Dangerous first impressions
The theme today is self-reliance. I intend to focus on the danger of relying on what even high profile investors are doing.
Let’s say you read or hear that a high profile investor, say one of Warren Buffett, Ray Dalio, Joel Greenblatt, Carl Icahn, Jim Simons, Jeremy Grantham or Seth Klarman, has established a position in a particular company. This jogs you to check it out and think about investing in that same company. After all, if it’s good enough for them it must be ok for you. This puts you on a very dangerous course.
The danger is that the company at this point has a halo around it. There is a slippery slope around what Daniel Kahneman calls the ‘Halo Effect’.
The halo effect and first impressions
From the moment we know that Joel Greenblatt has invested, our look at the potential investment comes with a first impression. As we proceed with our investigation a tendency sets in. Evidence that supports the first impression is happily noted and our first impression is confirmed. Then we come across evidence that casts doubt on our first impression but a behavioral bias in our brains tends to downplay or underweight contrary evidence. We are quickly jumping to a conclusion about the company and it will stick. Our brain will have worked quickly and automatically. Sometimes conclusions based on first impressions are right and sometimes they are very wrong.
The way Kahneman puts it: “…evidence accumulates gradually and the interpretation is shaped by the emotion attached to the first impression.” (Kahneman, 2011, Thinking, Fast and Slow) p.82.
Kahneman writes: “Conscious doubt is not in the repertoire of [our brain]; it requires maintaining incompatible interpretations in mind at the same time, which demands mental effort.” (Kahneman, 2011) p.81.
He adds: “[Our brain] is radically insensitive to both the quality and the quantity of the information that gives rise to impressions and intuitions.” (Kahneman, 2011) p.86.
Two things needed
The problem is that we often don’t realize the impact of our first impression. Two things are needed: 1/ an awareness of the problem and 2/ a routine to make sure proper due diligence is carried out before an investment decision is made.
Awareness of the problem
The Halo Effect around high profile investors is one of a group of behavioral biases that might be called the problem of jumping to conclusions. Other examples include:
Love Tesla cars, bought the stock
Ignoring base rates
Benefit to society of ESG investing
Familiarity and home bias
WYSIATI – what you see is all there is
To read more take a look at my post:
The worst behavioral bias – jumping to conclusions
Once you have sensitised yourself to the danger of first impressions, you are more than halfway there. Let’s think about it.
On the surface I don’t suppose there is that much harm in knowing what our favorite high profile investor owns or is buying. If it is simply for the purposes of creating a list of stocks to investigate there is some sense to it. But it makes sense only if you do your own due diligence free of powerful first impression and reach a solid independent conclusion.
You have to realize that these high profile folks are in the game for themselves, not for you. As Warren Buffett said: “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
High profile investors buy and sell for their own reasons
They have their own reasons for buying and selling. They may invest in superb companies but by the time you learn they are invested the stocks may be fully or overpriced. They may invest in a particular stock as a matter of balance against another position you are completely unaware of. Many of the stocks bought by the high profile investors trade at a premium price because their ownership position is known. They may trade at a premium because these investors can only invest in stocks with high liquidity. Buffett with his elephant gun is limited to hunting elephants. Small investors can use a pea shooter to good advantage for a more diverse range of prey.
If you have faith in your own stock picking judgement it really doesn’t matter whether the stock is owned by high profile investors.
And this leads to the issue of self-reliance and not having to rely on others when it comes to investing.
Self-reliance seems to be made up of two things: It requires the ability to think for yourself even if everyone around you has a different view. And it requires the courage to act on your ideas.
I suspect that self-reliance is a trait that develops in childhood. It is learned at school from good teachers and at home from good parents. Children need to be exposed to the natural consequences of their actions to learn to think for themselves and be self-reliant. I also have no doubt that self-reliance can be enhanced throughout life.
If you always look to others for confirmation that you are right you will never be self-reliant. There is a fine line. To some extend we need to rely on others. We need to gather information and ideas wherever we can. We read news reports. We read analysts’ reports. We learn what a particular high profile investor is buying. With experience in the stock market you come, in time, to know what you can rely on from others and what to reject. You will also come to know whether your judgment is sound. At that point you will have something to base your convictions on when you most need them. When you develop confidence in your judgment you become less vulnerable to all the behavioral biases and cognitive errors I have written about in my blog.
Self-reliance and independent thinking are tested in a crowd. Philip Fisher wrote: “A basic ingredient of outstanding common stock management is the ability neither to accept blindly whatever may be the dominant opinion in the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary. Rather, it is to have more knowledge and to apply better judgment, in thorough evaluation of specific situations, and the moral courage to act ‘in opposition to the crowd’ when your judgement tells you you are right.” (Fisher, 1958,1996 Common Stocks and Uncommon Profits and Other Writings ) p.277.
Doing your homework
I have developed dozens of what I call Gap-to-edge rules. They are designed to counter the behavioral gap and give the investor an edge over other investors who suffer from behavioral biases. All investors, even the most sophisticated and experienced on Wall Street, suffer from behavioral biases. Here is one Gap-to-edge rule that applies to this situation:
Gap-to-edge rule: Never buy shares in any company without doing your homework.
It’s easily said but hard to live by. And I mean ‘never’. We need to be strict with ourselves. We need to avoid buying based on little or no real analysis. As John Templeton says in his Maxim 2: “Achieving a good record takes much study and work, and is a lot harder than most people think.”
The danger in making a habit of checking out what some high profile investors are investing in is that a halo may surround our first impression. We may unconsciously tend to notice and rely on evidence that supports that first impression. At the same time we may unconsciously tend to ignore contrary evidence. We fall back on the heuristic that if the stock is ok for Warren Buffett it must be ok for us. This may often work out well. It can also be a disaster. The reason it can be a disaster is that we never did our homework and formed our own judgement as to whether the stock was suitable for us.
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.
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