The power of framing
Sometimes we are risk averse even though we are likely to win. At first blush, this is counter-intuitive.
Take a bet
Kahneman tells of a gambling proposition made by Paul Samuelson, one of the leading American economists of the twentieth century, to a friend. The offer was that on a single toss of a coin the friend could lose $100 or win $200. The friend apparently responded: ‘I won’t bet because I would feel the $100 loss more than the $200 gain. But I’ll take you on if you promise to let me make 100 such bets.’
Feeling the pain of loss more than the satisfaction of winning is known as Loss Aversion.
The proposition with one hundred bets apparently has an expected return of $5,000 with only a 1/2,300 chance of losing any money and a remote 1/62,000 chance of losing more than $1,000. (Kahneman, Thinking Fast and Slow, 2011) p.334-339.
The friend should have taken the single toss bet on two conditions: if they always acted consistently in life and the bet was of a moderate amount of money – in short, if they had taken the long view. The point is that with a single investment decision, one can nevertheless take the long view.
There are rules or policies we can adopt that lead us into taking the long view. 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.” (Kahneman, 2011)pp.334-341.
We can adopt investing policies that cause us to adopt the long view. It is a matter of framing our investment decisions broadly.
What I call gap-to-edge rules are investment rules or policies we adopt that help us to beat the behavioral gap and also gain a behavioral edge over Mr. Market; hence, gap-to-edge. They are the investing equivalent of Daniel Kahnaman’s risk policies.
These gap-to-edge rules are, for the most part, borrowed from the great investors like Warren Buffett and John Templeton. All I seek to do is show how the use of their ideas can help investors to overcome the various behavioral biases and cognitive errors discussed in the Motherlode.
Gap-to-edge rule: Explicitly set an investment horizon based on your life expectancy.
For younger investors this may be sixty years or more. For a newly retired investor, this may be twenty five years or more.
This should help investors to Frame Broadly using the insight gained from the Motherlode Section 12.04 Success through Broad Framing. At a horizon of thirty years, holding tight for the duration means the investor is almost certain to enjoy a handsome return.
Gap-to-edge rule: Invest only in superb companies.
Look for the seven footers. They are rare. When you find one, make a substantial investment. If they are superb companies, you won’t need to sell them any time soon. As for finding superb companies, see Part 7: Building and managing a portfolio.
Roger Lowenstein lists Warren Buffett’s guide to buying companies. He writes: “Study prospects – and their competitors – in great detail. Look at raw data, not analysts’ summaries. Trust your own eyes, Buffett said. But one needn’t value a business too precisely. A basketball coach doesn’t check to see if a prospect is six foot one or six foot two; he looks for seven-footers. (Lowenstein, 1995,2008)p.325.
Philip Fisher, whose writings were a significant influence on Warren Buffett, was an advocate of limited diversification. His philosophy simply was that there are a very limited number of truly excellent companies and that when you find them you should invest substantial portions of your portfolio in them. Fisher considered it a mistake to over diversify.
Warren Buffett describes his approach thus: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, 1998, p.93)
Gap-to-edge rule: Wait for the right pitch.
Without embarrassment, the previous gap-to-edge rule is repeated in different words. Both phrasing are worth keeping in mind.
Waiting for the right pitch is a Buffett metaphor. To understand it, consider how he puts it.
Buffett writes: “Ted Williams, in The Story of My Life, explains why: ‘My argument is, to be a good hitter, you’ve got to get a good ball to hit. It’s the first rule in the book. If I have to bite at stuff that is out of my happy zone, I’m not a .334 hitter. I might be only a .250 hitter.’ Charlie [Munger] and I agree and will try to wait for opportunities that are well within our own ‘happy zone.’”
You have money to invest. Many investment ideas come to your attention. You think, ‘if I leave my money in cash too long I will be losing the chance to make a good return from it’. You decide to invest in a decent stock. It is not a superb company. That would be a mistake. That is Buffett’s idea of swinging at a bad pitch. You have lowered your standards just to get your investment dollars invested. Waiting for the right pitch is waiting for a superb company at a bargain price.
