed through the acquisition of substantial stakes in undervalued companies with massive profit growth potential, and the disposal of those overvalued ones with no (or low) profit growth potential in visibility.
It should be noted that irrationality, delusional optimism, cognitive illusions and other human emotions have been largely overlooked when people assume that the market is efficient. In fact, the volatility of the stock market is, very often, driven by the irrational psychological factors. It is human’s uncontrollable emotions, biases, fallacies and false perceptions that result in the deviation of a stock’s price from its real business value. And the market is mainly driven by greed and panicked by fear. Or put simply, the movement of stock price is dictated by human emotions.
Of course, the changes in facts and fundamentals of a stock do play an important role in the movement of its price. But, without stock market participants bidding it up or selling it down, the price will always stay flat. For those investors who think that fundamental analysis and technical analysis (FA/TA) are the only knowledge needed to survive in the stock market, I urge you to consider spending more time on studying human psychology in investing too. This is one of the subjects least studied by most investors, but extremely important in investing. It is also the area where the largest chunk of gains can be obtained from stock investments if you know human psychology well. Stumble into the biases and mental pitfalls; on the other hand, will cost you a hefty loss in your investments.
Below are some common behavioural biases investors always fall prey to in investing.
5.1.1 Allow emotions to take over rational thinking
“Eighty percent of the market is psychology. Investors whose actions are dominated by their emotions are most likely to get into trouble.”
George Goodman (pseudonym Adam Smith)
People always allow their emotions to take over rational thinking and seldom use logical system to process information especially when they are in emotionally unstable state. This situation is commonly seen when people are in fear during bear attacks. When they are bombarded with noise and mentally overloaded as price plunges, the risk level they perceive will be raised, and their faith is wavering, even though the facts remained unchanged. Their Amygdalae (according to the study of neuroscientists at the California Institute of Technology, Amygdala – two almond-shaped clusters of tissue located in the centre of the brain – is a part of the human’s limbic system that supports the functions such as behaviour, long-term memory and emotional processing) will induce fear, thus causing them to be conservative and ignore bargains. They will either avoid the stocks completely (even if the investments are clearly high winning probability bets) or dump whatever they hold until the feeling of fear subsides. The latter is akin to throwing the baby out with the bath water, and in this situation value is completely ignored. The over-reaction of hitting the panic button at every Sen/Ringgit drop and disposing all their holdings at dirt cheap prices is the reason why people always buy dear and sell cheap. And this problem is commonly suffered by people who trade very often.
On the contrary, people become irrational buyers when they are in greed and an extremely happy mood. They have a tendency to take higher risks, buy aggressively and chase after hot stocks when they are in euphoria. This is more apparent when the market is on the rise and stock market pundits painting a rosy picture of an industry. At the same time, the dopamine level in the nucleus accumbens of investors will be rising. It will subsequently induce reward-motivated behaviour, lead to euphoria and result in people taking a high-risk bet and ignoring danger, as the irrational impulses get in the way and they become more optimistic about the future of the stocks. Over-optimism is one of the worst cognitive biases people always commit in the bull market. This type of optimism is a spontaneous one and always results in share price shooting to the moon as investors continuously bid up the share price. As you may recall, the moment before the Asian Financial Crisis in 1997, the market was filled up with over-optimism and the KLCI shot up to 1270. Within 18 months, KLCI fell 76% when the bubble burst. The Asian Financial Crisis is an important historical event showing that market bubble is caused by psychological problems and people overly react to both good and bad news. As I am writing this, I notice that many steel stocks have been making new historic highs every week, the people I meet everywhere as well as the people I exchange opinions with in forums are optimistic about steel companies’ future. When I advised people to be cautious, as the oversupply of property in every city of Malaysia will affect the earnings of some steel manufacturers, a few stubborn commenters even asked me to shut up. This is a clear sign of allowing greed to take over rational thinking. When the companies report decreasing earnings later, their prices will definitely plummet and this group of investors is vulnerable to a loss due to the oversupply problem.
“Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and mutual funds altogether.”
Peter Lynch
5.1.2 Hate facts, but like stories
“Too many people buy stories or trends - they don't buy businesses.”
Donald Yacktman
The human brain is hard-wired to understand stories better than data. Thus, people tend to favour stories more than facts. According to Jennifer Aaker, a professor at Stanford’s Graduate School of Business, “a story is a journey that moves a listener, and when the listener goes on that journey he or she feels different and the result is persuasion and sometimes action.” That’s why stories have a powerful ability to affect human emotions.
