Psychological Tendencies to Guard Against In Investing
“The first principle is that you must not fool yourself and you are the easiest person to fool”
-Richard Feynman
Do Something Bias, Social Proof and Confirmation Bias… Let’s walk through a theoretical situation where these three powerful Biases can destroy someone in the field of investing:
A new Investment Manager named Benjamin just signed-on a new client for his investment firm and is very excited about it. The new client, let’s call him “Thomas”, rolled over his IRA account of $500,000 and assured Benjamin that there will be more capital behind it if Benjamin performs well. Benjamin automatically feels a sense of pressure to find some ideas to put the cash to work because he does not want to disappoint Thomas, and he also wants to show performance so he can acquire his other assets as well. Benjamin naturally starts to scroll through Twitter, Value Investors Club, Seeking Alpha and wale wisdom – scouring for potential ideas from other “smart investors”. He finds an interesting idea through Value Investors Club and then proceeds to type the ticker into Seeking Alpha to see what other people think about the particular stock. There are a ton of write-ups and almost every single post along with the comments on the thread seem favorable and promising. Benjamin starts to get excited. To compound this feeling of confidence, he also learns that a very well known, astute hedge fund manager has a very large long position in the company. What could go wrong with this investment? He decides to further his “research” and reads the investment presentation that the hedge fund giant created for the company, talking about how wonderful the business is and even comparing it to being the next Berkshire Hathaway. By now, Benjamin feels so confident in the business that he buys a 20% position at $150 per share and rationalizes it to himself that the other smart investors had to have done more research than he ever could do to understand the company, so if they feel confident, than it must be a good investment.
As time goes on, this company continues to roar on and is now at the high price of $250 per share! Benjamin looks like a hero, his clients love him and he feels like he has found a true compounder. October 21 comes along and an investment research firm puts out a very negative piece about Benjamin’s beloved company and compares it to being the next Enron. There is no slight sense of positivity that can come out of a statement like that, and Benjamin deep down knows that. Frozen, he does not know what to do. After all, he realizes he does not know much about the company at all and was only riding the coattails of other smart investors in this investment. The company that he has loved and that has made so much money is now falling by 51% in a single day. Not knowing what to do, he waits for the big hedge fund investor to respond to the short report. Later that day, he feels confident due to this investor announcing that his firm has doubled down and invested more money into the company by buying more stock. Benjamin decides he agrees with this act of heroic confidence and decides to stay put.
Fast forward a few years, Benjamin is now down about 90% on his investment, the large investor that gave him the confidence to invest money in the company has now sold out, and Thomas still can’t believe what went wrong.
The End.
Congratulations, if you are still reading after my horrible attempt at creating an interesting short-story, I applaud you. I am sure many of you know what company was being referenced above, and I am also sure some of you may be able to relate to some aspects of it. Let’s go through some psychological biases or tendencies that encouraged Benjamin to make such a failure of an investment.
Do something Bias – People feel like they always need to show some sort of activity to show that they are doing something. Let me explain. There is an added sense of pressure to put cash to work when people have it. Clients do not like sitting in cash and neither do most individuals. Professionals and individuals may slip up and talk themselves into making an investment that they normally would not make just to put cash to work and show they are doing something. This is the wrong way of looking at it. No one should lay out capital unless they feel like they will earn a satisfactory return on that investment. As Warren Buffett has said, “Holding cash is uncomfortable, but not as uncomfortable as doing something stupid”. It drives me bonkers when I see certain individuals move money to a new money manager and on Day 1 they become fully invested. No incredible business is a worthwhile investment at the wrong price, so being patient and studying different businesses that you would like to own if Mr. Market gave you a favorable price to buy in at is the intelligent way to go. If you have extreme patience and are highly selective, you may not make any investments in years, but during those years you probably have gained so much experience on many different businesses if you continued to study on, which can be very valuable going forward. Let’s say during that time you read 50-100 books, learned about 150-300 different new companies and have added maybe 5-15 companies to your list of “future potential investments”, all while waiting for the next ripe opportunity. That’s a win in my book. Do Something Bias also relates to portfolio management. Short term fluctuations in stock prices are nothing more than noise you should ignore. If you start reacting to every tick your portfolio makes, it’s time to shut the computers down and tell yourself you will only check quotes afterhours.
Benjamin felt pressure to put cash to work when his client opened a new account with him, the last thing he would want is for Thomas to feel like he is paying fees for nothing due to lack of activity. He also wanted to do something as soon as possible so he could hopefully show performance to get more capital from him. This sense of pressure to do something rather quickly was the root cause of the disastrous investment.
How can you guard against this?
- Always remember you are not paid for activity, you are paid for being right
- In this business, there is a difference between being active (studying) and actually making an investment
- Try checking stock quotes after hours only
- Continue to read on about many different businesses and always be patient
Social Proof– This may be the worst psychological phenomenon of them all. If you think people act irrational by themselves, put them in a room full of other irrational people and watch the disaster unfold. People are more confident in crowds and assume if the whole crowd thinks one way then it must be the correct way to think. Many companies apply social proof to their advantage. Have you ever bought something on Amazon? Do you check the customer reviews and buy something based upon that? Social Proof. It can be dangerous in Investing if an investor is not aware of this. People think their idea has more weight if other smart people are also in the investment.
Benjamin lost it to Social Proof when he started scrolling through Twitter, Value Investors Club and Seeking Alpha to look for ideas without doing further research of his own.
How can you guard against this?
- Develop your own conclusions
- Think independently
- When you research a stock, develop your own opinion before testing them against other peoples ideas
- Don’t assume that just because an intelligent manager is involved with a company that it makes for an intelligent investment
- Be intellectually honest with yourself
Confirmation Bias – The tendency to search for, interpret, favor and recall information in a way that confirms ones preexisting ideas of beliefs. They say when people teach or write, they really are only pounding their own ideas further in their head.
Benjamin was confirming his biases for an idea when he read the idea thread on Seeking Alpha that agreed with the particular investment idea. He also read the favorable comment section, which further confirmed his belief in the company. He did not think independently for himself or draw his on conclusion based on his own research. The worst part, he did not even consider the sell side research piece because he already was so positive on the company and had so much confidence in the large investment firm that doubled down.
How can you guard against this?
- Again, always think independently
- Try to understand the bear case better than the bears do and be able to dispute it with facts
- Don’t read any research reports or blogs until you develop your own opinion on a company
All of this is easy to write about, but putting it into practice is no simple task. That said, being aware of these biases and tendencies can help us move along down the road towards being more rational human beings.