Think Like the Great Investors: Make Better Decisions and Raise Your Investing to a New Level

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.

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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.

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Men and women (overconfidence)

Most people have a lack of respect for economists. This partly derives from the basic assumption that underlies classical economic theory. The world that economists study is very complicated. The modern economy has a great number of moving parts, each of which interacts with the others. So there are a huge number of relationships to deal with. Moreover, these relationships change dynamically over time. Economists still struggle even to come close to building an accurate and complete model for how a modern economy operates, let alone have the computational power to run such a model to try to predict what will happen if we change some policy or other.

In order to try to understand the economy at a minimally useful level, classical economic theory was based on an assumption that mankind was totally rational in every decision made. Economic theory assumed that, when faced with a decision, we have all the facts, can weigh them up accurately and will always make a rational choice that maximises the (usually monetary) value to us. This led to the development of useful theories about how the economy worked.

However, anyone who has ever thought for a moment or two about what people actually do, and what they themselves actually do, will realise that these assumptions were bound to limit the usefulness of these theories. They were useful as far as they went, but they were not looking at the real world. We rarely have all the information. We have great difficulty weighing up all the issues. We most definitely do not act perfectly rationally every time. We all make some decisions impulsively and emotionally. We are all prone to cognitive biases, and we often make our most important decisions in a less than optimal manner.

In recent decades, this has led some researchers to study the way people really make decisions, rather than relying on the old theoretical models. They study how people actually make decisions, rather than assuming they always decide in a perfectly rational manner. Their work has helped to uncover the highly complex and chaotic system that is reality. It has also enabled us to recognise and understand the cognitive biases we are all subject to in making decisions. Out of this has come an understanding of how we can improve our decision-making skills by managing these cognitive biases.

This new field of study is called behavioural finance. It has probed into how we behave in a wide range of situations, including how we determine a price for something and how investors behave in stock markets. In the stock market, they carry out this research by observing and measuring exactly what people do and assessing the results they achieve.

One study by Brad M. Barber and Terrance Odean examined the trading results for 78 000 accounts at a large US discount broking firm from 1991 to 1996. A discount broker was chosen because it was far more likely that their clients were making their own decisions than at a full-service broker, where they would be acting on advice from a broker/salesperson.

The performance of the 78 000 traders was measured against the benchmark return that would have been obtained if they had done no trading over the year, but just held the stocks they had at the start of the year for the 12 months. The results indicate that they would have been better off not trading at all, because their start-of-the-year portfolio would have performed on average 2 per cent better than they actually achieved from trading. Table 2.1 summarises the results.

Table 2.1: Summary of the results arranged by percentile

Source: The Common Stock Investment Performance of Individual Investors, 1998 working paper by Brad M. Barber and Terrance Odean.

The clear conclusion is that only the best 10 per cent of traders went anywhere near matching the broad market index for the period. This is roughly in line with many previous studies, which indicate that at least 90 per cent of traders fail.

Now, when most beginning traders see this table, it does not bother them very much. Indeed, if your response to this table is the same as theirs — that they do not have a problem because they are one of the top 10 per cent — then that is exactly the idea that behavioural finance researchers call overconfidence.

Researchers have studied people from many professional fields. The results consistently show that, when making subjective judgements of situations, we all tend to overestimate the precision of our knowledge about most things. When people think their judgement is better than it measurably is, researchers say that they are overconfident.

Not surprisingly, researchers have demonstrated that overconfidence is greatest when the judgement involves difficult tasks, forecasting things that are difficult to predict and the lack of fast, clear feedback.

If we think about trading for a moment, we must conclude that trading is just such a situation. Indeed, leaving the full trading process to one side, just the initial step of selecting a stock is clearly a difficult task, where prediction is problematic and feedback is confusing and uncertain.

It therefore follows that stock selection is the very type of task for which we are likely to be overconfident.

Among traders the characteristic of overconfidence sets up a process, starting with the way we overestimate our knowledge about the value of a stock. We think that our information is deeper and more precise than it really is. Moreover, we seriously overestimate the probability that our assessment is more accurate than that of other traders. This intensifies differences of opinion among traders, which leads to more trading.

To examine this idea, the researchers divided the 78 000 traders at the discount broking house into five groups arranged from lowest turnover to highest:

• The least active 20 per cent turned their money over an average of 2.3 times a year. On average they made a net gain of 18.5 per cent a year.

• The most active 20 per cent turned their money over between 104 and 250 times a year. On average they made a net gain of only 11.4 per cent a year.

Clearly, the more they traded, the more they hurt their wealth creation efforts.

To try to demonstrate more conclusively that overconfidence leads to more frequent trading and poorer results, the researchers looked for ways to compare those they knew to be overconfident with those they knew to be less overconfident. There was a great deal of previous research to help them in this.

Previous research had shown that both men and women are overconfident. However, it also showed that men are generally and measurably more overconfident than women. An important aspect of this is that it depends a great deal on the task for which the overconfidence is being measured. For example, men generally claim more ability than women, but this is much stronger for what are seen as masculine tasks.

Previous research also showed quite clearly that men are inclined to feel more competent than women do in financial matters. Therefore, if men were generally more overconfident about finance than women, studying the trading results of men compared with women would be a good way to test the effect of overconfidence.