Gap-to-edge rule: Expect that the bargain you buy may take several years to become fully priced
Templeton says, “Often, when we get into something that we are sure is a bargain, it remains a bargain for years.” He goes on, “In other words, it doesn’t move up in price. The type of investment takes a lot of patience, but usually it pays off.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.107.
The idea is explained. “So I guess the basic principle is this: If you apply the same methods of selection that other people are applying, you’ll get the same things they’re buying and you have the same record they have. But we try to have a longer-range viewpoint – and the patience that goes along with it. So we try to buy those things that others have not yet thought about. Then we wait until the short-term prospects become good and other people start coming in and buying the stock and pushing the price up.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.107.
Gap-to-edge rule: Buy shares only in companies whose earnings are virtually certain to be materially higher five, ten and twenty years in the future.
This is from the Buffett quote a few paragraphs above. To be convinced of the ‘virtual certainty’ the investor must consider the strength of the business franchise, its pricing power, whether it is protected by one of Warren Buffett’s moats, its ability to generate Free Cash Flow and its opportunities to deploy its excess capital in a profitable way. As we will see in the chapter on the general approach to choosing companies to invest in, the range and variety of companies which can meet this test is quite broad. They do not have to be dull plodders. They can be great growth companies.
Templeton say to look at earnings two to five years in the future. This means paying much less attention to quarter by quarter results and forecasts for the next year.
Gap-to-edge rule: Buy only if you would be prepared to hold the shares for ten years.
This comes from the last quote. At other times, Warren Buffet has suggested that investors ask themselves if you would still buy the shares if they knew the stock market was going to be closed for five years. The same sentiment was expressed in the quote at the beginning of this chapter. Warren Buffett suggests his favorite holding period is forever.
As for his typical holding period, Templeton says: “Benjamin Graham did feel that if he bought a stock, thinking it was the best bargain, and in two or three years it hadn’t proved to be a good bargain, then he should change. Too much changing is too expensive. And so at present I’m holding things longer than four or five years. But the time period isn’t really the thing that guides me in making my decisions. If you find something that’s an excellent bargain, in order to buy it you have to sell something else. And so I look over my list to see which stock that I own is the least good bargain – and I sell that. But in this process I haven’t asked myself whether I’ve owned the stock one week of twenty years. It makes no difference! It’s only when I look at the history of what I did that I find I have an average holding period of about six years.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.109.
Gap-to-edge rule: When buying shares view the purchase as though you are buying into a private business.
Warren Buffett says that his attitude when buying common stock is to “approach the transaction as if we were buying into a private business…..When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett, 1998, p.63)
The rule that investors should consider that they are buying into a private company is designed to do more than stimulate proper due diligence. If one were buying a share in a private company one would become locked in for an extended time. There would be no stock market to dump the shares on if you have made a mistake. But, doing proper homework also stimulates Broad Framing.
Many investors will do more spadework when looking to buy a new car than they will when buying shares in a public company. We know we will own the car for many years. We better get it right. When buying a house we think about the neighborhood, check out schools, look at umpteen prospective houses, get a condition report and much more. We know we will own the house for many years.
When buying shares on the stock market many investors will content themselves with advice from a friend or broker, read a story in a newspaper or on the internet and take a quick look at an analyst’s report and its projected sales and earnings growth for the next year or two.
An investor should say to himself before every purchase: What would I be checking out if I were buying a share in a private company. This will encourage Broad Framing of the decision.
Gap-to-edge rule: Confine your investments to companies whose quarterly and annual reports demonstrate a credible commitment to a long term business philosophy.
It is amazing how many commentators warn investors off from reading what the CEO has to say in quarterly reports and the annual report. I find them revealing. If the Chairman or CEO is trying to sell me a bill of goods it is usually obvious. I look for frankness and honesty in these communications. I look for acknowledgements of mistakes. I don’t accept the excuse that the dog ate their homework. I want to see long term thinking expressed explicitly with tangible supporting evidence.
Gap-to-edge rule: Favor companies in which the directors and management own a large stake.
