Behavioral biases introduce subjectivity and limit objectivity; be aware of them, and overcome them. Failure is not a failing, but an opportunity for learning.
Avoid bias in research; seek to invalidate, not validate. Question what does not add up, not what does.
We confuse correlations and causation because we are wired for pattern recognition and neat explanations, even if they are misguided. These human instincts are great for survival but not for investing. These default factory settings need to be reset.
Failure Is Not a Failing If You Make It an Opportunity for Learning
Throughout the centuries, our species has singularly and spectacularly overcome its weaknesses. We have not only survived but prospered. Our early ancestors knew that other members of the animal kingdom outclassed them because they were faster, stronger, and better armed with claws, teeth, or muscles. Yet it was only by recognizing this overwhelming disadvantage that we were able to conquer the enemy. Instead of being handicapped by our weaknesses, we rose to the challenge. We figured out that the smart move was to avoid hand-to-hand combat with the predatory animals, because that would play to the enemy’s strengths and our weaknesses. We applied our brains to make sharp tools as projectiles (with bows and arrows) to kill the enemy from afar because it was critical to maintain a safe distance. The predators now became the prey. They did not even see what was coming; the unexpected speed and distance of the projectile became their blind spot. We vanquished them before they could even put up a fight.
We know what happened next. The hunters fed on the rich animal protein, which further reinforced their brain power, leading them from strength to strength. Thousands of years later, our brains have been responsible for astonishing inventions, discoveries, and incredible progress. Our species is a triumph of brain over brawn.
“Failure is not a failing if you make it an opportunity for learning.”
But our brains can also play mind games with us, sabotaging our own best interests. This chapter will hold up a mirror to reveal the enemy within. It exposes flaws that we often believe to be our fortes. While you may not relish knowing your flaws, failure is not a failing if you make it an opportunity for learning. And that is exactly how you should think about your behavioral shortcomings—not something you succumb to, but something to surmount.
Behavioral Biases = Mental Shortcuts and Faulty Wiring
Our brains are wired all wrong when it comes to making sound investment decisions. We have been programmed for survival, not soul-searching. The brain consumes the most energy of any organ in our body, so evolution has designed it to be efficient. For example, we are endowed with quick pattern recognition to make life-or-death decisions instinctively, as in our fight-or-flight response. But what helps in life hurts in investing when our hardwired decision tools play mind games and turn into behavioral biases. Academics give fancy labels to them, from the planning fallacy (poor planning by assuming best-case scenarios) to the endowment effect (overvaluing what one owns versus what one does not). In plain language, behavioral biases are nothing other than mental shortcuts that our subconscious mind uses to make fast decisions.
There is no escaping human biases when it comes to investing. We are genetically predisposed. However, we can train our reflexes to serve us instead of hindering us. This chapter shows how you can transform these behavioral vices into virtues. At that point, you take advantage of innate biases rather than suffering from them.
Flaw #1. Jumping to False Conclusions: The Availability Bias
This bias is easy to understand but difficult to defend against. Our brain relies on pattern recognition to form quick assessments of circumstances. It often extrapolates the recent past to forecast the near future. It is especially partial to what academics call the availability bias—using readily available information even if it is irrelevant.
The widespread use of price/earnings (P/E) multiples to determine valuations is a good example. Even though earnings multiples are in many ways flawed, inaccurate measures of value, investors routinely use them because they are readily available. On the other hand, even though free cash flows are the more relevant determinant of intrinsic value, they are not widely used because they are harder to calculate and therefore not readily available.
The human brain defaults to shortcuts. The necessity of making split-second survival decisions has programmed the brain to prioritize speed and ready availability over everything else. Fast-moving ticker tapes and TV shows with titles like Fast Money are designed to appeal to our baser instincts. Resist the urge. Investing is a marathon, not a sprint. Before you form any investment conclusion, take the time to collect all the facts, contextualize them, identify any disconnects, and resolve them.
Early in my career, I made this mistake while researching companies. I would devour copious amounts of research that was readily available—sell-side research, annual reports, investor presentations, news articles, and on and on. I felt I was being diligent and rigorous. But when all this effort did not result in investment ideas with a compelling value spread, I soon realized that all I had done was to review information that led me to the consensus view rather than formulate a non-consensus one.
The Fix: Go Outside the Sandbox
I went outside the usual sandbox. I searched out ideas from a wider range: academic papers, interviews with key division heads in specialty trade publications, books written by former employees of companies I was researching, memoirs of former CEOs, case studies of analogous challenges faced in other industries, and so on. I began to understand businesses from the inside out rather than the outside in. This helped me ask the right questions, which led me to the correct and often non-consensus answers.
For example, I considered investing in companies that had won power-project contracts in Asia in the late 1990s. The readily available information was this:
1. There was an acute shortage of electricity, but governments lacked money to invest in multi-billion-dollar power generation infrastructure projects.
2. The lack of infrastructure was proving to be a big bottleneck to GDP growth and affecting quality of life.
3. To incentivize foreign investment, many governments such as those in China, Malaysia, Indonesia, and the Philippines set up private-public partnerships (PPPs) with high guaranteed rates of returns.
