Investment psychology
Promote Broad Framing, long-term thinking and reduce trading
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 foibles and that of stock market participants as a whole.
Rather than list off a string of behavioral biases and cognitive errors, I come at the problem from a different angle. I have looked at the kinds of human errors we regularly make as investors. For each, I have come up with a set of rules that will help us counter these errors.
Kahneman’s risk policies
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. In explaining what he means by risk policies, he gives examples in an insurance context. Many consumers will chose a low deductible or shell out for an extended warranty because they want to lower the risk of loss. If they broad framed the insurance decision over the long run, they would see that low deductibles and extended warranties actually cost more over time.
Kahneman’s advice is to develop risk policies using a broad frame. In the insurance context this means having little rules or policies such as: “always take the highest possible deductible when purchasing insurance” or “never buy extended warranties.” Kahneman has a whole chapter on this. (Kahneman, 2011Thinking, Fast and Slow.) pp334-341.
Investing context
Many investors get caught up in short term thinking. They look at price movements of stocks they have bought on a week-to-week or month-to-month basis. And they also get caught up in short term movements of the broader stock market and the economy. What they have trouble with is Broad Framing the investment as part of a complete portfolio and as part of a long-term investment strategy – that is, they will have trouble taking the long view. A Broad Framing investor like Warren Buffett will look at the performance of the investment as part of the overall portfolio and over the long haul.
The risk policies I have developed for investors are aimed: first, to help us overcome the behavioral gap. That is, to overcome our human foibles that cause us to do things like frame narrowly. Second, they are designed to help us obtain a behavioral edge over other investors. That is, to take advantage of the human foibles of other investors, both professional money managers and individual investors. These other investors are what Ben Graham and Warren Buffett call Mr. Market.
I awkwardly call these risk policies gap-to-edge rules. This is not a felicitous term, but you get the point.
Part 1
Today’s post deals with the problem of short term thinking. I call this post Part 1 because I have developed gap-to-edge rules for a number of other psychological problems we have as investors. These include: Overweighting Improbable Outcomes; Changing our minds; Jumping to Conclusions; Overgeneralizing and Finding Causes; Focusing too much on Recent Events; Over-confidence and Optimism; and, Our Urge to Do what Everyone Else is Doing. These will be covered in a later post or posts.
Gap-to-edge rules to promote Broad Framing, long term thinking and reduce trading
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 human foibles we all suffer from.
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. For older investors with substantial assets and children, the horizon should be the joint lives of the investor and their children.
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. This is Warren Buffett’s metaphor about putting together a championship basketball team. The concept applies to putting together a really great stock 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 Buffett, The Making of an American Capitalist.) p.325. (Emphasis added)
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, The Essays of Warren Buffett: Lessons for Corporate America. Lawrence A. Cunningham) p.93 (Emphasis added)
Gap-to-edge rule: Wait for the right pitch.
Without embarrassment, the previous gap-to-edge rule is repeated in different words. Both phrasings are worth keeping in mind. This is another Buffett metaphor.
He 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.’” (Emphasis added)
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, 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. 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. Many investors think low risk investing means investing in cash cow companies with low price earnings ratios. Cash cow companies are superficially attractive but they typically have little opportunity to invest excess capital profitably.
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. 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, 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 their own personal wealth tied up in company common shares, I am content if they protect themselves 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.
Directors and management who only hold options 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.
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.
And keep it out of your mind forever. After purchase, the purchase price is utterly irrelevant. All that matters is the current fair value and the current price.
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 post.
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 it goes up to fair value is short term thinking.
Gap-to-edge rule: Sleep on any decisions you make to buy or sell shares.
I place all my orders online on Saturdays. They can’t be carried out until Monday morning, which gives me two nights to sleep on every decision.
Conclusion
No doubt we could come up with other gap-to-edge rules to promote broad framing and investing for the long haul. The main thing is to take these key risk policies seriously to heart. Today everyone is fretting about inflation and the potential for a recession. Trying to decide on the outlook for these macro-economic things can be a distraction. It’s interesting to read about this stuff. I’ve just finished a book by Ben Bernanke titled 21st Century Monetary Policy. It’s worthwhile to put it all in perspective and learn about the big picture. But, long term investors don’t need to worry themselves about what is going to happen in the economy or the stock market in the next year or two.
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Other posts touching on topic
The inherently short-term nature of the investment management industry
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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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I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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