However, in investing, allowing stories to influence your judgement may not necessarily be good for you. Many of the sensational stories created by the media are for viewership and have no “nutritional” value to your investments. Unlike facts, which cannot be created or manipulated easily, stories, on the other hand, can be twisted to meet the objectives of manipulators. For example, some analysts would write a fantastic story about a firm and capitalise on human greed to dupe gullible investors into buying the stock, even though the company does not have an earnings growth potential and many of its projects are low profit margin work, so that the analysts could take advantage of the market force to bid up the stock price to their target level and get to sell the stock at an attract price.
In addition, analysts and media understand that common investors are easily falling prey to framing effect, a cognitive bias in which the outcome of people’s decisions is influenced through the way a situation is presented. That’s why they would write a beautiful tale of a business with framing effect embedded in the story to bamboozle naïve readers into buying the stocks they intend to exit positions. For example, even if a company has started to suffer some financial losses this quarter and face some oversupply problem, the media may frame the situation positively by just highlighting the positive development of the company. They would frame it in a way that “despite the tough operating environment and uncertainty, Company XYZ managed to sustain its profitability for the current financial year and the management is endeavouring to continue improving their operating efficiency. We envisage the future outlook of the business to be positive.” Any intelligent readers who assess the company’s profit growth potential from a business perspective and study its financial reports should notice that the recent quarter’s financial loss has been muted and replaced with annual earnings in the statement. Further, they should be aware that oversupply is a serious issue. In this case, clearly, the analyst or media is telling a story with some hidden agendas. If anyone gives the story the benefit of the doubt, he or she would be suffering a loss in the investment when the price drops.
In addition, you should take note of some groups of stocks with inherent beautiful stories. The groups of stocks I refer to include, but are not limited to, blue chips stocks (with a hope to thrive continuously), rapidly expanding companies (with a straight line extrapolation of earnings forecast), IPOs (with a hope that the companies would take a quantum leap in its earnings), ACE market stocks (with a hope that they would be transferred to the main board), high-tech stocks (with potential to get high earnings multiple), government-linked companies (with a hope that they would get contracts without needing to go through any competitive tendering process) and other thematic stocks (with the likelihood of their prices being pushed up). These groups of stocks are always found with many beautiful stories created to trick ignorant investors into buying them up. That’s why people tend to love blue chip stocks that generally have good stories and to shun undervalued stocks with profit growth potential. Bear in mind that most of the blue chip stocks are relatively expensive and produce lower returns than value stocks, as the irrational Mr. Market has bid them up to an astronomical level without bothering about the risk and reward of the investments. Lo and behold, as I am writing this, Nestle is shooting through the roof and is selling at P/E multiple of 57.3X. Also, I see a lot of jubilant investors rejoicing and congratulating one another in forums everyday. They do not seem to know what the multiple signifies and the danger of bidding a stock up to an overvalued level. It implies that if the company were to pay out all its earnings to the shareholders every year, it will take each shareholder 57.3 years to recover the cost of buying the share. If you buy a share of Nestle today, you can only expect the earnings yield of 1.75%. That’s why stocks with beautiful stories underperform undervalued stocks with promising earnings growth potential more often than not.
“The fallacy is associated with our vulnerability to over-interpretation and our predilection for compact stories over raw truths. It severely distorts our mental representation of the world.”
Nassim Taleb.
5.1.3 Herd behaviour and follow others blindly
“Frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof.”
Robert Cialdini
Animals have a natural tendency to flock together as a group for security purposes and other self-interests. And just like animals, human too like to live in a group and act in the same way. People feel insecure when they are going in the opposite direction that the crowd is moving. In the study of Amygdala, Gregory Berns, a neuroeconomist of Emory University School of Medicine, also discovered that “social isolation activates some of the same areas in the brain that are triggered by physical pain”. In other words, following the crowd generally makes people feel emotionally safe and avoid the feeling of pain.
In investing, people also always exhibit herd behaviour. The reason why most investors always follow the crowd is that most of them do not have an independent point of view. They prefer to follow the tips given by other people such as their close friends, relatives, remisiers, investment bank analysts, columnists and other market “experts”. In addition, they have the fear of missing out. They would rather be wrong than to miss out any opportunity to win together with their friends. They always believe that if everyone is buying the same stock, other people must know something that they don’t. That’s why market participants always chase after hot stocks blindly in a group. Even if some of them may sometimes go against the crowd, they are unable to stay firmly on the ground when facing peer pressure. They do not know how to handle the social pain and stress when being criticized by their friends. In the end, they succumb to the pressure.