4. The logic was so compelling and the guaranteed returns so mouthwatering that there was a gold rush for these investment opportunities.
5. Many institutional investors, such as U.S. university endowments, invested in these PPPs. Retail investors who could not invest directly in them latched onto this gravy train vicariously by owning stocks in companies that were winning the contracts, such as Hopewell Holdings, which was listed on the Hong Kong Stock Exchange.
Clearly, the readily available information suggested this was a win-win, with both governments and investors acting in rational self-interest. As an early student of behavioral finance (which studies the role and impact of human biases in investing), I knew I should look beyond the readily available information. I looked for PPPs in other industries and found that they were commonplace in building highways and bridges—often referred to as toll road projects. My findings startled me. There were far more failures than successes. Often, when consumers found out about the high tolls they had to pay for using the roads, they protested, forcing governments to capitulate and default on the contracts. Or the builders faced massive cost overruns, which the contracts did not cover, causing losses for shareholders and defaults on bondholders.
I feared a similar predicament awaited the PPPs in the power generation sector and avoided them. My concerns proved well founded. The gold rush turned into a minefield. Many governments went on to renegotiate or renege on those PPPs when costs proved too prohibitive. The endowments, as well as infrastructure stocks such as Hopewell Holdings, took big write-offs on their investments. On the other hand, my dollar saved became my dollar earned.
Flaw #2. Falling Victim to Vividness: The Recency Effect
A close cousin of the availability bias is the vividness/recency effect. It is the tendency to measure frequency by our ability to think of examples, which in turn produces a tendency to overweight recent developments. For example, we believe flying is less safe after we see news of an airplane crash on TV. Even though the belief is baseless, it rings true because of the vividness of the imagery.
The recency effect is very similar. The human mind extrapolates recency into certainty. If you recently made money in the market, making money suddenly seems more likely or even a sure thing, even though reversals are just as likely. There is a 50–50 chance that the market could go down just as much as it could go up, but our brain believes otherwise because today’s headlines overshadow more distant memories.
This effect often manifests itself in pro-cyclical asset allocation decisions. When emerging markets do well, investors flock to them. When the markets correct, the investors rush for the exits. When international equities do poorly versus U.S. equities, many investors lament the underperformance and switch over to what’s working only to lose out or get whipsawed when the situation reverses.
The Fix: Think Long Term
Extend your time horizon and think long term. Ask what can go right when everyone around you is worrying about what can go wrong. It will help you make a balanced decision and stay the course. Long-term patient investors (and I am one) recognize the recency effect for what it is and tend to resist its pull. But it can be very seductive. Early in my career I made the mistake of having business news shows running in the background on my computer. The streaming headlines led me to subliminally focus on topical newsflow that explained recent developments or price action rather than inputs that affected the intrinsic worth of the business.
The fix was simple. I no longer watch live TV. I stay abreast of day-to-day news by reading newspapers instead of watching on the big screen as the vividness effect is a close proxy of the recency bias. (Moving images and sound are more vivid and tend to draw the viewer in emotionally while words tend not to have the same impact and allow one to consume information more dispassionately.)
Flaw #3. Monday-Morning Quarterbacking: Hindsight Bias
It is easy to believe we are smart when we make the correct call after the fact. I call it the “but of course” bias; academics call it the hindsight bias. You may recognize it as the Monday-morning quarterbacking syndrome.
Observed outcomes appear inevitable and predictable. If you already know which team won, you can look back and think the victory was inevitable and therefore predictable. Likewise, many who invested in Apple purely by fluke believe they just knew (with or without research) that the company was going to be a spectacular success story. They now view themselves as savvy investors, which may prove dangerous when they try their hand at picking the next Apple. Luck and skill are not the same thing.
I made this mistake myself when I invested in some stocks in the mid-1990s. I thought I had made the right call because they went up a lot. Fact of the matter is I did not have a good grasp of their business models or intrinsic values, but I thought I did because I made money. Several years later, when the air came out of these stocks, I got whipsawed by their volatility, not knowing whether I should double up or quit, as I had no basis to anchor my investment decisions. (This also goes back to the concept we learned in the previous chapter of markets rewarding correctness, not confidence.)
The Fix: Parse Luck from Skill
To give yourself a much-needed reality check down the road, take time to investigate before you invest, write down your investment theses and quantify your qualitative expectations in a spreadsheet. Then track how things are going in the business versus how you modeled it. This will enable you to separate out the luck from the skill. Most professional investors do this.
Flaw #4. Banking on Best-Case Scenarios: The Planning Fallacy
We all know that when the stakes are high, we should not count on the best-case scenarios, but instead plan for the worst. Yet most of us hope for the best and tune out the rest. In investing, such wishful thinking can prove problematic. I don’t know anybody who can afford to play Russian roulette with their life savings. This is why we must insist on a margin of safety in our investments: it’s like having insurance against large losses.
