Two quotes from investment legends summarise the importance of psychology.
Ben Graham: 'The investor's chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave'.
Peter Lynch was even more direct: 'In the stock market, the most important organ is the stomach. It's not the brain'.
Plenty of studies have proven that humans are not perfect in making rational decisions and in remaining consistent with decisions made.
In investing, it is crucial to keep this in mind. Our psychology can distort our decisions at every stage of the investment process: from choosing a stock for a possible addition to the portfolio, during the analysis phase, as well holding the stock and deciding when to sell it.
I see at least four causes for these shortcomings:
1. First act, then think. Humans have emerged in a wild world and quickly reacting to potential dangers was more important than whether the actual decision was correct. If our ancestors spotted something loosely reminding them of the ears of a lion, they would be far better off running away immediately, then taking extra time trying to confirm their initial guess. The downside from being wrong was some extra running, while the upside from being right – a saved life.
2. Social proof. In addition to living in a wild world, we also got used to being social animals preferring to live in a group than individually. We seek decisions that get social proof such as when buying popular stocks that everyone is discussing. It makes it painfully difficult to avoid those stocks and sectors when you see your friends and neighbours getting rich by holding the 'most obvious winners in today's economy'.
3. Look for order, avoid randomness. Somehow, our brains cannot handle randomness and seek to put things into order often looking for correlation and causations between events when there is none. This leads to various biases such as hindsight ('I knew this would happen'), 'illusion of knowledge ('the data and detailed analysis supports this'), overweight of 'experts opinions' and others. Our preference for certainty often makes us overpay for stocks with predictable and stable dividends. We also tend to buy stocks with clear 'stories' behind it.
4. We follow our emotions much more often than we think so. 'It is easier for us to say yet to people we like' is a famous advice from experts on self-improvement and relationships. The reason this advice works is that we often assess information not on its own merit but based on who we get it from. A well-spoken management can often 'sell' company's strategy and convince us faster even if reality is far more challenging and unclear.
We often assign higher probabilities to events that we can visualise better or which we just have experienced ourselves. Various studies show that people believe another natural disaster is more likely to happen if one just happened even if thousands of years lead to a different statistical probability.
Surprisingly at first, but even if the same information is presented differently – people tend to make different decisions. For example, studies show that individuals would likely choose to go ahead with some action (e.g. medical operation, construction) if they are told that 'there is 95% chance all goes well', while they are more likely to reject the decision if told 'there is a 5% risk of things going wrong'.
The whole field of Behavioural finance is full of various studies which have identified a list of all kind of biases and weaknesses in our decision making process. This list is worryingly long and includes some of the following ones:
- Loss aversion
- Mental accounting
- Endowment effect
- Over confidence
- Hindsight bias
- Social proof and peer pressure
Various biases lead to all kind of problems like 'over trading', short-term investment horizon, focusing too much on TV experts, not doing enough fundamental research, over-paying for popular stocks with stable earnings and captivating 'stories', paying more attention to the final result rather than the process.
From my experience, the best books on this subject that are worth reading are:
'Thinking, fast and slow' by Daniel Kahneman and Amos Tversky
'Nudge' by Richard Thaler
'Behavioural investing' by James Montier (or a shorter version of it – 'The little book of behavioural investing')
'Fooled by randomness' by Nassim Taleb (as well as all his other books including 'Black Swan', 'Anti-Fragility' and to a lesser extent 'Skin in the game'.)
I keep thinking on how we can overcome our human's weakness to get better investment results sharing some of my findings on this website. Some of them include writing investment thesis, having your own checklist, creating simple rules (e.g. having a maximum position size), avoiding 'hot' stocks and widely known 'stories', asking 'How I would allocate my savings if I had all of them in cash?' rather than 'should I stick to this or that stock, reduce / add?', checking stock prices less often.
Ultimately, perhaps the most important advice although the one which is probably the hardest to follow is to never stop learning especially through reading books to keep expanding your circle of competence and accumulate knowledge.
Being mindful of your habits, practising meditation and having the 'right' circle of like-minded investors are also important steps to improve your decision making.
I can imagine an intelligent person reading the above points and thinking ‘Well, this is obvious’ or ‘Yes, it is a good summary of dozens of books on investing some of which I also read’. The challenge of course is applying these principles in real-world investing. Just like with some other processes – they are very simple when explained, but require practice and skill when practiced. For example, it does not matter who explains to a child how to ride a bicycle – you or Lance Armstrong – finding a balance, looking forward, sitting straight, pushing the pedals – all these steps are obvious but almost impossible to implement for the first time. It is quite similar in investing.
So one reason I decided to launch this website is to build a bridge between the theory and practice of investing so that anyone can start a journey from the safety of a library to the jungles of a stock market, avoiding pitfalls and maximising their returns.
I am also keen to meet like-minded investors to exchange ideas and find new opportunities, so please do get in touch here
. And do not hold back any criticism you may have on my work – I am doing it because I want to improve my skills and achieve better results – so learning about my weakness and what I can improve is very important to me.