As much as following the crowd makes investors feel safe, the herd behaviour won’t help them much in investing. It is impossible for you to achieve an exceptional result by following the crowd. Most of investing ideas shared by the group members are inferior in quality. Even if the investing idea that you follow is a terrific one, you can only expect an average outcome since the prize has to be shared by so many winners. Further, studies show that investors who follow the crowd buying in euphoria (when the market at its peak) and selling in panic (when the market at its trough) always end up with a disastrous investment outcome.
Also, you should be wary of any investment professionals who claim to have an ability to predict short-term stock price movements. If you buy or sell on their advice, you are literally trading blindly. Bear in mind that these professionals do not know the market movement more than anyone. They do not a crystal ball either. In fact, most of them underperform the market index – KLCI – more often than not. History has demonstrated again and again that most economists too failed to foresee crisis arriving when the market was still in euphoria.
5.1.4 Impatience
“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”
Warren Buffett
From my years of observation, most of the stock market participants are short-term investors who simply take a punt with short-term orientation and without having an edge. They usually invest with a very short time frame – about a week or two. Many of them do not have the patience to wait for at least a year for their investments show some improvement in earnings. They get in and out; back in and back out of particular stocks frequently when there is news or rumours about the companies’ development and when they believe that the stocks’ prices will move soon. Even if the stocks they hold are growth stocks, when their investments show some gains they would immediately cash in without waiting for the growth being reflected in the stock price.
Most of them do not aware that the cost of trading in and out actively is so expensive that it could reduce their investment return substantially if they don’t control their behaviour. In addition, they have to pay a higher price for a stock since they are not willing to wait for the right time to buy it. Likewise, they will miss the opportunity to win big since they sell their stock too soon before the price reaches its peak. If you are a patient investor and can empathise with market participants, you can definitely get it at a fire sale price and sell it near its peak. Patience is the key to successful investing, but not many people realise it. That’s why Charlie Munger always says “the big money is not in the buying or the selling, but in the waiting.”
5.1.5 Hesitate to seize opportunity
“You have to have the courage of your convictions. That’s what you are getting paid for. This is the time when I really earn my money.”
Bruce Berkowitz
We always see people blame fate for having no opportunity to grow and prosper. But, in actual fact, I always see people hesitate to seize opportunities when they are given chances to buy good stocks at fair prices. They have a proclivity to procrastinate when opportunities arise. When the stocks in their watch list have met their selection criteria, instead of scooping up the incredible bargains, they spend too much time pondering over the companies’ survivability, thinking if they should still buy the stocks and calculating how much money they should allocate for the investments and so on and so forth. Also, sometimes they would wait for the companies to show a few consecutive quarters of earning growth before they are prepared to buy the stocks. Eventually, when other investors gobble up the shares, the value quickly vanishes into the thin air and the opportunities are gone. That’s why Buffett said in 2008 that “if you wait for the robins, spring will be over.”
Another reason why people fail to grab opportunities is that they fall prey to anchoring bias. Investors always anchor their decisions to an outdated analysis, all-time low or all-time high price, and their previous buying or selling price of a stock. For example, if a stock’s 52-week low is Rm0.50/share, most conservative investors would not be willing to buy the stock at Rm0.70/share, even though the value of its business is Rm1.00/share (apparently undervalued) and it has a tremendous profit growth potential. They would still fix their target buying price at Rm0.50/share – the price they had missed out last time. Likewise, people are very likely to buy a stock when it touches its 52-week low – Rm0.50/share, even though its earnings have been decreasing, the value has dropped to Rm0.20/share and there is no reason whatsoever in buying the stock which may put a dent in their portfolio. Another interesting finding I discovered is that if people sold a fast-growing company at Rm1.00/share a few years ago, it is very unlikely that they would buy back the stock above Rm2.00/share even though the stock is extremely undervalued at the price.
