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How Thinking Affects Investing: Part 4 of 4

Recipe for Long-Term Success


Saturday, July 7, 2012

This is the last in a series of four columns. The series’ purpose is to discuss the practical lessons we can learn from behavioral economics, that branch of economics that studies how decision-making is influenced by what we feel and think.

We have noted that to be a successful investor we must know what we are doing, make good decisions, think rationally — and be lucky.

Harley Hahn

Most people, however, are poor investors because they make decisions primarily to avoid emotional discomfort. This is because their thinking patterns are unconsciously influenced by heuristics and cognitive biases.

Summary of Heuristics and Cognitive Biases:“Heuristics” are mental shortcuts that underlie our decision-making processes. We use heuristics many times a day to help us make good decisions quickly, often with minimal information. However, when we apply heuristics to the stock market — which is much different from everyday life — they often lead us astray.

Cognitive biases” are powerful patterns of thinking, mostly irrational, that tend to always lead us astray.

We are generally not aware that we are applying heuristics or cognitive biases to our decision-making, which means it is difficult to recognize and correct the source of poor results.

Here is a summary of the heuristics and cognitive biases, along with the Rules of Investing, that we have discussed in the previous columns.

1. False Analogies to the Physical World

Interpreting investment information, such as graphs, as if they were describing phenomena in the physical world. This leads us to assume that stock prices act as if they are following the laws of gravity and inertia.

Harley’s Rule of Investing #1: Your intuition cannot predict what a stock will do.

2. Representation Bias

Assuming that similar circumstances will lead to similar outcomes. This leads us to assume that the past can predict the future.

Harley’s Rule of Investing #2: When you are investing, the past does not predict the future.

3. Loss Aversion

Experiencing more satisfaction from avoiding a loss than from acquiring a similar gain. This leads us to make decisions because of the fear that we will suffer emotionally if we sustain a loss.

Harley’s Rule of Investing #3: The most expensive tuition is what you end up paying the market to teach you how to take a loss.

4. Endowment Affect

Placing a higher value on something we own, compared to how we would value it if we didn’t own it. This makes it difficult for us to sell our holdings even when it is in our best interests to do so.

Harley’s Rule of Investing #4: The stock doesn’t care who owns it.

5. Disposition Effect

Waiting too long to take losses or to moving too quickly to realize gains. Over time, this causes us to increase our losses and decrease our gains.

Harley’s Rule of Investing #5: Ignore what you feel; buy and sell when it makes sense.

6. Sunk-Cost Effect

Refusing to acknowledge that money that can never be recovered is gone forever. This makes it difficult to abandon a misguided plan when we have already spent money on it.

Harley’s Rule of Investing #6: Once money is gone, you can’t get it back — so don’t try.

7. Anchoring

Relying on only one specific item of information (an anchor) when making a decision; for example, the price that we paid to acquire a stock. Anchoring makes it difficult to analyze a situation logically, independent of previous costs or gains.

Harley’s Rule of Investing #7: The stock doesn’t care what you paid for it.

8. Confirmation Bias

Remembering and interpreting information in a way that tends to confirm what we already believe. This severely limits our ability to make independent, rational decisions.

Harley’s Rule of Investing #8: The market doesn’t care what you believe.

9. Cognitive Dissonance

The mental discomfort caused by holding multiple contradictory ideas related to a belief or a desire. This discomfort is especially pronounced when our actions do not match our beliefs. Cognitive dissonance often occurs when we encounter information that indicates that a previous decision may not work out as well as we had hoped. This leads us to reduce our discomfort by ignoring or discrediting the new information.

Harley’s Rule of Investing #9: It is a lot easier to be honest with other people than it is to be honest with yourself.

10. Bounded Rationality

The realization that our potential to make the best possible choices will always be limited by our information, our ability to think rationally, and the finite time we have to make decisions.

Harley’s Rule of Investing #10: Sometimes good enough is good enough.

How to Think Clearly and Invest Well

To be a good investor, you must, over time, acquire skill and knowledge. To become a successful investor, however, requires more. You must be able to make good decisions consistently, month after month after month.

Like a pilot who learns how to depend on his instruments, you must train yourself to think clearly and logically at all times. This requires you to base your financial decisions on rational thinking, not on your feelings or intuition.

The easiest way I know to develop these habits is to apply your knowledge of heuristics and cognitive biases every time you find yourself making a financial decision. Eventually, this will eliminate distortions from your decision-making, at which point thinking clearly about your investment activities will become second nature. Here is how to do it.

Whenever you find yourself making a financial decision, no matter how small, go through the following checklist, one item at a time.

1. False Analogies to the Physical World

2. Representation Bias

3. Loss Aversion

4. Endowment Affect

5. Disposition Effect

6. Sunk-Cost Effect

7. Anchoring

8. Confirmation Bias

9. Cognitive Dissonance

10. Bounded Rationality

For each item, recall the nature of the bias. Then ask yourself:

Right now, is this particular bias affecting my decision-making?”

If you are honest, you will often realize that your thoughts are distorted. When this happens, simply revise your ideas and try again. I promise you, once you can get through the entire checklist, and you honestly feel confident that none of the biases are affecting your thinking at that moment, you will be happy with your decision.

Eventually, as you train yourself to avoid the cognitive biases that plague financial decision-making, you will find that, more and more, you are able to think carefully and act prudently, especially under pressure.

When that day comes, you will be a successful, confident investor.

The Final Word:

The recipe for long-term success can be summed up simply:

1. Adopt a reasonable plan that is likely to work in the long run.

2. Stick to your plan.

3. At regular intervals, carefully reevaluate your plan and your results, and make any adjustments that are necessary.

These three guidelines are the foundation of all successful, long-term investment strategies. As such, I am sure they make a great deal of sense to you. However, there is more.

Being a good investor requires more than becoming proficient at trading stocks and managing money. You must also develop a sense of humility. As you do so, you will slowly learn about yourself, your thinking habits, and your unconscious motivations. In the long run, these insights are crucial to your overall success, as they enable you to master your emotions, particularly fear and greed.

The stock market is a complex and uncaring place, and it is up to you to look after your own interests. You must learn to respect the strong, impersonal forces that can affect you without warning. This requires an honest, realistic understanding of your personal shortcomings, as well as the limitations placed upon you by your environment.

This idea is so important that I will embody it as one last rule.

Harley’s Fundamental Rule of Investing:

The market doesn’t care whether or not you make money.

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