Part I

Stretching our mind

Man’s mind stretched to a new idea never goes back to its original dimensions.

Oliver Wendell Holmes

Most of us have learned to make decisions in a haphazard manner based on doing what comes naturally. However, research in the new field of behavioural finance has shown that our natural instincts often do not serve us well. Once we are introduced to the common cognitive biases in the way we make decisions, we will never look at the investing process the same way again.

Chapter 1

Shaping our destiny

It is in your moments of decision that your destiny is shaped.

Anthony Robbins

I am a very keen reader of books and articles about investing. In particular, I love reading about the great investors, those who consistently achieve outstanding returns that make them and their clients very wealthy. After all, if we want to be better investors, our best models are those with a proven outstanding track record.

The more I study the great investors, the more I am struck by the way the quality of their thinking seems to be superior to that of the ordinary investor. I find that the great investors have several key attributes that, in combination, lead to outstanding results and to their classification as outstanding investors:

• Education. This is a must. A very few have been entirely self-taught, but most will have a tertiary qualification, usually at postgraduate level. Moreover, they maintain their level of education over their career in all sorts of ways, both formal and informal.

• Intelligence. They tend to be of above-average intelligence but do not have to be in the genius class, which can, in fact, be a handicap. Modern finance is not easy to understand and conceptualise. It requires a great deal of deep thinking over many years.

• Experience. Great investors do not just burst onto the scene. They ripen over time. They develop a great depth of knowledge about how markets work and what has happened before and have honed their skills under pressure in the markets.

Out of all this, the great investors seem to learn to think in ways that are quite different from those of the average person in the street who is trying to invest his or her savings.

When I read about decisions great investors had made that led to their investment success, I found that their decisions often seemed to be counterintuitive. This puzzled me for years. Warren Buffett, one of the greatest investors of my lifetime, started to help me put my finger on it when he wrote in his famous preface to Benjamin Graham’s investment classic The Intelligent Investor: ‘What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework’.

For a while I thought this was the key I had been looking for: to master the market we have to learn to master ourselves. It seemed that the solution was to be so coldly logical in every decision that I shut out my emotions by the sheer power of my logic. However, while this was a part of the puzzle I was grappling with and was a big step in the right direction, it was very difficult to implement and did not seem to provide the solution that I was seeking.

What still puzzled me was exactly what my emotions were and why decisions made by the great investors, which I read about, seemed to be counterintuitive rather than simply logical. Then one day the light came on for me. I came across what is called behavioural finance or behavioural economics. What I was calling emotions were in fact a whole set of cognitive biases in my thinking.

Since 1971 a tremendous amount of research has been done into the way people make decisions. As an economist, I was trained to assume that people always made decisions to logically maximise their personal gain in whatever situation they were in. From the research that has become behavioural finance, I have learned that people are far more complex than that and in fact do not always maximise their possible gains in investing or in life generally.

Instead I found that, when faced with a decision about something, we use shortcuts or heuristics. A heuristic is a rule of thumb for solving problems. For example, if a married couple are both blond-haired, we assume that their children are likely to be blond. Quite frequently these kinds of heuristics will be reliable guides and we will make sound decisions based on them. This is likely to be even more so when the heuristic is founded on experience formed over many situations over many years and becomes intuition. This is why experience is so important in investing: we develop intuition-based heuristics that avoid the common cognitive biases we are seemingly born with.

However, common heuristics and intuition that are not always well based on experience can lead us to make very poor decisions, because we are all prone to a wide range of cognitive biases when we make decisions. The Nobel Prize winners who began this new field of study have provoked wide-ranging research, which has meant that I have greatly improved my decision-making methods.

I began to study the cognitive biases that had been explored in the research and time after time I found them in myself. More importantly, I found that they began to explain the apparently counterintuitive thinking behind the decisions made by the great investors who I read about. Gradually I came to realise that their counterintuitive decisions could often be explained by the fact that they avoided many of the cognitive biases to which we are all naturally prone. This was partly because they had developed better intuition from the depth of their experience, which was greater than that of inexperienced investors. However, it was more than that: they also seemed to have developed an awareness of, and an ability to avoid, many common cognitive biases when they made decisions.

As a result of the pioneering work of the behavioural finance researchers, there is now a body of knowledge that can give us valuable insights into the task of making investing decisions. Many of these ideas were quite challenging to me at first, as they will be to you. However, once I became aware of some of the common cognitive biases in my thinking, I began to make better investment decisions and my returns began to improve. Not only that: I also saw the cognitive biases in my own thinking and that of others around me in all facets of life.

Decision making is right at the focal point of investing. No investment exists until we make a decision. No investment is successful unless we also make a series of sound decisions in managing it. We make the best decisions when we understand what is happening inside our minds and avoid the natural cognitive biases to which every one of us is prone, but which the great investors seem to know how to avoid.

My personal aim is to keep honing my thinking skills in order to come closer to being a great investor. How close I come is an unfinished story.

I have stressed two things in this description of my journey to writing this book:

• The common cognitive biases in our thinking are very natural. They never feel wrong to us.

• We are all prone to these cognitive biases to a greater extent than we imagine. It is not a criticism of us; it is just how we are made as human beings.

I have found that the initial step to dealing with our cognitive biases in investment decision making is to become aware of them. It is not until we know they exist that we can recognise them and start to deal with them. Therefore, a large part of this book will be devoted to a description of the various cognitive biases that can be present in the way we make investment decisions.

I have also gradually developed strategies for avoiding and countering many of these cognitive biases. These will be described after I have introduced each cognitive bias in our thinking in part I. Many of the strategies are effective in countering more than one cognitive bias, so some of them will appear several times, perhaps with a different emphasis.

I hope that having these strategies to work on will offer a roadmap to follow on our progress to becoming great investors. I invite you to join me on the journey.