Beat the behavioral gap and take advantage of Mr. Market’s foibles

Behavioral biases

A small edge can make a big difference

I offer gap-to-edge rules as the best way to address the problem of behavioral biases and cognitive errors.

They are my version of what Daniel Kahneman (Nobel prize in economics) calls risk policies. Kahneman describes risk policies as decision rules that are always applied in similar situations. Examples he gives are in the insurance context: “always take the highest possible deductible when purchasing insurance” or “never buy extended warranties.”

He explains: “The relevant issue is your ability to reduce or eliminate the pain of the occasional loss by the thought that the policy that left you exposed to it will almost certainly be financially advantageous over the long run.” So, the long run becomes the Broad Frame. In this context, Kahneman’s risk policy is used to deal with Loss Aversion. (Kahneman, 2011)pp.334-341.

The expression risk policy doesn’t fully capture what I call gap-to-edge rules. The term risk policy suggests an approach that is, in an investment context, purely defensive. As well, I have chosen to use the word ‘rule’ rather than Kahneman’s word ‘policy’. The word ‘policy’ suggests a little less discipline in its use. I might have used the expression ‘gap-to-edge maxim’. ‘Maxim’ is the word used by John Templeton to list his essential rules of investing conduct.

The greatest failing of most investors, both professional money managers and individual investors, is a failure to understand the impact of their own very human behavior and that of stock market participants as a whole. The whole issue of investment psychology is dealt with in Part 2: Human Foibles and Investment Decision Making of the Motherlode.

There are dozens of behavioral biases and cognitive errors at work. There are two ways of coming at the problem. One is to look at each bias and error in turn. The second is to look at the kinds of problems we have in investing and examine the biases and errors that hurt our critical investment decisions. It is this second route that is followed in the Motherlode.

My gap-to-edge rules are listed at the end of each of the eight chapters in Part 2 of the Mothelode and are set out in a complete list in Appendix 3: Gap-to-Edge Rules.

The term gap-to-edge rules is not elegant. I would be happier if I could find a more felicitous expression. It does capture my idea clearly. I prefer clarity to sweetness. The idea is to adopt rules to improve your performance.

The gap-to-edge rules need not be followed slavishly. For every rule there is an exception. Kahneman’s word ‘policy’, Templeton’s word ‘maxim’ and my word ‘rule’ carry essentially the same meaning. It may seem inconsistent to propose rules and emphasize discipline in their use and then say there will be exceptions. I don’t pretend the world is simple. Investors have to be both disciplined and flexible.

Gap-to-edge rules have a dual function. They play defense to help the investor avoid the behavioral biases and cognitive errors that lead to the behavioral gap (the gap in gap-to-edge). That is, they are used to avoid the traps that lead to underperforming the market. At the same time gap-to-edge rules play offence, to help the investor take advantage of Mr. Market’s behavioral biases and cognitive errors, to create a behavioral edge (the edge in gap-to-edge). This will assist the investor in outperforming the market.

In gambling an ‘edge’ is a well-studied idea. All gamblers are looking for an edge. In gambling, an edge, however small, can mean the difference between winning big or going home broke. In a casino the difference between the house and the customers is the edge. In that context, the edge is ever so slightly better odds. But, that edge makes all the difference. It is the house that makes money – lots of it. The customers lose money – lots of it. I don’t wish to associate my term behavioral edge with gambling. I only reference gambling here because it underlines the fact that a small edge can make a big difference.

In investing, an edge is an advantage, no matter how slight, over other investors that can lead to superior investing results.

Developing gap-to-edge rules and an investment philosophy to take advantage of the behavioral edge is not easy. There is a long and steep learning curve. A great deal of study is required. There will be many false steps, mistakes and hard lessons learned along the road. Once up the learning curve it becomes easier.

Ultimately it becomes fairly straightforward, in the sense that the investment philosophy allows a style of investing that meets the “KISS” test. One can keep it simple, stupid. KISS becomes the operating principle – one buys only superb companies at bargain prices and holds them for the long term. One sells companies that temporarily lose their way. The portfolio is balanced, properly diversified, with built-in hedges. One doesn’t over-diversify. And that’s about it. But, easier said than done.

There are other ways of mitigating behavioral biases and cognitive errors. Holding an index fund or index EFT for the long haul works and provides a satisfactory performance. Alternatively, an investor can invest in actively managed mutual funds or ETFs, although this exposes investors to the behavioral foibles of the fund manager. Quant funds claim to get around this problem by having decisions made by computers. Another way is to use hard rules or formulas such as automatic rebalancing of asset classes or the ‘magic formula’ devised by Joel Greenblatt. (Greenblatt, 2006).

In 2006 a tiny book appeared titled The Little Book That Beats the Market that had the audacity to claim that by following a ‘magic formula’ and without further research or reading, an investor could beat the market. (Greenblatt, 2006) Formulas like automatic rebalancing and Goldblatt’s ‘magic formula’ seek to take the behavioral biases and cognitive errors out of play by removing the human decision element in investing.

I have a natural aversion for using formulas. They preclude being able to do a reality check. You basically have to blindfold yourself and follow the formula regardless of what your instincts are telling you. That, of course, is the whole purpose of using a formula. But, I would rather develop learned instincts to counteract the effect of behavioral biases and cognitive errors.

The gap-to-edge rules listed at the end of each chapter of the Motherlode are for the most part taken from or inspired by the approach to investing exemplified by Keynes, Graham, Templeton and Buffett.

My use of and constant reference to terms such as behavioral gaps, behavioral biases, cognitive errors and gap-to-edge rules will no doubt drive some readers to distraction. It would be wonderful if these concepts could not only be explained but also used without resort to what seems like mind numbing jargon. Unfortunately, these concepts are not simple and clarity of thought and expression demands that they be defined or described with the utmost clarity so that they can be used with clarity later.

Other posts on investment psychology

This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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