Despite making money in Leucadia National Corp. (LUK) it is my dumb trade of the month. My trade has had me feeling bad for a while and this stock seems to want to make it personal and kick me while I’m down, if I may anthropomorphise. Up another 4.4% to $24.60, and a kick in head to Dean for good measure.

I am totally comfortable with stocks trading higher after I sell them. It is so normal that I barely ever notice. However, in the case of LUK, I did not want to sell and I thought I’d have plenty of time to build a large position. I wanted to own this puppy at bargain prices and I did for a month.

As I posted about here and on Seeking Alpha I liked LUK a lot. So why the hell did I sell $15 April Calls? Why the hell did I only make $2.35 a share? I’d like to claim it was risk management and in part it was, but the truth is slightly different. While the truth may hurt at least it reinforces another lesson or two for me.

First on the positive side. I made money on LUK. An 18% return in one month. I also got to know another company, but wait there’s more. I also got to know a couple bonus companies a little better, two of Leucadia’s holding, Fortescue andAmeriCredit. Three for the price of one, woohoo! 

So why did I sell those calls, if I liked the company so much? What was my mistake and why did I make it? My issue was I had been on a spending spree and was 14% on margin. I sold the calls on 12 March, if you can remember back that far you’ll recall it seemed like the sky was falling and the end of capitalism was nigh. I didn’t believe that and was recommending an aggressive stance in my TMF posts, but the cacophony of wails was deafening and despite considering myself an independent thinker I became uncomfortable with 14% margin.

My mistake was attachment, anchoring and recency. I had not yet even been put LUK, but was likely to be. LUK had been my research focus. So when I came to sell something and I decided on selling calls it was the first company to mind. I was not attached to it, like I unfortunately am to some of my other shares, heck I didn’t even own it yet. If called I would make a good profit, whereas unfortunately that would not be the case with many of my other shares at that time. My mistake was I did not compare my holdings to determine which had the least prospects going forward, I sold calls on what I was currently focused on. Last in first out is not a good investment style. 

LUK are due to report Q1 2009 between 8-May-09 – 18-May-09. ACF will hang heavily on the Q1 book value, though it is now back up above its end of year price. FMG.AX has been a steady gainer and with Chinese iron imports hitting an all time high it is likely to continue heading up. 

I hope a reader bought and held Leucadia. Though I really hope the market swoons again and I once more get an opportunity to buy LUK at a bargain price. 

As an aside I’m now 0.3% in cash. Long time readers will know that I wanted to utilise margin at low market prices or upon confirmation of a new bull market. Well I did utilise margin to a small degree, 14% is small for me, but the speed of this rally has taken me by surprise and I am not yet convinced a new bull market has arrived. I’m looking to sell three companies in our US portfolio and have no US purchases planned. Anyone got a great stock recommendation for right now?

I do know my LUK regrets are all post hoc, but the pain the pain

The Greenspan Put: Put as much blame on Greenspan as possible!

While everyone is now signing on to the lynch Greenspan mob, here is someone who appears to have been six years ahead of the mob.
Losch Management called out Greenspan in a Client letter from 2002.

Behavioral Economics tells us that markets learn from pain but forget about rational values after long periods without economic pain. If this is correct then it is likely that concepts such as “Soft Landings’ and the “Greenspan Put” fathered a good deal of our recent foolishness, and history will not view Mr. Greenspan’s role quite as enthusiastically as the business press does today.

I like this comment on Losch’s behavioral finance page:

Markets are not about math, they are about psychology, and although, in a lot of ways, the market may be very efficient it certainly is not rational. The market is very efficient at registering not only the value of the stock but also the current mood of ‘Mr. Market.’ The price of a stock at any given point can be seen to have two components 1. Its value, and 2. A psychological component determined by the degree of mania or panic prevalent in the mind of the participants.

Many investors concentrate on the first component, value. They dive down into detail to determine what the value right now is. To make their guess work sound analytical perhaps even scientific they call it intrinsic value and parade it around for all to see as a reliable indicator of value. Value is part of investing, no more.