John Templeton wrote in 1982 in his Maxim 17: “In the long run, shares of companies in which management owns a large stake generally will out-perform the others. See Appendix 2: Templeton Maxims 1982 Version
In this regard, I have no problem with multiple voting shares. If the CEO or Chairman has $50 million or $500 million of his own personal wealth tied up in company common shares I am content if he protects himself with multiple voting shares. Directors and management with a large stake cannot play the heads I win and tails you lose but I don’t lose game. With options they are incented to take major gambles with the company’s money with the hope of a major gain. If the gamble doesn’t work out they haven’t lost anything. If a major portion of their personal net worth is tied up in the common shares of the company they will make more prudent capital allocation decisions. This is consistent with your interest as a shareholder and your thinking as a long term investor.
Gap-to-edge rule: Pay no attention to economic forecasts and ignore all predictions as to where the stock market will be in the next year or so.
In the in the Berkshire Hathaway Chairman’s letter for 1988 Buffett wrote: “As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies. We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.”
According to Roger Lowenstein, one of Warren Buffett’s guides in relation to buying companies was to “pay no attention to macroeconomic trends or forecasts, or to people’s predictions about the future course of stock prices. Focus on long-term business value – on the size of the coupons down the road [referring to Buffett’s idea that ‘owner’s earnings’ or Free Cash Flow performed essentially the same role in valuing common stock as coupons performed in valuing bonds]”. (Lowenstein, 1995,2008)p.325.
Gap-to-edge rule: Put little weight on news, either good or bad, that affects the short term, except when you take advantage of it to buy shares at a bargain price.
News, especially news that is written up (framed) to help sell newspapers and draw viewers, is a distraction.
Gap-to-edge rule: Avoid watching the nightly TV business news report.
Apart from the framed news, investors will be exposed to the unrelenting and useless forecasts of pundits.
Gap-to-edge rule: Avoid any buying or selling of stocks based on the idea that this is the right time to buy or sell.
The basic rule is to buy the shares of high quality companies at bargain prices and hold them through thick and thin.
Market timing is a major cause of the behavioral gap. Buying based on a well thought out margin of safety is timing by price and is fine. It is another animal entirely. Also, buying bargains based on John Templeton’s point of maximum pessimism is timing by price, also a fine approach.
Gap-to-edge rule: Put the price you have paid for a stock completely out of your mind.
The price you paid for a stock is utterly irrelevant the moment you have bought it. This can be helped by purposely not looking at any account reports that show the gain/loss in individual positions.
Gap-to-edge rule: Make no sale of a winning stock in your portfolio unless the sale serves to improve the overall quality of the portfolio.
Kahneman refers to a study of trading records of 10,000 brokerage accounts of individual investors spanning a seven year period. Altogether there were 163,000 trades. The data allowed the researcher, Odean, “to identify all instances in which an investor sold some of his holdings in one stock and soon afterward bought another stock. By these actions the investor revealed that he (most of the investors were men) had a definite idea about the future of the two stocks: he expected the stock that he chose to buy to do better than the stock he chose to sell.”
The results: “On average, the shares that individual traders sold did better than those they bought, by a very substantial margin: 3.2 percentage points per year, above and beyond the significant costs of executing the two trades.” (Kahneman, 2011)p.213.
Kahneman believes the reason investors do this is because of overconfidence. We will look at this phenomenon in another chapter.
Gap-to-edge rule: Sell only if the long term prospects of the company dim, or if you find a better company at a bargain price.
Selling once a stocks’ price has reached intrinsic value is a mistake. Over your long term holding the price will fluctuate around fair value. Selling when goes up to fair value is short term thinking.
Gap-to-edge rule: Sleep on any decisions you make to buy or sell shares.
My practice is to placer orders online only on Saturdays. This gives me all day Sunday to reflect and change my mind.
For a deeper read on the perils of short term thinking see Chapter 12. Short Term Thinking and our Flower Garden
This Chapter continues with these Sections:
In the whole discussion of investing psychology several terms keep coming up and need to be clearly understood. There are more, but we can start with these two pairs: 1) risk aversion and risk seeking; and 2) Narrow Faming and Broad Framing.
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