I made this mistake with a family-owned food products company. The company was enjoying great success in its dairy products’ division as yogurt consumption was witnessing a resurgence among Western consumers. However, growth stalled when regulatory authorities stopped the company from advertising unsubstantiated health claims of probiotic benefits in its yogurt. I had assumed that they would launch other products or market them differently, to offset this headwind. Instead, they chose to be acquisitive and bought growth instead of achieving it organically. They acquired a high-growth infant-nutrition business, at what I judged to be an extremely high valuation. To make matters worse, they funded this expensive acquisition by taking on loads of debt.
I had fallen for the planning fallacy. I had not considered the possibility that they would satisfy their growth envy through acquisitions, no matter how expensive or risky. I had assumed that because the management was also the largest shareholder, they would be excellent stewards of capital. But simply being aligned with shareholders is not enough for the best outcomes. Even well-intentioned, well-incentivized management teams can make mistakes in allocating capital. It was clear that I should have considered worst-case scenarios, not just planned on the best case. The company remains highly indebted, and the stock has had no traction for about a decade ending December 2018, a period when most equity markets around the world have appreciated considerably.
The Fix: Play Devil’s Advocate
I believe in debating my investment theses with someone else who plays the role of a devil’s advocate to weigh the strengths and weaknesses of an investment case. By the way, this is not an original idea—I borrowed it from the world’s greatest investor, Warren Buffett. In my opinion, Charlie Munger is Buffett’s de facto sounding board and devil’s advocate, whether he sports the title or not. Frankly, it is what we all do in our daily lives—naming a designated driver when we go out drinking. Similarly, the job of the devil’s advocate is to stay sober and balanced, even if the person advocating the investment case has had one beer too many.
Flaw #5. Overvaluing What You Possess, or Denial on Steroids: The Endowment Effect
The endowment effect is the tendency to overvalue what you own over what you do not. It means rationalizing a decision once it has been made, whether or not it was made on valid grounds.
The endowment effect can dull the brain. We get lulled into a comfort zone and stop scrutinizing our holdings. Growth managers often fall in love with their high-flying stocks, justifying their rich valuations by endowing them with qualities that are easy to pitch, even if they do not truly exist. This flaw comes back to haunt when growth disappoints and the stock craters. Complacency is not a good reason to continue owning overrated stocks well past their prime.
The Fix: Practice Zero-Base Thinking
This flaw can be fixed using the same idea management consultant Peter Drucker used with GE’s CEO Jack Welch. Drucker challenged Welch: “If you weren’t already in this business, would you enter it today? And if the answer is no, what are you going to do about it?” That single question reset the trajectory of the company. It transformed the way Welch thought about running a conglomerate. Likewise, you should ask yourself a similar question: “If I didn’t own the stock already, would I buy it today?”1 This is known as zero-base thinking.
Many hedge-fund managers guard against the endowment effect by forcing preset stop-loss limits on trades. They automatically sell the stock when the limit hits. The manager can then reassess whether to reinstate that position by buying it back. Some would regard this as suboptimal from the standpoint of transaction cost: it costs money to liquidate and reinstate a position. But the smart money considers it a small price to pay to guard against the larger cost of suffering from the endowment effect. In fact, because the benefits can outweigh the costs, in many hedge funds this is a standard risk-management policy.
In hindsight, I suffered from this syndrome when I owned Ericsson in the mid-2000s. Ericsson makes telecom equipment that carries about 40 percent of the world’s mobile-phone traffic. Its base stations allow mobile phones to access cellular signals so we can make phone calls or surf the internet while on the move. A key element of my thesis was that the company would benefit from consolidation in the industry, and both revenues and margins would improve. This seemed a reasonable assumption, given the demise of Motorola and Nortel and the mergers of Lucent-Alcatel and Nokia-Siemens. Unfortunately, it did not play out as I hoped. Stiff competition came from Chinese vendors ZTE and Huawei, who were willing to offer ultra-low pricing to gain entry into the global market, even at the expense of profitability.
As it happens, I was aware of this threat. However, I did not take the competition seriously because Ericsson’s management led me to believe that their technology was a differentiator and their costs were competitive. I also liked management’s strategic pivot toward offering professional services—persuading their telecom customers to outsource the running of their wireless networks to Ericsson. The computing world had found success with outsourcing back-end infrastructure, so it seemed logical to assume the same benefits would apply in the communications’ networking world.
Sadly, that did not prove to be the case. Unlike IT customers, who are numerous and can derive scale benefits from outsourcing, telecom companies are a small handful, no more than three to four in any given country. So unless everyone in that country outsourced, there would be low to no synergies. Last but not least, the largest telecommunications companies typically had a large and long-serving employee base, so their severance and pension costs were prohibitively expensive. This meant they had a disincentive to outsource.
I wanted to believe that the company was well positioned, but there were growing signs that my thesis was not holding up. Despite management’s assertion of technological superiority and cost competitiveness, I had noticed that the Chinese company Huawei was winning contracts with big customers such as British Telecom. When I questioned the management of Ericsson about this potential threat, they dismissed the win as small potatoes; the contract, they pointed out, was for a tiny territory like the Isle of Man, a mere outpost for British Telecom. What they (and I) did not realize is that those small wins were test beds to secure learning curves; they turned out to be precursors of larger contracts down the road.