Also, people are averse to loss and hesitate to pull trigger after losing money in an investment. According to Kahneman and Tversky, “the pain of losing is psychologically about twice as powerful as the pleasure of gaining.” Their self-defence mechanism will kick-in when dealing with the same stocks they have suffered some losses before, even though the stocks have a great upside potential. For example, after losing money in a stock a couple of years ago, some investors will hesitate to buy back the stock, even though the fundamentals of the business have improved and the company has reported increasing earnings. When I bought Eversendai last year, many of my friends advised me not to touch the stock as some of their friends have lost money in the investment. They have got a phobia to invest in the company and would ignore the profit growth potential of the stock even though the fundamentals of the business have shown some improvements.
In addition, people tend to avoid buying stocks immediately after seeing blood in the streets or experiencing huge losses in the bear market, even though the prices are dirt cheap. The recency bias results in people overestimate the probability of event happens in the recent past (that the recent market crash has rendered a sharp rise in bankruptcy rate) and give lesser weight to the event that happens in a distant past (that the last bull run rewarded many contrarian investors generously). If you are an intelligent investor, you should be aware of the bias, make your judgement based on facts, focus on the long-term objective of your investment, pay attention to the companies’ profit growth potential, and look at the long-term trend of the stock markets, not the short-term movement of stock price. Statistics show that stocks are relatively cheap every time after the market crash. The worst is always behind us when the markets bottom out. And the best time for bargain hunting and accumulating fast-growing stocks is when they turn the corner, and when there is blood in the streets. If you hesitate for a minute, your reward will be gone in no time.
5.1.6 Refuse to cut loss
“Letting losses run is the most serious mistake made by most investors.”
William O’Neil
Another behavioural bias people always stumble upon is their refusal to cut loss when they discover that they have made some mistakes in their analysis work, and when the situation has changed and the reason to hold a stock is no longer valid. The reason why investors refuse to sell the losers is due to disposition effect (“the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value.” Source: Wikipedia) as well as the fear of missing out. Further, they don’t want to feel shame and get the pain for booking a loss. Therefore, they tend to hold on to their losers for a very long period and sell the winners very fast. They believe that as long as they do not realise their loss, the paper loss is not considered a loss and they will not miss the chance to win back when the tide turns. The worst is that some of them have a tendency to take a greater risk after devoting so much time, energy and money in the investments and are still suffering some losses. They will add to their losing position by buying more of the down-trending stocks at lower prices. This fallacy is called sunk cost fallacy.
Also, investors always forget that share price seldom declines continuously for having no reason. Price plunge related to fundamental business problems such as oversupply issue and increasing operating costs will linger a very long time, and very often may continue to depress the stock price until the issues cease to have a significant influence on its earnings. When a business’s highly profitable go-go days are gone, it will take a very long time for the stock to regain its former glory. The best you can do is to dispose the stock as quickly as possible before its price collapses (so that your investment won’t be affected by the decreasing revenues and the earnings disappointment) and then use the proceeds to buy stocks with better earnings growth potential (to avoid falling trap into the bias of loss aversion). Holding on to the losers will only deteriorate your portfolio performance and make you feel more depressed.
5.1.7 Invest with wishful thinking
“Never act upon wishful thinking. Act without checking the facts, and chances are that you will be swept away along with the mob.”
Jim Rogers
Just like gamblers, some investors too have a tendency to invest with wishful thinking. Many of them do not invest with realistic expectations and focus on facts; rather this group of investors lives on wishful thinking. They follow their friends falling for the popular myths that everyone believes. Further, they pay high prices for non-performing assets, and wish that the stock prices would go higher and expect other fools to acquire the trashes from them generously. They must know that this type of situation is untenable and the trend is subject to reversal when the market wakes up one day to realise that the stocks are unworthy of their money. Another scenario is that they buy some good stocks at attractive prices and then set their expected return unrealistically high, and they wish that the market would reward them lavishly for the investments. Whilst the market may sometimes be irrational in their willingness to pay for the good assets, very often having a disappointment for investing with unrealistically high expectations is evitable.
