The individual investor
Coming to grips with our human foibles
The theme of this post is practical steps we can take and practical things we can think about to avoid doing stupid things in the stock market and take advantage of stupid things others do.
Peter Lynch, one of the great investment managers of the 20th century wrote: “Things inside humans make them terrible stock market timers. The unwary investor continually passes in and out of three emotional states: concern, complacency, and capitulation. He’s concerned after the market has dropped or the economy has seemed to falter, which keeps him from buying good companies at bargain prices. Then after he buys at higher prices, he gets complacent because his stocks are going up. This is precisely the time he ought to be concerned enough to check the fundamentals, but he isn’t. Then finally, when his stocks fall on hard times and the prices fall to below what he paid, he capitulates and sells in a snit.” (Lynch, One Up on Wall Street. 1989,1990) p70. Lynch is talking about what, today, behavioral psychologists would call, amongst other things, overconfidence, risk seeking and risk avoidance behaviors. These are all pathological behavioral biases.
By buying and selling at the wrong time, investors suffer from poor results and what has been called the behavioral gap. The gap is the spread between their portfolio results (worse) and the performance of the underlying securities (better).
Through reading and experience investors can develop skill. With time they can enjoy a behavioral edge. They can enjoy superior performance. They are able to do this because their counterparty is Mr. Market. (If you want to read more about Mr. Market just click [don’t just hover] on the highlighted blue).
What follows, first, is a list of bullet points. Simply reading and understanding these bullet points will not make you a skilled investor overnight. They are listed to give you a clue as to the kinds of things to think about.
Following the bullet points are links to a series of posts that discuss the different behavioral biases that negatively impact our investing. Each post has a list of what Daniel Kahneman, a Nobel Prize winning psychologist, calls risk policies and I call gap-to-edge rules.
Things to think about
- Read avidly
- Learn something from every mistake.
- Consciously and on a regular basis look for and read evidence and opinions that disagree with your current views.
- Cultivate an open mind and independent thinking.
- Remain skeptical and flexible regarding your own approach to investing.
- When all is going well in the stock market be wary. When all is going badly, take heart from the opportunities that present themselves.
- Do not to be contrary just to be contrary. We must be prepared to be contrary when our independent judgment tells us to be.
- Maintain some physical and mental distance from Wall Street.
- Take nothing on faith from experts.
- Disregard pundits entirely except for amusement.
- Be on the lookout for Mr. Market’s refusal to give weight to evidence in plain sight that is contrary to his views.
- When you have had a few recent successes – that is the time to be more cautious.
- When you have had a few recent failures that is the time to learn from your failures and not lose heart. That may be a time when opportunity knocks. A few recent failures don’t make you a bad investor.
- Educate yourself about the pervasive impact of the availability heuristic.
- Always take time to step back and get perspective.
- Ignore ‘doom and gloom’ and ‘new age’ pundits completely.
- Recognize the fact that purely random data can produce what looks like a pattern or a trend even though no pattern or trend in fact exists
Reading material
Reading is the first step to countering our behavioral biases and developing a behavioral edge.
A set of rules to develop a behavioral edge – Part 1 The problem of short-term thinking
A set of rules to develop a behavioral edge – Part 2 The attractive trap of extrapolating the most recent past into the future
A set of rules to develop a behavioral edge – Part 3 Control our animal spirits when faced with risky situations
A set of rules to develop a behavioral edge – Part 4 The herd mostly gets it wrong
A set of rules to develop a behavioral edge – Part 5 Our minds search for confirming evidence
A set of rules to develop a behavioral edge – Part 6 We generalize from limited observations
A set of rules to develop a behavioral edge – Part 7 Over-confidence and optimism bias
A set of rules to develop a behavioral edge – Part 8 Jumping to conclusions
Conclusion
Investing can be easy. You put your retirement savings into an index ETF and forget about it until you retire. You won’t have to manage yourself. You will achieve satisfactory results. If you want to achieve superior results you have to work at it. It doesn’t take a lot of time because, once you are invested in superb companies, the best policy is to do nothing and be patient. Through the magic of compounding over the years, the difference between satisfactory results and superior results is like night and day. The added bonus is that it is very satisfying.
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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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You can reach me by email at rodney@investingmotherlode.com
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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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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