Even though I suffered from the endowment effect and believed in the company’s capabilities and strategy, I did not suffer from confirmation bias (see Flaw #10). I kept looking for evidence that undermined my thesis. Once I had gathered enough evidence to the contrary, I sold the stock in 2006 and 2007, even though it meant taking a loss. That decision proved to be the right one. A decade later, the company and its stock have continued to struggle (figure 9.1).2
FIGURE 9.1 Share price performance: Ericsson, 1/31/2007–12/31/2018. Source: Thomson Reuters.
Flaw #6. Ignoring a Wrong Instead of Righting It: Loss Aversion
This is a close cousin of the endowment effect, and the antidote is the same. People resist taking losses on failed investments because they do not want to acknowledge failure or defeat. To make matters worse, instead of quitting, they often double down. Cutting your losses ensures two salutary outcomes: you learn from your mistakes, and you spare your portfolio further damage from an investment that is headed south.
The best way to figure out if one is wrong, rather than simply ahead of others in an investment call, is to compare how the underlying business is performing (as opposed to how the stock is performing) versus one’s expectations in the original investment thesis. If the business (not the stock) is tracking my expectations, I hold onto or even average down on my investment. However, if it is performing worse than my expectations, I force myself to rethink my thesis and apply the fix discussed below. As we have seen throughout this chapter, the worst part of a mistake is not the mistake itself but how soon you identify it, acknowledge it, and address it. Loss aversion only compounds one’s mistakes.
The Fix: Acknowledge Reality and Cut Bait Quickly
Over the past few years, many value investors have continued to cling to their investment in the hitherto successful but now troubled British food retailer Tesco, hoping that a new management with a different strategy will restore the company’s profitability. This behavior stems from both anchoring (past success is etched in people’s heads, described next) and loss aversion (denial).
Initially, in 2012, I shared this view. By 2014, I changed my mind as new facts emerged. I realized that the competitive dynamics of the UK market had permanently shifted and management’s profit targets would miss by a mile. Tesco’s hypermarket formats would struggle to compete with the biggest hypermarket in the world (Amazon) in general merchandise as well as with discounters (Aldi and Lidl) in groceries. Consumer preferences for choice and low cost were met by these two distribution channels, which sat at opposite ends of the spectrum. Tesco sat in the middle and got squeezed by both. In response, it embarked on a major cost-cutting program to restore competitiveness and win back customers. However, contrary to what management had guided, even if it worked, profit margins and profits would reset to a materially lower level and stay there. What made matters worse is that the company tried to disguise or delay acknowledging these profit shortfalls by extracting unfair and unsustainable rebates from suppliers and reporting earnings that had not really been earned. The poor quality of management decisions raised corporate governance concerns in my mind. The returns were falling while the risks were growing—the opposite of the attributes I seek. I saw the writing on the wall and cut my losses by selling out of my position. Better to acknowledge that my thesis had been busted and cut bait to redeploy the proceeds elsewhere.
I mentioned before that failure is not a failing but an opportunity for learning. I zeroed in on the root causes (there were many). A key lesson was that the hypermarket/supercenter format was structurally vulnerable to the threat from e-tailing, and therefore best avoided. To apply this learning, I identified many other retailers in the world with similar formats and competitive dynamics and made a note not to own them.
Flaw #7. Clinging to the Past and Being Slow to React to Change: Anchoring Bias
You are stuck in the past, refusing to admit that things have changed. In the case of investing, it means fixating on a certain point of view.
Many companies generate high profits when times are good, not necessarily because the company itself is good. When the tailwinds turn to headwinds, the company flounders. The mind takes time to process this changed reality. Academics call this anchoring—the tendency to adjust prior estimates insufficiently when presented with new information. In simpler terms, it means human beings are slow to react to change and prefer to cling to a point of view even though it is no longer valid.
Many investors prefer to invest in industries that do not change, such as consumer staples. Actually, I think it may be time for these investors to change. Change is inevitable, but the anchoring bias is preventing investors from sizing up and pricing in the emerging risks in the sector. Instead of glossing over these risks, one should take a hard and honest look. The price transparency on e-tailing platforms such as Amazon is giving a headache to manufacturers of branded goods. For instance, it is commonplace for the same product to be priced higher in the convenience store channel than the supermarket channel, which in turn would be higher than the price charged at a warehouse club. However, the days of easy markups and price discrimination among different distribution channels may be behind us. In the online world, the consumer is king. Consumers can readily search for the product with the lowest price and highest value, marginalizing retailers and manufacturers who do not adjust to this new paradigm. Eventually, investors will be forced to question whether the pricing power that anchored their favorable investment view of the “fast-moving-branded-consumer-goods” sector still holds.