Also, the investors who take a greater risk after suffering some losses (discussed earlier on) always invest with wishful thinking. They will buy more shares with a greater sum of money after losing money in a stock in the hope that they could win back the money they have lost in the previous investment. As they increase the sum of their investment, they are actually taking revenge after getting clobbered by their failed investment, let their anger influence their judgement, and wish that the stocks reaching new lows will rebound. That’s why they buy even more shares and up the ante as the price keeps falling. And they wish that the rebound will occur soon. They are definitely unprepared for the any unforeseen circumstances. If the stock price falls lower, they will definitely be in financial trouble if they buy on margin. Bear in mind that what goes up must come down, but what comes down may not necessary go up. Making judgements based on a false notion and without having evidence to support your hypotheses is a dangerous move. Stocks seldom fall to their historic lows for no reason. The companies are either suffering from financial distressed or facing oversupply problem. Never expect a troubled company to pull a rabbit out of its hat, unless there is sufficient evidence showing that the problem has been addressed with business expansion and earnings growth in the pipeline. In investing, there is no magic dust to bail you out for your mistake – wishful thinking. Do not take a greater risk after a loss. If you insist on doubling your stake in your failed bet when the stock price falls, make sure that you know the root cause of your failure and that the odds are now stacked in your favour prior to committing more capital to the investment.
5.1.8 Value stocks in possession unrealistically high
“……people are more likely to keep what they start with than to trade”
Richard Thaler
People have a tendency to value things in their possession higher than the prices quoted in the markets and higher than the things they have not yet own just because they own the things. This bias is called endowment effect. Again, this shows that people do not always look at the facts and live in their dream. They are inclined to value their own properties higher than their market prices. For example, if a house is for sale at Rm100,000 and the market value of the property is also Rm100,000, the potential buyer would find it pricey before buying the property. But, after purchasing the house, he or she will think otherwise. He or she will claim that the property is undervalued and can easily fetch over Rm150,000 or more.
To prove this bias, Daniel Kahneman, Jack Knetsch and Richard Thaler conducted an experiment by distributing mugs to half of their students and ask the students to sell the mugs to the other half of the group who did not have the mugs. They found out that those students with mugs had a tendency to overvalue their possession and placed a higher selling price for their mugs than the price offered by another group of students due to the mere ownership effect called “endowment effect”. In another experiment, Kahneman and his colleagues distributed mugs to half of their students and chocolate to the other half of the group, each with the same value. The students are then asked to trade with their possession. In the end, they found out that only a small group of students were willing to part with their original possession.
This divestiture aversion behaviour is also commonly seen in investing. People always fall in love with the stocks in their portfolio, assets they inherit or something they are familiar and comfortable with, and are inclined to believe that the stocks they possess are worth more than their market values, regardless of their real values, and have a tendency to remain at the status quo. Therefore, they refuse to sell the stocks in their possession then use the proceeds to buy other stocks with better profit growth potential, even though the reason to keep the original stocks in their portfolio is no longer valid. For example, if an investor bought stock A last year at Rm1.00/share, he or she expected the stock to rise to Rm2.00/share in a year, but so unfortunate that the business faces some headwind, the EPS of the stock fails to increase and the stock price hovers at Rm1.50/share level for a year. At the same time, stock B, an undervalued stock selling at Rm1.50/share, seems to be a better investment for the investor. Do you think the investor is willing to sell stock A for stock B? The most probable answer to the question is “NO”. Behavioural bias theory tells us that it is very unlikely that the investor will sell stock A before their expected value is reached, so that he or she could use the proceeds to buy stock B. As he or she sticks with his or her original possession, he or she will eventually miss out a good investment opportunity.
5.1.9 Overconfidence
“Overconfidence is a powerful force.”
Richard Thaler
People have a tendency to overestimate their own ability, efficiency, intelligence and knowledge level. Most of them believe that their investing skills, knowledge and strategies are superior to other market participants. Whilst having confidence is important to your personal success, overconfidence on the other hand may hurt your investment performance and be detrimental to your continuous learning. Overconfident investors always believe that they are better than other people in stock picking. Therefore, they are not well-prepared for what may go wrong with their investments and won’t be prepared for any unforeseen circumstances that may stack against them. For example, if an investor believes that a company has a bright future or that he or she has found an investment which would provide him or her an exceptional return, he or she then bet big on the stock without identifying the possible threats that may jeopardise the business, or listening to the critical comments of people in the opposite camp, he or she is prone to a shock when the stock price and earnings take a hit and he or she may be unable to get out safely.
In addition, people have a tendency to feel overconfident and wager aggressively after winning a few small bets. It is very normal that after a few consecutive of winning games, we will take it for granted that the odds will still be in our favour in the next few trades and we will be getting very greedy in the pursuit of more rewards. But staying in the game with an exaggerated swagger is a deadly mistake. Again, shock always occurs when we fail to foresee what may go wrong with our investments, and we are susceptible to a huge financial loss if we insist on moving ahead in foggy situations with overconfidence before the vision gets clearer.