OT: Intelligence isn’t everything. The average IQ in that building in Greenwich, Conn. [the offices of Long-Term Capital Management], was probably over 155, wouldn’t you say Charlie? Buffett in Foolish 2007 Interview

A month ago I was not checking the VIX daily. The Volatility Index hit a new high of 59.06 during Wednesdays sixth straight fall for US markets.

For the Dow and the S&P 500, Wednesday capped their biggest six-day point loss ever. It was a session of wild swings, with no clear direction determined until the final minutes…
In the last hour of trading, U.S. Treasury Secretary Henry Paulson warned that the turmoil “will not end quickly.”

In possibly unrelated news. Last night I decided to re-read The Book of Investing Wisdom, Part IV, Market Cycles.
At first there is Charles Dow “the panic of 1873 was essentially a money panic”. Dow describes the cycles and to mind highlights behavioural finance, contrary positions, market and economic cycles and long term big picture thinking.
Then William Peter Hamilton discusses Dow Theory. I mention those two first so I do not seem to be segueing from Paulson into the brilliant Three Different Stock Market Movements by Roger W. Babson. Babson like those before him describes the business and stock cycles and then goes further to discuss the conscious and unconscious manipulation of the markets by the six wise men and a larger Wall St group. “The operations of these bigger men are based wholly on fundamental conditions and long swings.” They accumulate around the lows while fundamental conditions improve to later distribute while continuing to talk the markets prospects up.

During which time the leaders are talking optimistically, the banks are loaning money at low rates and the corporations are raising their dividends. Nevertheless, fundamental conditions are no longer improving,…

When the public has bought as much as they can, word is passed around to “pull the plug”.

You get the idea. I think the difference between Buffett and many value pretenders is that he utilises a lattice work of multiple models. On top of his fundamental detailed analysis he surely layers, among many things, a detailed understanding of cycles. Cycles are why I fell into my 50:150 style of investing. Market timing combined with fundamental analysis is where the best investors get their alpha. It’s all about Fusion.

Most Friday’s I drop my daughter at dance class, head to one of Melbourne’s best cafés and have a latte while I wait for Borders to open at 10. I then have around 20 minutes to choose and scan an investment book. While I am normally a slow reader I can skim a book in 20 minutes and pick out a few lessons which resonate with me.

Today my book of choose was Way of the Turtle, by one of the original turtles, Curtis Faith.

Almost every page I scanned contained a gem. From the introduction where Faith said he has learnt something from almost everyone he has every interacted with to his thoughts on edge and his simple clear rules.

Before I buy this book I thought I should re-read the Turtle Rules, a copy of which is linked at the bottom of this blog post on investment tips.

Faith’s Dos and Don’ts for Thinking Like a Turtle, are a great example why even strict fundamental investors can learn a lot from trading books like this or Tharp’s Trade your way to Financial Freedom.

1. “Trade in the present. Do not dwell in the past or try to predict the future. The former is counterproductive and the latter is impossible.
2. Think in terms of probabilities not predictions. Instead of trying to be right by predicting the market, focus on methods in which the probabilities are in your favor for a successful outcome over the long run.
3. Take responsibility for your trades. Don’t blame your mistakes and failures on others, the markets, your broker, and so forth. Take responsibility for your mistakes and learn from then.”

Jim (BMW) has provided the framework to easily implement number two. The BMW method provides a framework rooted in probabilities for a successful outcome over the long run.

But Dean, what does this all have to do with EDGE? I hope to wrap up the loose ends at and tie it back to many conversations held on the BMW board. First indulge me with one final quote from Faith, this quote spoke to me so strongly that other shoppers looked up as I exclaimed “Fork yeah!”

“the best edges come from the market behaviors caused by cognitive biases.“

I realise the market is made up of different opinions and communities such as this are a reflection of those opinions. However, I all too often see cognitive biases in TMF posters and no doubt some of mine ooze on to these digital pages.

People talk about price way to much. The worst examples of this can be found in TMF subscriptions publications. Many issues contain phrase like “XYZ is now a bargain at 30% off its high” or “we’re getting to buy XYZ at a 30% discount form recent prices”. While XYZ may be a bargain, I find this constant reference to price insidious in publications which aim to educate investors.