Historically, established branded-goods companies had the upper hand in securing distribution, as shelf space is scarce in a retail storefront. But in the digital arena, shelf space is unlimited; anyone with a compelling product can reach consumers. The distribution access and advantage that only big brands once enjoyed is fading.
Big advertising budgets used to be another barrier to entry for upstart brands. But in the digital world, a one-to-one marketing campaign is eminently feasible. In this paradigm, not only is advertising expense far lower, but it is a variable expense and success-based. The large upfront costs incurred by the behemoths on prime-time TV, with their hit-or-miss results, are becoming hard to defend.
Branding used to be a huge competitive advantage for consumer-staple companies. However, millennials are proving more resistant to advertising and tend to be influenced by user reviews and transparent side-by-side product comparisons, which are readily available online. The opportunity to charge large premiums on branded consumable products with generic quality are shrinking, as trusted retailers and e-tailers offer their own private-label alternatives.
Anchoring bias may be preventing investors from seeing this changed reality. Consumer staples still trade at large premiums despite the emerging threats. This is no different from many brick-and-mortar retailers who ignored, then resisted, the emerging omnichannel world. By the time reality caught up, many business models and stocks had been decimated.
Investors in many former blue chips suffer from this syndrome. Consumer-staple stocks such as Kraft Foods (which merged with Heinz Ketchup) come to mind. In February 2019, Kraft’s owner, 3G Capital, announced a massive write-down as cost cuts failed to offset declining revenues. Investors finally saw the writing on the wall, and the stock collapsed by more than 25 percent in a single day.
Anchoring represents an innate human desire to ignore change in the hope that it won’t happen, using denial as a coping mechanism.
The Fix: Adopt Clean-Slate Thinking
To overcome this bias, it is best to appoint someone else to do clean-slate research so that original or contradictory points of view emerge. That person needs to be ruthless and relentless in looking for information that invalidates, refutes, upends, or discredits any or all beliefs about company X. For individuals who don’t have someone they can count on to play this role, perhaps an investment club might be a good forum for such a debate (although investment clubs are not a panacea as they can be a case of the blind leading the blind—be sure to enlist someone who has the expertise to understand industry trends and also apply that knowledge to specific companies and what is priced into their stocks). Or you can role-play, using the techniques described later in this chapter, and make a concerted effort to look for information that negates your views.
The Opportunity: Turn This Behavioral Vice Into an Investment Virtue
Because many investors can be slow to react to changes in a business, even one that is improving, you can take advantage by being early in such investment opportunities. Not only does this offer high returns, but it can also come with low risk. That’s because bad news is expected and priced in, while good news is not. Here is an example.
For several decades leading up to the mid- to late 2000s, the auto-components sector had rightly been regarded as a dog of a sector. A fragmented supplier base had a poor bargaining position against a concentrated original equipment manufacturer (OEM) customer base. Reflecting this weak position, the sector had traditionally traded at a large discount to the market. However, as more electronics began to be embedded in a car, many auto components were no longer discrete parts but part of a larger system solution glued together by software rather than nuts and bolts. Suppliers who were part of such tightly integrated system solutions could not easily be swapped out, which gave them greater pricing power. This improved bargaining position would eventually result in better profit margins for those companies, but the markets were anchored in their old point of view and slow to price in this change. Astute investors could exploit this bias just as we saw in the case of Harman, the misunderstood and mispriced auto-components company described in chapter 8.
Flaw #8. This Emperor Has No Clothes: Relying on Intuition Over Data
Billy Beane confronted this syndrome in baseball, where team owners lost both games and money by basing their decisions on instincts instead of information. Listening to your gut instead of checking the facts is what academics describe as intuition bias: relying on intuition over data.
Sometimes headlines seduce you into believing there is substance when there is only sizzle. Many people buy companies that advertise during the Super Bowl, confusing familiarity for fact-checking. In the same vein, many investors think if they like a company’s product, it must be a great investment as well. GoPro is a great action-adventure camera, but that does not necessarily make it a great investment. Like many consumer-discretionary products, it can face severe ups and downs. In fact, GoPro stock has crashed, even though their cameras work just fine. The growth rates and profit margins proved unsustainable, and when the business did not perform to the lofty expectations priced into the stock, it fell hard from a peak of $87 in late 2014 to a low of $4 in late 2018.
The Fix: Collect and Connect Information
Take the time and make the effort to collect the relevant data to make a well-informed decision. But be careful not to go overboard. As we will see in the next section, too much data collection can itself be a behavioral flaw.
Flaw #9. Knowing Less Than You Think You Know: Overconfidence Bias
Of all the personality traits we tend to value and envy, confidence leads the pack. We are told to raise confident children, be confident in our careers, approach new situations with confidence, wear our clothes with confidence, and so on. Yet confidence contains the seeds of big problems, which begin to sprout when healthy self-esteem turns into overconfidence and arrogance.
In fact, you might call overconfidence the original sin of investing. Thinking we know more than we do, certain that we are right, works against having the humility—or the common sense—to know when our judgment is off. Several landmark studies have shown that most people think they are above average—obviously impossible. Sometimes called the superiority illusion, this tendency manifests itself as overconfidence.
