“In the earliest one, eventually preserved in the Bible, humans were formed from clay or dirt, which an intelligent god then infused with its spirit. That spirit ‘explained’ our intelligence - grammatically, at least. The invention of hydraulic engineering in the 3rd century BCE led to the popularity of a hydraulic model of human intelligence, the idea that the flow of different fluids in the body - the ‘humours’ - accounted for both our physical and mental functioning … By the 1500s, automata powered by springs and gears had been devised, eventually inspiring leading thinkers such as René Descartes to assert that humans are complex machines. In the 1600s, the British philosopher Thomas Hobbes suggested that thinking arose from small mechanical motions in the brain. By the 1700s, discoveries about electricity and chemistry led to new theories of human intelligence – again, largely metaphorical in nature. In the mid-1800s, inspired by recent advances in communications, the German physicist Hermann von Helmholtz compared the brain to a telegraph. Each metaphor reflected the most advanced thinking of the era that spawned it. Predictably, just a few years after the dawn of computer technology in the 1940s, the brain was said to operate like a computer, with the role of physical hardware played by the brain itself and our thoughts serving as software. The landmark event that launched what is now broadly called ‘cognitive science’ was the publication of Language and Communication (1951) by the psychologist George Miller.”
My apologies for such a long quote, but it’s an outstanding example of the expansion of our own views of the human being’s ability to think, discern, calculate and work out increasingly difficult and complex problems facing us as a race and a species that happens to reside on a planet with finite resources and - with some certainty - finite time.
Most of my readers at this point are probably asking what has gone wrong with my limited cranial capacity and what this has to do with value investing, but I assure you it does a great deal. As we expand our understanding of how we think and feel about investing, we increasingly develop the field of behavioral finance. This field focuses on three key concepts: what are the best means (and tools) to assist humans find ways to manage and develop self-control, how to isolate areas where humans show the least rational behavior and limit their impact, and what cognitive biases influence our investment decisions.
Losing (and Finding) Self-Control
Certainly, losing self-control can be one of the easiest ways to lose your hard-earned investment dollars. Whether it be Newton getting back into the South Sea bubble after having exited with great gains (he simply couldn’t resist seeing his friends make even more money) or an investor using vast amounts of margin to increase their gains, all too often investors lose self-control and take actions that are impulsive and self-destructive.
The ability to build emotional guard rails – barriers that keep your emotions on the straight and narrow – can make a huge difference in long term-investment returns. There was a great story where Abraham Lincoln wrote an extraordinarily cutting reply to a general’s update. Historians found the document later, but what was most interesting was discovering Lincoln’s technique of using an unsent letter folder to guide him in his more emotional moments. I try to do this with trades. I find if I’m willing to make the trade one week after making the initial decision, then I will likely proceed. I see it as my own “draft emotional trading folder.”
Buying 1,000 shares of ACME Rubber Band company because everyone else is would be classified as lack of self-control. Purchasing shares of ACME Rubber Band company for $1,000 per share after estimating a fair value of $50 per share would be considered irrational behavior. Neither will likely lead to great results, but some might consider the latter more dangerous because a certain level of conscious thought has gone into the process and the individual has decided – for whatever reason – to ignore their (rational) estimate and forge ahead.
Irrational behavior implies that the investor has the possibility of utilizing rational behavior. Building a process to prevent making an irrational decision is similar to helping maintain self-control – with one exception. When delaying after making an irrational decision, one should always seek to see what a rational decision might look like.
Create a Process that Questions your Key Assumptions
In his classic 2006 paper, “Behaving Badly,” James Montier (of then-Dresdner Kleinwort Wasserstein) interviewed 300 investment managers and asked them if they produced above-average, average or below-average results. Seventy-four percent of the 300 fund managers surveyed believed that they had delivered above-average job performance. The majority of the remaining 26% of those surveyed believed that they were average in their performance. Nearly 100% of those surveyed felt that their performance was average or better. Basic statistics, of course, show that only 50% of the sample group can be above average.
Further research has shown that not much has changed since Montier completed his research in 2006. The issues that showed up in his research – confirmation bias, anchoring, disposition effect and so forth – are just as prevalent today as they were in 2006. The key is building a process that can scrub out these inherent biases and question your assumptions. Whether this is the Nintai “Getting to Zero” process or your own personalized method that finds a way test or break your case, include it every time you evaluate a potential investment.
Why This Matters
Over the years I’ve written a lot about high fees, turnover and how investment managers rarely outperform the markets in the long term. All of this is still as valid today as the day I first wrote about it. But the simple fact remains that investors underperform – whether investing themselves or by utilizing professional money managers through mutual funds, hedge funds and so forth – mainly for reasons centered solely on their own behavior. It’s easier of course – and contains some truth – to blame this underperformance on others.
You can’t stop doing it until you recognize it
When I was growing up as a kid, it seemed there was always a “leg-bouncer” in most families. You know the one – sitting at the dinner table or watching a movie – and the leg is bouncing up and down. A never-ending motion that seemed to shake the house from floor to roof. I was (un)fortunate enough to dwell in a house with two – my brother and me. I’m not sure we were fully cognizant that we were doing it on a regular basis and that it was annoying, until my father developed a way to “assist” us in identifying the problem. We certainly didn’t forget it a second time! That type of jolt to the system – which immediately brings you in contact with your unfortunate habit – makes it much easier to identify it the next time you start and even easier to try to stop.
It’s nearly impossible to stop, but try to minimize the effect
Many of the biases we bring to our investment process are hard to stop entirely. An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports their original idea about an investment rather than seek out information that contradicts it. Over time, the ability to break entirely free from this bias is very, very small. If you find that confirmation bias constantly seeps into your thinking, develop a process that tries to limit its impact, not eliminate it. I look upon eating more healthy as much easier than dieting. If I try to eliminate all sources of my weaknesses – chocolate, ice cream, cookies and so forth – I find I completely fail at my objectives. Eating a salad once per week made changing my eating habits far easier over the long haul. Incremental change in your investment process will likely be more effective than suddenly trying to emulate Ben Graham overnight.
Thinking is a never-ending process
I keep a log and quote book that tracks thoughts and quotations that I find interesting – as well as valuable – in helping me think differently. Not every quote or thought is earth-shattering in its importance or fundamentally changes the way I approach value investing. But over time I find they slowly impact my daily thinking and investment process. In writing this article I went through the three volumes I have in my office, counted the total quotes and ranked them on a 1-to-3 basis with 1 being a quote that profoundly changed my thinking and 3 being a quote that had little or no impact on my business thinking.
Over the past 16 years, I have written down roughly 1,300 quotes or roughly seven entries per month. Of these 1,300 quotes I ranked roughly 15% as 1 (profoundly impactful on my thinking), 20% as 2 (moderate impact on my thinking), and 65% as 3 (little or no impact on my thinking). The fact that nearly two out of three quotes made little or no impact isn’t discouraging at all. In fact, to me it demonstrates the need to keep learning, keep researching and keep writing things down never ends. You never know when that diamond might show up in the rough.\
Every day it seems we find some new twist in how our brain works through investment decisions. Whether it be research on biases or the difference in emotional responses to losses versus gains, we are always learning ways in which the investment brain works.
Returning to the quote that opened this article - Epstein’s “The Empty Brain - the breadth and depth in the development of human thinking is truly amazing. No matter where you are on your investment journey continuum – just starting out or nearing retirement – or where you are in the learning process, the ability to keep learning will give you a leg up or a decided disadvantage in the long run. The path you choose – and the success you have – will be greatly determined by how you think, what you think about and how much you think in total.