One of the more difficult things you human investors have to deal with is how your own heuristics, biases and cognitive deficits impact your views. It is how you are wired, a flaw in your wetware, and it consistently trips up your results.
I am not referring to the obvious sentiment extremes — greedily buying in at major tops and selling in a panic at lows. Rather, I am referring to the more insidious ways your brain betrays your objectives as an investor.
I have been exploring this theme for the better part of a decade, and the science has caught up and past many of our worst suspicions. What I am referencing goes beyond Behavioral Economics, which teaches us that the rest of the professions’ basic underlying assumption is in error: No, Humans are not particularly rational economic actors.
The newest research in Cognitive Neuroscience reveals misleading and incomplete our constructs of reality actually are. What we believe to be true is often far removed from what actually is.
And, it gets worse: Once we have a point of view, especially as a result of owning a position, we are even more inclined to misunderstand the inputs the world presents to us. This typically works to the detriment of our investing performance.
This morning, I want to discuss three examples of these biases:
1. Talking Your Book: This is a classic example of seeing the world through a lens of your own holdings. You want them to succeed, you root for them to go higher, and this bias impacts your view of everything that occurs around the positions.
It still surprises me when I see examples of this bias revealed by some of the world’s best investors. Warren Buffett owns the largest stake in America’s largest mortgage lender. In his annual letter, Buffett claims that banks were “Victimized by Excesses of Ousted Homeowners” who emerged as winners in the foreclosure process.
Objectively, banks made loans to people they never should have. They abdicated traditional lending standards because they expected to sell them so quickly the loan quality was irrelevant. These same banks went on a forgery spree, engaging in institutionalized fraud.
What do you think was behind Buffett’s WTF moment? Might it have been brought to you by his frustration with a position that perhaps is not working out so well?
2. Looking for Confirmation: How many times have we seen a particular point of view reflected not by the facts on the ground, but by the inherent bias caused by specific holdings. The most illustrative example these days is inflation as spotted by holders of Gold.
The Fed is causing not just inflation, but hyper-inflation! Its coming, its here, look at the price of everything going higher!
Except, not so much in the data. But medical care prices are skyrocketing! They have been going up for 2 decades, long before QE. Look at Gasoline prices! Does US/Israeli/Iran saber rattling have anything to do with that? And, gas is still cheaper than pre-crisis peaks.
When you own a specific position, its not just that you see the world differently — you actively hunt out information that confirms that position, while ignoring data that contradicts it.
3. Expressing Political Views via Portfolio:
There is a sub group of commentators I always find intriguing: The Political Economists. This is a set of people who see the world not through the lens of their portfolio holdings, but rather through the holdings of their political views.
The danger of this perspective is to you, the investor. These folks do not care about economic expansion, earnings, or your portfolio gains. They are only concerned with the next election.
We were treated to a world class, Harvard Business School case study example last month when NonFarm payrolls were released. CNBC’s Rick Santelli went through incredible contortions to explain why last month’s surprisingly good NFP report was actually terrible. I suspect a similar bias is why Fox Business channel has failed to become the ratings bonanza that Fox News is: Relentless negativity in the face of a 3 year, 106% SPX rally makes for poor ratings.
The 3 pounds of 1o0 billion or so neurons sitting atop your spinal cord is the result of millions of years of evolution. You are likely stuck with your grey matter, and its inherent foibles. We cannot rewire our brains; at least, not anytime soon.
If portfolio managers and investors can at least develop an awareness of their own biases, it will help them understand when they are making decisions based on factors other than their trading methodology.
Indeed, the most one can hope to accomplish is to be enlightened enough to have some degree of self-awareness as to these biases and cognitive deficits. That allows you to at least recognize, and perhaps compensate for, your own errors. Smart investors can quarantine money-losing political pundits as investing news sources.
But, putting politics aside, investors should always seek out different investing perspectives from their own. This include reading economists with differing views, and portfolio managers more bullish and bearish than they — if for no other reason than to understand the other side of your investing thesis.
Its too expensive not to . . .
Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data, ability to repeat discredited memes, and lack of respect for scientific knowledge. Also, be sure to create straw men and argue against things I have neither said nor even implied. Any irrelevancies you can mention will also be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.
These touch on a biologically rooted issue which gets little attention but will eventually be understood as the source of much more trouble in scaling a civilization than we realize…
Issues in Scaling Civilization: The Altruism Problem http://culturalengineer.blogspot.com/2012/02/issues-in-scaling-civilization-altruism.html
“When you own a specific position, its not just that you see the world differently "” you actively hunt out information that confirms that position, while ignoring data that contradicts it.”
Insert photo Mish Shedlock here…..
One way of dealing with such biases is to be a systematic (e.g. trend following) trader. Works for me.
Completely off topic but have you read the rest of the Buffet letter for 2011? http://www.berkshirehathaway.com/letters/2011ltr.pdf
I particularly like his view on Gold.
“Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce "“ gold's price as I write this "“ its value would be $9.6 trillion. Call this cube pile A.
Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?”
IOW Pile B spits out $840 billion per year recovering the investor’s initial outlay in 11.4 years…Pile A? And it will keep spitting out money thereafter…Anyone’s guess when that pile will double in value.
he continues:
“Beyond the staggering valuation given the existing stock of gold, current prices make today's annual production of gold command about $160 billion. Buyers "“ whether jewelry and industrial users, frightened individuals, or speculators "“ must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops "“ and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.”
Talking Point ………… Waiting for the Pull Back ! Waiting for the Pull Back!
Pure Kahneman. What a terrific book his is by the way.
~~~
BR: Just finished James Gleick’s The Information, Kahneman is next up in my queue!
Terrific post today Barry!!!!! In golf: “be the ball” with portfolios: “be agnostic”
Guilty as charged counselor! Can you give us a list of competing, contradictory, reasonably reliable information sources that we should intently review and incorporate into our thinking process….
Where were you when I was swinging $100m around a day as head trader of a v large hedge fund? This would have saved me millions.I made enough to retire at 45, but you could have saved me 7 years.
I still trade, but now, its for fun
Thanks for the kind words
The tricky part is whether you would have listened to me 5 years ago
i explored this with regard to debt and interest rates few days ago. Very obvious that 2 concepts are not challenged from a view standpoint. 1) debt is bad 2) interest rates would be higher if not for Fed. NEVER challenged in media..EVER. When 70′s explosion and 80′s 90′s mean reversion is “folded out” of a 10 yr yield chart (back to the 40′s and 1900)..yields are not abnormal. yield negativity is a Fed influence but nominal yields,,meh. The debt bias continues to move back the line like Bugs and Elmer…debt gearing ratio way more important than level..Say’s Law
“Talking Your Book” is an nice example of the Endowment Effect (“What I own is more valuable”) and Loss Aversion combined with “What You See Is All There Is (WYSIATI)” (from Kahneman’s new book "“ highly recommended). Voila, Warren Blindness.
Add (the ever popular need for the) Illusion of Control and you too will find yourself “Looking for Confirmation” (bias).
But the best is for last. Owning an idea (or ideology) is the cognitive equivalent of owning a position. (“I have a _____ .” Even more difficulty to extract oneself from is being one (“I am a _____ .”) We’re back to WYSIATI with a dollop of the Self Serving Bias (“It is difficult to get a man to understand something when his salary depends on his not understanding it.” – Upton Sinclair) and (pundit) Herd Effect thrown in for good measure. Millions of _______ can’t be wrong.
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