Human beings are prone to overestimating what they know and underestimating what they do not know. Confucius put it best when he described knowledge as knowing the extent of one’s ignorance. The worst part of this behavioral flaw is we do not know what we do not know. So we underestimate the uncertainties of the future and invest as if we knew all there is to know. Such blind faith leads us to bet the farm on investments that appear to have great promise because we ignore what can go wrong.
In the mid-2000s, many investors were so convinced of the super-cycle in commodities that they poured money into this sector, only to lose vast sums of money when the seemingly surefire bet unraveled. Many portfolio managers fell prey to overconfidence and converted their hitherto diversified portfolios into a concentrated thematic bet, overweighting anything directly or indirectly linked to commodities, such as copper stock Freeport-McMoRan, or a country linked to the commodity such as Chile. Just a decade prior, investors had made the same wrong bet in overweighting tech stocks, especially internet stocks. Of late, in my opinion, that insanity has found a home in loss-making unicorns which are going public at egregious valuations as investors buy into hyper growth rates lasting far out into the future.
Sadly, just as trees don’t grow to the sky, most hyper growth companies flame out instead of meeting or beating expectations (as we saw earlier with the GoPro stock example). Excessive optimism is usually a marker of overconfidence, not a plausible real-life scenario. High multiples are often a manifestation of high confidence, not high earnings prospects. This often proves to be the undoing of growth investors, who tend to suffer from this bias more than any other kind of investor. In fact, high growth is the exception, not the rule, yet investors routinely overestimate growth. The commonly used valuation method, discounted cash flow (DCF) analysis, turbocharges the value of a company that is forecasted to have high profit and high growth. Note how the DCF formula works: the wrong input (high growth) will give you the wrong output—accurate, but wrong. It is not the fault of the formula; it is the fault of the forecaster in believing and estimating the wrong growth assumptions.
Overconfidence in the sustainability of growth often leads growth investors to inflate their earnings forecasts as well as the multiples they are willing to pay for such rosy forecasts. If reality sets in worse than expected, the stock sinks, hit by the double whammy of both earnings and multiples resetting downward. The opposite is true for value investors; they tend not to pay, let alone overpay, for a rosy future and insist on owning companies where expectations are low.
Another form of overconfidence that overtakes investors is home-country bias. Familiarity breeds comfort and confidence. Because these investors feel most knowledgeable and secure about their home turf, they overweight investments in their own country even if better opportunities are available abroad. But familiarity is no substitute for research. In fact, it is more likely to breed ignorance than awareness. In investing, as I have said before, ignorance is loss not bliss.
Many Canadian investors learned this lesson the hard way when their portfolios reflected a home-country bias toward stocks listed on the local Toronto Stock Exchange (TSX), whose benchmark index had a large 33 percent weight in Nortel during the mid-2000s. In January 2009, when Nortel filed for bankruptcy, it triggered a 99 percent drop in its stock price, from about C$15 a year prior to under C$0.15 by the time of the announcement. At the time, the bankruptcy case was the largest in Canadian history, and it left pensioners, shareholders, and former employees with enormous losses. Fortunately, since that fateful episode, Canadian investors have made significant headway in diversifying their equity investments to have more global exposure and less home-country bias.
The Fix: Accept What You Do Not and Cannot Know
Think in terms of odds rather than outcomes or certainties. Evaluate scenarios ranging from best case to worst case. Accept that you are dealing with known unknowns and unknown unknowns. Acknowledge that where there is data, there is uncertainty. All data are subject to error, so statisticians always assign confidence intervals denoting the margin of error and prefer to supply ranges instead of precise numbers. But long footnotes do not make for a pithy headline, so they are invariably omitted by the media outlets. This gives the illusion of precision when in reality there is significant room for error. Give up the ghost of precision. Accept what you do not and cannot know.
“Think in terms of odds rather than outcomes or certainties.”
I made the mistake of owning a large position in British Petroleum (BP), the British oil company. I lost 40 percent in a matter of days when news of the Deepwater Horizon oil spill emerged in April 2010. Before the accident, I had viewed BP as a well-positioned and well-managed company. Like many others, I had failed to understand the safety risks associated with poor maintenance of their equipment.
When the fire occurred, my initial assessment was that the damage was limited to the cleanup costs for the oil spill in the immediate vicinity of the ship. Over the next few days, even though the fire was contained, new information emerged that the company and its vendors could be sued for negligence. This meant a jury could hit the company with triple damages. In the following weeks, I learned that the oil spill was spreading because the currents in the Gulf of Mexico were carrying it toward the Florida coastline instead of keeping it closer to the Louisiana shore. This shift in wind patterns mattered because damages for lost business in an area with higher commercial property values are far greater than in poorer regions.
The cost of cleaning up the oil spill and damages awarded literally depended on which way the winds blew! If they shifted course, then the oil spill would not reach the coast of Florida. It became clear that no amount of data-gathering would help me to handicap the outcome; there was simply no way for anyone to know. After stress testing the numbers for various potential outcomes, I was unable to rule out bankruptcy in the worst-case scenario. The stock had become too risky, so I exited the position.
