Why understanding behavioural finance is just as important as stock picking

Afternoon all,

Rather than look at a theme, sector, or stock this week, I want to spend some time writing about behavioural finance, something that is just as important to portfolio returns.

Understanding the basics of behavioural finance, the biases we’re all subject to, and the need to apply strict, unemotional discipline when investing is just as important as finding great companies in which to invest.

If I carry out thorough research on an opportunity and decide to invest, then that’s a great start. However, circumstances change, competition changes, the economy changes, management changes... Deciding whether to keep holding an investment or close out has an enormous bearing on my portfolio’s performance. To make that decision I need to regularly and unemotionally revisit the rationale for my investments and recognise my own bias.

The types of behavioural characteristics we are all prone to include Confirmation Bias, Availability Bias, Herding, the Gambler’s Fallacy, and Prospect Theory, all of which I briefly describe below. If you remain cognizant of these human weaknesses we all suffer from, it will help you to manage your portfolio, reduce the opportunity cost of selling out too soon and the actual losses of running bad trades too long.

Prospect Theory

Dr Kahneman and Dr Tversky put forward Prospect Theory in 1979, for which Kahneman later received a Nobel Prize in Economics. In their work, they found that people don’t experience equal levels of emotion to equal gains and losses. In fact, people suffer more pain at a monetary loss than they experience joy at an equal monetary gain.

The impact on investing is that we are predisposed to bank profits too early for successful investments and we run our losses too long in the hope they will recover to avoid the more painful experience of crystallising a loss.

Availability Bias

The definition is: “the giving of preference by decision makers to information and events that are more recent and so more memorable. This is because memorable events tend to be more magnified and are likely to cause an emotional reaction.”

The implication for investing is that the importance of breaking news that is good or bad is magnified because of its recency. This can make us overreact and lend more weight than we should to its implications on valuation. Availability Bias is, in my view, a big reason why markets often overshoot.

There are certainly times when you have to act quickly, but it is important first to estimate what your view is on the implications for valuation, your margin of comfort, and the likely future news flow, before comparing that with the market’s reaction.

Confirmation Bias

One of the biggest weaknesses I contend with is confirmation bias. This is defined as: “the tendency to search for, interpret, favour, and recall information in a way that confirms one's pre-existing beliefs or hypotheses while giving disproportionately less consideration to alternative possibilities.”

For investing this means looking for information that supports my preconceived view on an investment opportunity, and dismissing the glaring contradictory information that is staring me in the face. The way to combat this is to recognise your preconceptions explicitly and rigorously question them. It also helps to have a devil’s advocate picking your thesis apart.

Herding

It’s difficult to be a contrarian because humans are predisposed to follow the consensus.  Herding is a phenomenon where people do what the crowd appears to be doing. Relating to investing, this instinct is most commonly seen in panic sell-offs and irrational bubbles, neither of which are supported by fundamentals.

The classic example here is the dot com bubble around 2000, where many investors piled into internet stocks with reckless disregard for the fundamentals of valuation, and fear that otherwise, they would miss out on the incredible gains everyone else was enjoying.

Gambler’s Fallacy

If I flip this coin and get nine heads in a row, the next flip has to be a tail! This is the classic gambler’s fallacy. There is no conditional probability for the 10th flip, and the probability will still be 50:50.

The implication for investing in equities is particularly evident for growth stocks. Anyone who invested in Fever Tree in late 2014 would have enjoyed a 250% gain by the end of 2015. Surely it can’t keep going up? For those that held fast, 2016 increased that 250% gain to 550%. As of today, the shares are up 800% since IPO.

If the fundamental potential value is still significantly north of the current share price, then the fact that the shares have gone up a lot shouldn’t matter. In fact, if what has driven the shares up is tangible operational progress, then the value range may also have shifted. The problem is human nature means we anchor around certain levels.

Many lessons to be learnt from Seth Klarman

I’ve been scanning through my copy of Seth Klarman’s fantastic book, Margin of Safety, again over the last week or so and I’ve pulled out a couple of quotes below that I think are worth highlighting. If you haven’t read it, I would highly recommend taking the time. It’s a relatively short book (250 pages), and while I don’t fully subscribe to his more inflexible interpretation of value investing, it has had a pronounced impact on the way I do my job.

“Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes, and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.”

He makes a valuable point, demonstrating the need as an investor to keep in mind a valuation range you think applies to a company. This range can widen or narrow or jump up or down as events unfold. Another more succinct quote from Seth Klarman summarises this well:

“It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. ”

The key, therefore, is to not look at the change in share price as the starting but, but rather your own view of the change in value, and then you can start to take a view on whether Mr Market has overreacted to events or not.

A good example of this was the severe lurch down in share price for PLUS, IG Group and CMC late last year. It's hard to keep emotion out when a company you own shares in is falling in value. We felt strongly that the move in share price was an overreaction to the news from the regulators. We also felt there was enough margin of error built into our investment in PLUS that, instead of panic selling, we thought the drop in share price presented an even more attractive bargain, and so we increased our position.

“If the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more.”

“Investors can become obsessed for example with every market uptick and downtick and eventually succumb to short-term trading. There is a tendency to be swayed by recent market action, going with the herd rather than against it.”

 

“The most crucial factor in trading is developing the appropriate reaction to price fluctuations. Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the tendency to become overly enthusiastic when prices are rising. ”

I could include dozens of other quotes as the book is full of wisdom. Without explicitly defining the common behavioural finance biases, it covers many of them with real world examples.

Over-analysis leads to paralysis

The last subject I wanted to cover on this is the issue of overanalysis. As with many things in life, I find the 80:20 rule applies to investing as well. I can usually get 80% of the way to understanding an investment opportunity in the first 20% of the time I dedicate to it. After that, there is a definite law of diminishing returns. Also, sometimes I can spend so much time trying to consider every detail I end up losing perspective.

As a fund manager, analyst, or private investor, we are in the business of estimating the future potential and risk of an opportunity. There are too many unknowns to be able to accurately model every factor, so you reach a certain point where increased precision of forecasts doesn't get you anywhere.

For this reason, I prefer to keep the number of investments relatively focused and make sure I have a thorough understanding of the main levers that will affect valuation, rather than all minutiae.  This helps me keep tabs on my safety margin, while still allowing me to see my family occasionally.

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To read a brief outline of how I think about stocks, and what I aim to achieve in this blog, please check out my first blog where I set out my stall.

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Please Note: To be clear, I do not and will not ever give any advice. I will rarely mention individual stocks but when I do these will not be recommendations, instead just my thoughts at that point in time.