Whilst both genders generally exhibit the same trait, studies show that overconfident is more prominent in men than in women. Male hormone always leads men to be more confident and to make high-risk gambles. In comparison, men trade more frequently (and often excessively) than women, and men suffer lower returns with higher trading costs. They always believe that the investing decisions they make are right, even though sometimes they may not know what exactly are they doing, and may not be aware of the presence of some blind spots and the consequences of their decisions. Women, on the other hand, are more likely to acknowledge their ignorance if they do not know anything about a company and are more risk-averse in making any investing decisions.
5.1.10 Reject opposite view
“We were also well aware of the dangers of what social psychologists call confirmatory bias, in other words the tendency to collect all the information that agrees with your position and to ignore the information that doesn't. Behavioural theory teaches that the best antidote to this bias is to listen to the opposite side of the case and then dispassionately to identify the logical flaws in the argument.”
Barton Biggs
In investing, people do not like negative comments about their stocks, and always search for evidence to confirm their investment decisions. This type of bias is known as confirmatory bias (or confirmation bias). According to studies, investors are twice more likely to look for information and interpret ambiguous evidence in a biased way to support their decisions rather than to look for flaws in their original hypotheses. At the same time, they ignore the impact of contradictory facts on stock price. For example, in 2014, when OPEC (Organization of the Petroleum Exporting Countries) ramped up their production to 30 million barrel per day of oil and was in a price war with the shale oil producers of the United States, the price of oil started plummeting, people who are optimistic about growing global oil demand did not only refuse to sell their oil and gas related holdings and ignore the fact of increasing crude oil inventory and the impact of supply glut, they kept finding reasons such as depleting oil reserves and surging demand of oil from China, India and emerging countries due to GDP growth to shore up their argument. In the end, those investors who refused to listen to the opposite view and clung on to their beloved oil and gas stocks eventually suffered huge losses when the prices of their oil and gas stocks tanked, as the price of crude oil plunged to the level below USD30 per barrel.
When like-minded investors get together in a group, they have a tendency to form a stereotype view. They will reject those opposite opinions, alternative views and disconfirming information, and ignore warnings. They then strive for unanimity. To achieve their goal, they also impose pressure on and angry with the dissidents or people in the opposite camp. They distort facts and information to justify their hypotheses and decisions. At the same time, the group will use mind guard to prevent their group members from accepting any opposite opinions. Independent thinking is lost when everyone is indoctrinated into believing the distorted stories and trusting the philosophy which may be composed of false notions, and unable to think for themselves, as they are afraid to be criticised by the group members. The groupthink or group polarisation, whilst seems to help the members to stay confident, is actually a curse in disguise, which very often does more harm than good to investors and will lead to over-optimism and overconfidence.
“For if we are uncritical we shall always find what we want: we shall look for, and find, confirmation, and we shall look away from, and not see, whatever might be dangerous to our pet theories.”
Karl Popper
5.1.11 Overly focus on short-term performance
“When an investor focuses on short-term investments, he or she is observing the variability of the portfolio, not the returns - in short, being fooled by randomness.”
Nassim Nicholas Taleb
Our market is mainly dominated by short-term oriented investors who concentrate too much on short-term price fluctuations and noise, always aim for quick profits and exit a stock position after holding the counter for a few days, regardless of its earnings growth prospects. They will rush to buy a stock when there is a rumour about the company and feel the urge to sell it when the holding starts showing some gain. They call themselves serious investors, but their average holding period is only less than a week. They prefer speculative stocks with higher volatility to stocks with good long-term earnings prospects. They are unable to see the term long-term earnings potential of a company. In investing, we call this a problem of short-sightedness or Myopia.
This group of overambitious market participants also devotes too much effort to predict the short-term price movements of a stock and ignore the underlying business and its profit growth potential. They think they have the ability to predict the market and to beat the market short-term, but their portfolios always end up underperforming the market averages, if not with a horrendous loss. Again, this shows that people always overestimate their own abilities and underestimate all the competitors – including those sophisticated investors who are not only knowledgeable and experienced in investing, but can access to the latest news within seconds, are able to predict the short-term earnings quite well and outmanoeuvre the market.