The lesson learned is that investing comes with uncertainty. No matter how much you to try to handicap all outcomes, unexpected things happen. No amount of research would have uncovered this accident. Sometimes all you can do is reassess the risk/reward of an investment as new facts emerge, and then take appropriate action.
Ten years after that ill-fated accident, the stock traded around $43, well below its pre-spill level of $60. Even though BP avoided bankruptcy, I believe my decision to sell was the right one. The risk of being wiped out was real and large. The only way to manage the tail risk was to avoid the stock completely.
Flaw #10. Believing What You Believe Instead of Questioning It: Confirmation Bias
I saved the worst for last. As biases go, this one tops the list because it engenders a false sense of security instead of exposing your blind spots. As Claude Bernard, a French physiologist, quipped, “It is what we think we already know that often prevents us from learning.”
Imagine yourself on a beach on a warm July afternoon. All around you are lots of people enjoying the day. You quickly conclude this is a safe zone and you have nothing to worry about. You see, the mind believes in visual cues. To avoid expending undue energy, it trusts what it has already concluded. So in this case, you would ignore the many posted signs warning of dangerous undercurrents close to the shore. Because you don’t see them, they do not exist. Your mind gets its confirmation from seeing all the other people on the beach laughing and playing. This leads you to lower your guard, to the point of risking your life if you swim into one of the invisible riptides.
That’s confirmation bias. It can cause risk to disappear, making you more exposed to danger than you bargained for. This is what happens in markets. When a stock is going up and lots of people own it, you get complacent and stop looking for the warning signs, until it is too late.
“Figure out what does not add up, instead of what does. Actively look to invalidate rather than validate.”
In investing, you cannot let your guard down. Beliefs are not facts. Assumptions are not proof. In day-to-day life, such distinctions may not matter if they work, but in investing, ignorance is not bliss but loss. Our instinct to believe what appears to be true in our minds is so hardwired that we tend to look for confirming evidence and tune out anything that contradicts it.
However, in investing, we need to do the opposite. Figure out what does not add up, instead of what does. Actively look to invalidate rather than validate. This is not normal behavior for most people. As a species, we have benefited from getting along and going along. And it is distinctly uncomfortable to question long-held beliefs. Yet that is exactly what sound investment research requires of you.
The Fix: Look to Disprove, Not Prove
Research is a quest for truth, not a confirmation of predetermined beliefs that we have concluded to be true. It must be conducted without an agenda. You should not care what truth will be revealed, as long as your process reveals the truth. Investors who go about their research to validate a preset conclusion are doomed to fall into the confirmation trap. For example, it is commonplace for investors to screen or shortlist companies that meet certain financial criteria, such as a high return on equity or a net cash balance sheet. Such screening criteria make an implicit assumption that they are markers of high-quality businesses, and therefore that the people using them are fishing in a high-quality lake.
But facts can mislead. For example, many investors believe that if a company or a security is rated AAA, that indicates high quality. On the face of it, this hardly seems like a mistake. But the error is assuming that a high rating is some kind of foolproof guarantee. I believe this was a significant factor at the root of the 2008 financial crisis. Many investors and analysts zeroed in on securities in the financial sector with AAA ratings and took comfort when they were able to verify that the securities indeed had AAA ratings. But verification is a form of confirmation bias. It seeks to validate rather than invalidate. Triangulation, not verification, is the right research approach. If you asked whether that particular security or company deserved the AAA rating, if you looked for evidence to figure out if the rating was warranted, you would have ferreted out the deeper truth and perhaps avoided the extraordinary losses that ensued. I did my own investigation at the time and concluded that the rating was undeserved which led me to sell my position in the mortgage insurer Dexia, even though it was AAA rated. My clients were spared the pain that ensued when the company faced bankruptcy and had to be rescued by the authorities. As an aside, this explains why naïve risk-management or audit teams often fail to unearth risk: they accept superficial labels such as AAA ratings without questioning its validity, a form of confirmation bias.
Too many investors inadvertently set themselves up for confirmation bias by favoring companies that score well on a checklist of desired attributes. The non-consensus investor should do exactly the opposite—look for what does not fit one’s desired investment criteria, or things to dislike. I actively seek to eliminate bad ideas instead of selecting good ones. When I cannot find much to dislike, I know I am onto something. Only then do I dig deeper to find things to like.
I do my own independent assessments of companies that are highly financially leveraged, instead of subordinating my judgment to third parties such as credit-rating agencies. My research shows that many bonds currently rated as investment grade (BBB) should actually be rated as below investment grade (commonly referred to as junk bonds or flatteringly referred to as high yield). Their financial ratios and metrics simply do not stack up to warranting a higher credit rating. This substantial and perilous grade inflation has caused me to avoid the stocks of many BBB-rated companies. In the next crisis (which I believe will be a balance-sheet-led crisis in which financially leveraged companies may go bust or be severely handicapped), this latent risk exposure is likely to prove costly to those who blindly rely on ratings, without doing their own independent homework.