In looking at the broking house clients’ results, the researchers obviously had to exclude accounts that were clearly those of married couples, because they might have influenced each other’s decisions. Therefore, they focused on accounts in the name of single men and women. The first thing they looked at was turnover, or trading activity. The turnover for the women was 50 per cent, but for the men it was 85 per cent.

Then they looked at the all-important net results. Again, they measured them against the result if their portfolio at the start of the year had remained fixed. Both men and women under-performed against the static portfolio they had started the year with. Their trading had resulted in women under performing by 1.45 per cent a year. Unfortunately for the men, their underperformance was worse, at 2.9 per cent a year.

Here are some other gender differences that this and other research shows:

• When feedback is immediate and clear-cut, women and men are equally overconfident. When feedback is absent or ambiguous, women are less confident than men. Stock market feedback is mostly ambiguous, so men are destined to be more overconfident.

• Investors take too much credit for their successes. This bias is greater for men than women, so men become more overconfident.

• Men spend more time than women on money and financial analysis. They rely less on brokers. They make more transactions. They have a greater belief than women do that returns are predictable. They anticipate higher returns than women do. All this makes men behave more overconfidently.

• Both men and women traders bias their portfolios to smaller and more volatile stocks, but women do so less. Thus, after accounting for risk, women earn reliably higher net returns than men.

There it is — women are better traders than men, because they are less overconfident. However, before women take this as carte blanche to take over the trading, remember that both men and women are overconfident and that both detract from their wealth from trading; men simply do it more often and more destructively. The research strongly suggests that both would be better off financially if they traded less often.

The next chapter will explore overconfidence in more detail and a wider context. At the end of it I will provide some strategies for dealing with overconfidence generally.

Summary

Behavioural finance explores the real world rather than developing theories based on unrealistic assumptions. One study showed that 90 per cent of traders produce lower results than buy-and-hold. The problem is overconfidence — an overestimation of our trading ability. Another finding was that the more transactions a trader made, the lower their results. Both men and women are overconfident, but men are more overconfident than women.

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I am absolutely certain (overconfidence, confirmation and availability)

A frequently overlooked aspect of investment is how we make decisions. Our decision making can carry with it important unconscious biases. Typically, this area of decision making is the final step in the investor’s development from beginner to good investor. Earlier stages are analysis, money/risk management and the development of an investment plan.

Good decision making features two key elements. The first element is fact finding. Most investment decisions will be more soundly based if we have uncovered all of the easily readily available facts. The internet has made this a great deal easier than it was twenty or thirty years ago. We can discover information more quickly and search many more possible sources. Increasingly we should be able to avoid the sick feeling in the pit of our stomach when an investment fails because there was something that was readily available, but that we did not take the time to find out about. However, the flood of information on the internet has two downsides:

• Doing the research takes time, which none of us has in abundance.

• Some information on the internet is of dubious quality or mere opinion. We must be ever more able to assess the value of what we read there.

The second element is having an appropriate level of confidence, or being well grounded in the limits of our knowledge. Clearly, we cannot operate as effective investors unless we have enough confidence in what we know and what we decide to do, so that we can reach the point where we are able to ‘pull the trigger’ on transactions.

However, this tends to be the minority and to apply most to raw beginners. Once we are past that stage, many of us fall into the overconfidence trap.

Overconfidence is a term coined by behavioural finance researchers to describe a particularly dangerous bias in our investing decision making. This bias is present when we are far more confident about our decisions than we should be.

Overconfidence afflicts beginners, other than those who actually lack confidence, more than it affects those with experience. This is because with experience comes greater humility about what we think we know. However, we are all overconfident about all kinds of things. When teaching this I often give this kind of quiz:

Answer the following 10 questions. All questions request a range, not a specific fact. Your answer should be a range where you are 90 per cent certain that the correct answer is within the range you give. In other words, your task is to estimate a range that is neither too narrow nor too wide. Write your answers in the spaces provided below each question.

1 Length of the coastline of mainland Australia in kilometres?

Low:      High:

2 Number of English monarchs?

Low:      High:

3 Number of countries in Africa?

Low:      High:

4 Number of plays written by Shakespeare?

Low:      High:

5 Age of Julius Caesar at death in years?

Low:      High:

6 Number of naturally occurring chemical elements in the periodic table?

Low:      High:

7 Number of species of eucalypt?

Low:      High?

8 Year in which Martin Luther was born?

Low:      High:

9 Length of the Large Hadron Collider beneath the Franco-Swiss border in metres?

Low:      High:

10 Length of the Trans-Siberian Railway from Vladivostok to Moscow in kilometres?

Low:      High:

When you have written in your answers, go to the end of the chapter and mark how many of the correct answers were within the range you estimated. This is how to interpret our score, which is to gauge our level of overconfidence:

• If nine of the answers were within our range it suggests that we exhibit little sign of overconfidence (1 per cent of the population).

• If only three to six of the answers were within our range it suggests that we exhibit a strong tendency to overconfidence (this is where most people fall).

Overconfidence is when we think we know more than we actually do. The more of our estimated ranges that were too narrow to include the provided answer,