south african fsp

Changing lanes

When experienced drivers change lanes, they know well to look out for vehicles or other objects that are in their blind spot. Objects that are in a blind spot, cannot be seen in either a vehicle’s rear- or side-view mirrors. So the driver has to know to glance over her shoulder so that she can be sure that it is safe to change lanes or overtake.

Very experienced drivers also try not to be in someone else’s blind spot. Whenever possible, they try to be as visible to other drivers as possible. In this way, they avoid being inadvertently crashed into by drivers who neglect to check their blind spots.

Some modern vehicles come with a blind spot assist – flashing or beeping a signal that warns a driver if there is an object in her blind spot.

As this is not a motoring website, I won’t be writing about how to avoid blind spots when driving or how technology is assisting in addressing this issue; but rather about blind spots in life generally and how they play out in investing, particularly.

 

Some common biases

Various psychological studies have identified a number of cognitive (i.e. thinking) biases. Very simply, a cognitive bias is defined as a psychological tendency to draw incorrect conclusions.

The way that we see the world is as a result of our individual experiences, the culture of our communities (home, work, religious, etc.), our environment and how we develop over time. Inevitably, these lead to each of us having certain biases. In an extreme example, these biases could take the form of racism, sexism or tribalism. These biases could also be much more subtle and difficult to detect (like blind spots).

Some examples of cognitive biases are:

• Halo effect – in this bias, we do not readily question the views of someone we have a natural liking to. I like her (or she’s attractive), therefore I readily accept what she says. The converse is also a bias. Example: I don’t like Donald Trump therefore I disagree with whatever he says (he always talks nonsense). Okay, bad example, he does always talk nonsense!

• Availability Bias – we base our decisions on the information we have available, rather than the information we need to make the right decision. So, instead of doing the hard work of getting the right information so that we can make a proper decision, we draw from the information that we have and in all likelihood make the wrong conclusions or decisions.

• Hindsight Bias – we overestimate our ability to predict the future. We have an inclination that we ‘knew-it-all-along’ that something was going to happen. How many times don’t we say ‘I told you so’?

• Self-serving bias – give yourself credit for successes, or higher credit than what the rest of the team would give you; and of course blame others or external factors for any failures. This industry is littered with people with a self-serving bias: performance is good because I made the right investment decisions, performance is bad because the market is bad (i.e. not my fault).

• The problem of induction – i.e. we formulate a general rule or establish a pattern with insufficient information. My favourite: using a sample of one to derive a general conclusion. Example: so-and-so lost money on the stock exchange, therefore you shouldn’t invest on the stock market.

These are just a few examples and if you wish to see a more comprehensive list of cognitive biases, have a look at this presentation and there is also some excellent literature on this topic.

There are many other biases and they play out in our everyday lives. Most of the time, we continue oblivious to our poor decision making as a consequence of these biases.

 

Investment decision making

Similarly, these biases play out on whether we invest or not, and how we invest.

Early in my investing experience, I had good success in investing during the Information Technology and Financial Services boom of the late 1990’s. At that time, the resource sector was considered as a dinosaur industry and that the new-age industries (IT, financial services) were going to go from strength to strength. So when the great resource boom started, it took me a long while to identify that trend and to understand how growth in China was having this profound effect on the resources sector.

Broadly, two types of biases are playing out in my experience above:

• Market Biases – The market is showing a bias towards certain industries – over-extending valuations in one case and under-valuing businesses in other cases;
• Individual or Personal Biases – My own experience limited me from seeing opportunities in other industries. I had a blind spot towards the resource sector, thinking that it would go extinct like the dinosaurs.

This is what human nature is all about. Whilst we can think of ourselves as rational beings, we do find that both at an individual level as well as in groups, we can be profoundly irrational. This provides both great opportunities as well as risks for us as investors.

 

What can you do?

Whilst, I do not believe that you can be completely rid of cognitive biases, you can continue to improve the quality of your decision making over time.

Rationally, when the market is oversold, we should be buying and vice versa. This is what the great value investors like Warren Buffet do. However, I recently read that George Soros, another great investor, will bet with the trend, even if disagrees with the valuations. His theory is that he will take advantage of the trend (and I guess get out before everyone else tries to get out). Arguably, this is also a rational approach. It comes back to knowing your investment philosophy and style and sticking to it.

At a personal level, some of the techniques that you could use to improve your decision making are:

1. First and probably most important is to accept that you do have cognitive biases.
2. When faced with a decision, it’s more important to ask the right questions, so that you can get to the right answer. Has this happened before? What are the underlying assumptions that needs to be true for a trend to continue? Ask yourself what data you need to make a decision, then get that data rather than use what you have available.
3. Test your thinking with others who can be brutally honest with you, especially those who think differently to you. When you get diverse views, and if you are open enough, you are more likely to identify your blind spots.
4. Invert, always invert as Charlie Munger says. This means always think about what if the opposite happens, what if your assumptions don’t hold true? What will be consequence of this?
5. You don’t have to be an absolutist in your thinking. The world is too complex for you to be able to forecast what will happen. So, don’t be afraid to live in a world of probabilities and invest accordingly.

 

 Summary

We are all familiar with driving blind spots, but much less familiar with the biases that we have with respect to how we make decisions.

These biases play out in the markets, when we have bubbles and similarly when the market over-reacts to adverse economic conditions. They also play out in how we decide to invest and if we invest at all. Sometimes it takes the form of a halo effect: if so-and-so market commentator says it is a good stock to buy, we buy without questioning the underlying assumptions or reasons. Similarly, we may credit ourselves for predicting a market crash when in fact we were just fearful or lazy to invest.

We can get smarter in our decision making by working harder at identifying our own biases. Similarly, we should be helping others to see theirs. By making better decisions, we can improve our investment track record and build wealth for ourselves, our families and the community at large.