Wrong Fix: Chasing Quantity Over Quality
Can you do too much research? Absolutely. Do not assume that doing more research will solve the overconfidence bias; in fact, it might reinforce it. The more data you collect on a subject, the more confident you feel about its validity. Now you are in danger of confirmation bias. When you seek out information that does nothing more than confirm what you already “know” to be true, you have swapped confidence bias for confirmation bias.
Remember that confidence is irrelevant in investing. Correctness is everything. Being confident about incorrect answers only multiplies your losses and flushes both your ego and your money down the drain. The art of smart research is to know when you have reached the point of diminishing returns, when additional information is noise as opposed to signal. Working alongside experienced practitioners will help you navigate this continuum. If you are an individual investor, try role-playing, described next.
Another Fix: Role-play
Fast-forward to the future, and imagine the company misses a product cycle, or earnings. Will you double down or quit? Why? What signposts will you look for to conclude that the challenge is temporary and not structural? After the changed reality, what does your endgame look like? Role-playing forces you to empathize. It gives you a preview of how you will behave when the future unfolds differently from what you believed.
Yet Another Fix: Remind Yourself of Unexpected Developments
A few years ago, did you imagine that GE would lose its AAA rating? Or that Alan Greenspan would go from being revered as a perfect central banker to being reviled as the worst offender? Or that the UK would exit the EU? Or that oil prices would collapse? Or that interest rates would be low or negative in many parts of the world?
Acknowledging such surprises trains your brain to guard against overconfidence in what you believe today, so you are better able to handle tomorrow’s unexpected realities.
It has become an article of faith in the world of investing that humans are doomed to failure and our (biased) minds represent our undoing. As a corollary, many believe that quantitative or algorithmic investing that is devoid of such human bias is programmed to succeed. But to accept this premise is to short sell the human race. Those who promote such defeatist views of human behavior would be wise to remember that as a species, our predicted destiny could have been death and extinction, yet we lived and multiplied. For all our human frailties, humankind has one overwhelming advantage that we can always count on: we do not believe in giving up. It is that spirit that has kept us marching upward and onward. A few behavioral biases are no match for our innate ability to not just overcome the odds but defy them.
Yes, our minds can play simple tricks, but they can also solve complex conundrums. How we use them is up to us. This chapter shows you how to improve your mental agility, by not just focusing on facts and figures but by fostering a state of mind in relation to them. Here is a summary of the top five mental states a non-consensus investor would do well to cultivate:
1. Skepticism (poke holes, insist on triangulated validation)
2. Optimism (consider what can go right)
3. Pessimism (stress-test what can go wrong)
4. Pragmatism (don’t bet the farm on on some hunch or belief)
5. Stoicism (be equanimous amid adversity or euphoria)
Although this chapter requires you to surrender your fantasies, illusions, and habits of denial, it also shows you where other investors are likely to stumble. Knowing that you have certain blind spots and hidden biases is humbling. Knowing that other investors suffer from the same is a potential opportunity, because the very brain that is burdened by biases is also loaded with antidotes. For every flaw, there is a fix.
| Flaws |
Fixes |
| 1. Availability bias |
Go outside the sandbox |
| 2. Recency effect |
Think long term. |
| 3. Hindsight bias |
Parse luck from skill. |
| 4. Planning fallacy |
Play devil’s advocate. |
| 5. Endowment effect |
Practice zero-base thinking. |
| 6. Loss aversion |
Acknowledge reality and cut bait |
| 7. Anchoring bias |
Adopt clean-slate thinking. |
| 8. Intuition bias |
Collect and connect information. |
| 9. Overconfidence bias |
Accept what you do not or cannot know. |
| 10. Confirmation bias |
Look to invalidate, not validate. |
It is true that our conscious mind is wired for efficiency and expediency, not elaborate and exhaustive analysis. This division of labor between the conscious and subconscious serves us well in life, but not in investing. We need to (and can) overcome our instinctive impulses and tap into the subconscious mind to separate the deeper truth from the superficial reality. This takes effort and willpower, which not everyone wants to engage in. But those who do can reap rewards at the expense of those who do not.
Top Takeaways
1. We may be flawed, but we are also gifted. The very mind that suffers from biases also holds the antidotes to overcome them. Flaws need not be failings if we make them opportunities for learning, allowing us to profit from them instead of suffering from them.
2. For every flaw there is a fix. The power to change is within us. We can be prey or predators; it is up to us.
3. We can play to our strengths instead of being handicapped by our weaknesses, by cultivating the five “isms”—skepticism, optimism, pessimism, pragmatism, and stoicism.
4. Those who give in to their predispositions lose out to those who transcend them. Rainbows emerge for those who don’t run away when it rains.
5. We can choose to surmount not succumb to our biases and be a victor instead of a victim. We can define our own (investment) destiny with our strengths or let it be defined for us by our weaknesses. The choice is ours to make.