Many people fail to recognise that companies are on sale for a reason and those reasons are obvious to all market participants. Once a reason is priced is, you need to invert your thinking and see if a reversal of that reason is an opportunity for a catalyst. Making predictions based on known priced in reasons or worse predicting based on your own views is unlikely to outperform a focus on the probabilities. This mental momentum, make us believe that as everything is going wrong for XYZ it will keep going wrong. While that can occur the BMW method highlights that it probably won’t keep going wrong. The most probable outcome for companies with proven track records is that they will bounce back.

Consider your biases and formulate strategies to overcome then. If you are not buying more now than you were over the last couple years then perhaps you are predicting and letting your cognitive biases rule the day.

FWIW – in personal and/or model portfolios

• I continue to hold SSD and sell calls on it.
• I recently sold my trading position in Amgen. While the news flow has changed from negative to positive recent investors are likely to be nervous and have little conviction. Pocketing 50% in short order was a no brainer and more than compensated for my only ever loss on Amgen (2008 Leaps vertical spread which due to inexperience with spreads I let slip from profitable to a loss)
• I’ve bought PFE, FDX and GE.
• Taken large losses on a number of companies.
• Started buying Australian banks (not recommended for US investors due to Fx rate).
• Passed on BARE.
• Safely profiting with SAFT.
• Continue to hold way to many companies.
• Trying to make time to look at AKAM and STP, which from a cursory look both appear to offer good value and excellent prospects.
• Been very distracted trying to get a couple businesses off the ground when I should probably simply be focusing on My Family Inc. Despite having overcome monetary desires I still fail to contain my egotistically desires. While I should be the most contented I have ever been, my ego pushes me to achieve more, denying me the enjoyment of here and now. I must find a solution for that! Oh the pain, the pain of being an A type

Belief Systems

Why do so many intelligent people not transfer their success to investing success? Think about that for a minute. Got an answer?

Now consider this question. Why has investing research such as the following found that psychologists are more successful investors than some of the smartest people around?

Recently, a research, which was conducted by Bank of England, the universities of Heidelberg and Bonn together with McKinsey, observed the share-buying behavior of about 6,500 persons in an Internet experiment. They found that psychologists, particularly, were good at guessing other players behavior and mistrusted the overvalued stock by others. On average, psychologists were markedly more successful in their speculation than physicists or mathematicians – or even economists.

One answer is that most investors focus on valuation and detailed fundamental research as their belief system tells them a scientific, quantifiable, repeatable approach is the path to success. After investing for twenty years I am almost positive (that’s as sure as a doubter like me gets) that there is no edge to be gained from valuation and detailed fundamental research. Perhaps the absolutely smartest, most experienced and skilled fundamental investor can gain an edge through their research, but is that you? Fundamental analysis is a necessary step, for most investors, but it is not the key to alpha.

Take a few minutes to consider what beliefs you may have that are stopping you from become a better investor. Invert every belief you have. Consider your core investing beliefs from every angle.

A life coaches would suggest you make a list of all your disempowering beliefs and ask yourself these three questions:

1. Why do I believe this?
2. What is this belief costing me?
3. What do I have to loose if I let go of this belief?

I hope you found at least one investing belief that limits your possible success. I’d love you to read what it was.

Didn’t come up with a disempowering or limiting belief?

How about these few?

• It is impossible to time the market. (Any belief you have which includes the word impossible should receive double your focus!)
  Invert it.
  It is possible to time the market. Now write down, research, consider how it is possible.
• Technical Analysis is a waste of time.
  Turn that frown upside down.
  Technical Analysis can give me an edge and help me gain an extra percent or two when both buying and selling.
• Options are risky?
  Options are less risky than direct share ownership.

A major disempowering belief that I have held since my early teens is that I could never be a teacher. When I became a dad I realised that was a disempowering belief I had to tackle head. I’m still working on it and hopefully incrementally improving. Part of my problem is another disempowering belief I’ve held since childhood, I must learn that not everyone is a dickhead!

So why do psychologists outperform? They understand behaviour and have learned understanding of psychological biases. Could that become an edge for you?

Cheers
Dean

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