Nerve over intellect
Warren Buffet was once asked whether intelligence or discipline is more important in investing. His response: “To be a great investor you don’t have to have a terrific IQ. If you’ve got 160 IQ, sell 30 points to somebody else because you won’t need it in investing. What you do need is the right temperament.” Let’s look at some ways to develop the ‘right temperament’.
Investing is a game of both analysis and nerve. You certainly need strong rigorous analysis, but also the right mentality to see through an outcome. To beat the market, you need to find insights the market does not appreciate, and then have the audacity to go against the crowd. Developing both analytical skills and psychological strength is thus essential to above-market returns. In this blog, I want to focus more on the nerve than the analysis.
Behavioural psychology often talks about cognitive biases. These are rather like a blind spot in thinking. Just like you have a natural blind spot when driving, there are natural gaps in the way we think. In a car, we can’t remove the bias, but we can add sensors, to alert us to danger, and cameras, to improve our vision. Similarly, with cognitive blind spots we can learn more about them to better identify them, and we can take measures to help us be more vigilant around them. Whilst the biases cannot be removed, they can be acknowledged, recognised and adjusted for.
I want to introduce you to the three most common biases: Amy, Eddy and Cathy[1]; and some tools we can use to protect against them.
Amy the anchor
Bio: Anchoring is a natural human tendency to link to a reference point. Amy is a creature of habit, she is stubborn and struggles to go deeper than a first impression.
Weapons: Amy is very influential – when a stock falls 20% on a company announcement, she will tell you it’s 20% cheaper than yesterday. However, if the announcement changes the fundamental value of the company, this bias can be dangerous and detract from the new fair price. Amy is extremely powerful – in 2007 Clayton Critcher and Thomas Gilovich[2] found that even incidental numbers (unrelated numbers seen in an environment), can create anchor bias.
Defence: The best approach here is to lean on rigorous analysis. Look at multiple sources for information so that you’re not married to just one. Another technique is to return to analysis with a clean slate and see if you come to the same conclusion.
Eddy the Endower
Bio: The endowment effect causes you to attribute more value to things you own. Eddy is protective, possessive and unwilling to let go.
Weapons: Eddy most commonly appears in winning calls. You may have been right on a stock, and he’ll pat you on the back saying there’s more to go – value you haven’t seen before. He’ll encourage you to hold on to capture all the value, even when the tide begins to turn.
Defence: Call in the devil’s advocate and question your assumptions. Just because you’ve been right on it so far, doesn’t make you immune to change or share prices getting ahead of themselves. It’s important to stay grounded and take money off the table when valuations are high.
Confirming Cathy
Bio: Confirmation bias is a little like selective hearing. Cathy comes in with a view and any information you give her is passed through that filter.
Weapons: Cathy makes it hard to see a change – either in an existing holding, or in a potential new idea. She struggles to see counterarguments and twists any fact to support her original idea. She’s so convinced in her original thesis, that she misses red flags for change, and ignores new data.
Defence: Healthy debate and multiple sources of information. Ensuring you explore a range of sources, and perspectives that challenge your own, gives you more chances to spot red flags and turning points. Discussing as a group also helps highlight information you may have overlooked and addresses this bias.
We all have a little of Amy, Eddy and Cathy in us – and that’s perfectly human. These biases are natural, and help with a lot of day-to-day decisions we make. However, when it comes to investing they can shade the facts and lead to lost opportunities and investment errors. The best approach is to be aware of them, and take measures to stop them influencing your analysis.
[1] These personified names are not from psychological theory, but rather introduced to illustrate a point
[2] Source: http://node101.psych.cornell.edu/sec/pubPeople/tdg1/Critcher&Gilovich.08.pdf
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Chris
:
My favourite has to be ‘illusory superiority’, where everyone thinks they are a better ‘whatever’ than everyone else, e.g. Svenson surveyed 161 students in Sweden and the United States, asking them to compare their driving skills and safety to other people.
“For driving skills, 93% of the U.S. sample and 69% of the Swedish sample put themselves in the top 50%; for safety, 88% of the U.S. and 77% of the Swedish put themselves in the top 50%.”
(Which is physically impossible).
Lisa Fedorenko
:
That’s a great one. Confidence calibration is very poor for most people – an interesting test on this can be found here: http://confidence.success-equation.com/ It’s a simple trivia test with questions and degree of confidence you have in answering them.
Also always find the differences in data segments fascinating. Nice stats!