In order to increase the winning probability of their short-term bets, sometimes they are willing to pay lofty service fees to investment consultants for hot-stock tips and investment advice. However, those tips are mostly inaccurate ones and the returns of their products always underperform the market. Even if those products are really magnificent ones, after deducting the consultation fees, brokerage commissions and other transaction costs, only a paltry gain is left over. In the end, they still get beaten by the market. Keep in mind that these investment consultants do not have a crystal ball too. Just like you and me, they do not have the “supernatural ability” to accurately predict the short-term stock price movement either.
That said, it is not hard to beat the market in the long-haul game. As the active investors, such as professional money managers, day traders and other short-term oriented market participants (who constitute a greater proportion of the market) are overly focused on the short-term performance of a stock, the long-term earnings prospect of the company has been largely overlooked. This is the area where smart contrarian investors with fortitude and patience can outperform the market and be handsomely rewarded if they only concentrate on investing in undervalued companies with bright earnings growth prospects.
5.1.12 Refuse to admit mistakes
“There’s obviously a balance to maintain between confidence and humility. You have to be humble enough to recognise when you’re wrong. I’m willing to look silly.”
Bill Ackman
Would you admit your mistake when you do something wrong? In most cases, people are just unwilling to admit their blunders. There could be many reasons why people refuse to admit them, but the most obvious one is due to egoism. In general, big ego hinders self-assessment, affects visibility and ruin investing performance. People with the self-importance problem always seek glory, crave for credit and compliments, boast achievements and are unwilling to recognise their weaknesses. In addition, they have too much pride to accept the advice of other people. Even if they make bad decisions, they would give all sorts of justifications for their errors. In the end, this group of people always sticks to the wrong hypotheses, flawed philosophies and the poor perceptions of their investments. They are predisposed to repeat the same old mistakes again and again.
In investing, it is easier to make mistakes than to make perfect “moves”. That’s why we make so many mistakes every year. From a psychology perspective, these failures will cause emotional pains and kill our self-esteem. But from a learning perspective, these mistakes (be it misjudgements, misinterpret data, misestimate earnings or mistimed shots) make us grow and stronger. In other words, if we are willing to accept the embarrassment, take responsibility for our incompetence and correct the misconceptions, our investing skills will improve significantly. Unfortunately, many stubborn investors are simply unwilling to admit their fallibility, so as to avoid feeling shame. Keep in mind that people who are reluctant to control their emotions and refuse to admit their mistakes seldom learn, and hardly will they see much improvement in their investment performance.
5.1.13 Poor self-awareness
“The first thing you have to know is yourself. A man who knows himself can step outside himself and watch his own reactions like an observer.”
George Goodman (pseudonym Adam Smith)
Very often the failure of people in investing has been stem from not having a good understanding of themselves. How can anyone formulate a viable investing plan, rule and strategy for him or herself if he or she does not even know his or her own personality, strengths and weaknesses well? I always hear people call themselves long-term investors, but they behave like traders. They trade so frequently that their portfolio turnover ratio is very often greater than 1 and the transaction costs will eat into their lifetime savings. Some of the people wanted to follow those über-investors like Warren Buffett and Charlie Munger to put all their eggs in only one basket and watch the basket closely, but they don’t have the stomach for concentrated investing. They do not have the discipline to perform due diligence, devote effort for soul searching, unable to demonstrate the abhorrence of action and cannot hold stocks for long-term. After building a substantial position in a stock, they become unable to sleep well and intend to exit their position as soon as possible. As they dispose their holdings hastily when the stocks are declining in price (or selling below their buying prices), their portfolios are vulnerable to a loss.
Also, having a poor understanding of oneself is the reason why people cannot see their own bias blind spot. They always think they are less subjective to some cognitive biases than the other market participants, but in actual fact they are also the victims of the biases. For instance, people always overestimate own ability and underestimate the other people’s talents, and they claim that they can control their emotions better than other market participants. But they eventually turn into panic sellers when the market crashes and join the crowd buying aggressively when a stock is selling like hot cakes.
Poor self-awareness is also one of the factors leading to self-attribution bias. People often give credit to their own skills, talents and knowledge for their success, but they blame others’ mistakes, market conditions, environment, government policy, price volatility, bad luck and other factors for the poor outcomes. They must understand that other than disavowing responsibility and avoiding feeling shame, the externalisation – blaming others for causing their loss – will not benefit them for their own growth. To be a better investor, they should identify their strengths and recognise their weaknesses, and learn continuously to improve their investing skills and philosophies.
Chapter Summary (Part 1)
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