Behavioural Finance Part One

One of my favourite investing topics is behavioural finance. It is the area which I believe has the largest effect on the returns of most investors. I consider getting to know yourself a very valuable endeavour and should be a priority for all investors. Many investing newsletter writers and analysts have already mastered stock picking and will sell you their ideas for a relatively inexpensive price. The place most investor can add real value to their portfolio is in understanding themselves and conquering their biases. But then again I would say that as my first degree many moons ago was in psychology, so I probably have a psychology bias.

Cognitive Biases
When does the virtue of patience become the failing of commitment bias? I believe it was Whitney Tilson who said that when you change your investment thesis to remain invested in a company then you have commitment bias. If your original investment thesis has not worked out then it is time to sell, if you find other reasons to hold then maybe you have commitment bias.

Here is an archive of Whitney Tilson’s posts on the Motley Fool. Others may be found here at Tilson Funds.

List of cognitive biases from Wikipedia.

And some more biases

Investor Psychology

  • Here is one of the many articles Tilson has written on investor psychology.
    And another one I can’t find a “Putting Someone on a Pedestal” bias, but I am sure it should be there somewhere as it is surely one of the biggest biases in investing
  • Cognitive Dissonance. This NY Times article on the Monty Hall Problem has some great insights into cognitive dissonance.
  • What is Behavioral Finance? An interview with Meir Statman.
    Another interesting paper by Statman is this on the rules of diversification in behavioral portfolio theory. I don’t agree with many of the ideas put forward, but nonetheless the paper is worth reading.
  • So You Want To Be The Next Warren Buffett? How’s Your Writing? By Mark Sellers
    This speech that Sellers gave to a Harvard MBA class is a must read for all investors. It resonated strongly with me as I have always believed it is ones psychological make-up that is the largest factor in your investing success. Read this to realise that 20% annual compounded gains is a delusional aspiration for most people. Investing is not a get rich quick scheme it is a life passion and even then you’ll be doing well to beat the indexes my a few percentage points.
    I always found Sellers discussion on psychology the most interesting part, though he also provides interesting insights into economic moats and prompts the reader to consider their own investing moat.
    I believe his speech would have been more useful if he provided some tools to improve the traits which he mentioned, but he seems to be of the opinion that they are hardwired and can’t be overcome.

    Sellers seven traits are:
    1. Ability to buy fear sell greed.
    2. Obsessive about investing.
    3. Willingness to learn from past mistakes.
    4. Inherent sense of risk based on common sense.
    5. Confidence in convictions.
    6. Both sides of your brain working.
    7. Remain true and thoughtful in a volatile environment.

    My favourite psychology professor devoted a lecture to ways to improve the connection between your brain’s hemispheres. I’m sure Google can provide some good ideas. My favourite has always been juggling. It is one of the few activities that simultaneously engages both hemispheres and strengthens the link between the two. I recommend you add juggling to your daily routine, if you don’t already do it. For parents out there, kids love it and it fun for all the family.

    A quick primer on the brains hemispheres.

  • Inertia and indecision.
    From the MMC March 2008 Update.
    In the recent edition of the Outstanding Investors Digest, a highly regarded US value manager Seth Klarman from the Baupost Group neatly summed up the impact of fear on an investor:”If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost of a loss may be far greater than the initial loss itself.”

Thanks for reading and feel free to leave me a comment

Dean Morel

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