Updated: May 17
Having now written two series of articles exclusively for Trustnet on the subjects of ‘investment risk’ and ‘value investing’, I now turn my attention to ‘behavioural investing’. Warren Buffett’s partner Charlie Munger once said, “If it isn’t behavioural, what the hell is it?” True, this was in relation to economics, but he could well have been talking about investing.
"Reality is subjective not objective"
The classical approach to the study of economics, finance and investing assumed that we humans behave rationally or optimally. In other words, that there is an objective reality and, having calmly analysed this objective reality, we make the best or right decision. This made things appear neat and tidy, but there was a tiny, almost imperceptible flaw - it was rubbish. We humans can and often do make bad decisions, sometimes en masse.
What we think of as ‘objective reality’ is not objective at all. The world around us is something that we perceive through our various senses and cognitive processes, and thus is subjective not objective. We are all born with a unique way of seeing the world, which may well not be the same way others see it. It is like each of us being born with our own uniquely tinted sunglasses, which we wear throughout our lives. We are not generally aware of the tint, because it has always been with us, but tint there is. Try perceiving reality without using your perception. See, it’s impossible!
The study of behavioural ‘anything’ must start with the fundamental acceptance that reality is subjective not objective. To benefit from this study, you’ll then need to analyse your own tint, to make adjustments to it if and where possible, to appreciate the various tints of others, and finally to make an informed judgment as to whether your tint helps you see things more clearly than they do. If you deem that it does, you may well make a good investor.
Another word for ‘tint’ is ‘cognitive bias’. Think of these as mental shortcuts that help us make sense of the world. For example, when we ‘see’ a cobra, we do not actually see a cobra. Instead, we perceive a shape, movement and context that we have been told, probably by our parents, is ‘cobra’ (the omission of the word ‘a’ is intentional as we are talking here about ‘cobra’ as a concept rather than a ‘real’ thing). We also learn a cognitive response to encountering a cobra, assuming there is nothing between you, the technical term for which is ‘getthehelloutofthere’.
However, a shortcut, by definition, stops us from seeing the whole picture. The missing pieces, whatever they are, can cause us to make bad decisions (the right decision with cobras is to stay very still and cover your eyes which, incidentally, I learned from experience).
In other words, we are flawed beings, but it could ne’er be otherwise. As Alexander Pope wrote, “To err is human”. You may well be reading this thinking, ‘I’m not flawed’ or ‘I see the world clearly’. In which case, I would urge you to look up ‘cognitive reflection test’ or ‘birthday paradox’ or ‘Monty Hall problem’ or ‘the barbershop paradox’ or ‘Russell Paradox’ (formal version of the barbershop paradox). Or look at Dutch artist Martin Escher’s etchings. Or try to grasp Kurt Godel’s incompleteness theorem. These are all things that expose flaws in one’s thinking and perception, and make it patently clear that we can never see things clearly (another paradox!)
If you have accepted your flaws, and perhaps even embraced them, you are well on the road to becoming the best investor you can be. You’ll either have accepted that you’ll never be able to make adjustments, such as standing still rather than running from a cobra, in which case passive investing is for you. Or you’ll make the adjustments necessary that will enable you to succeed in ‘active investing’.
In the last two of three years, I have increasingly noticed people, many of whom should know better, making the ‘Granddaddy’ of investment mistakes, namely to translate ‘there is a lot to worry about’ into ‘stock markets will go down’. There is a good chance, particularly if you watch the news or read newspapers, that what you are worrying about is something that many others are also worrying about. And since financial asset prices reflect the views of market participants, they will already reflect this
To make money, you’ll either have to worry more than others or worry less (being different is an essential ingredient of successful investing). Furthermore, you’ll also have to take account of the fact that news channels and newspapers are commercial enterprises that understand that bad news sells better than good news.
Worrying even more than people who are worrying about the same thing and whose worries may already be irrational given media bias is either doubly irrational or requires specialist insight and expertise that, with respect, you probably do not have. Ask yourself where markets are on the worry-euphoria spectrum. The closer they are to one of the extremes, the more likely they are, by definition, to move away from them (there is more space on that side).
In other words, when others are fearful, be greedy. Now, who was it who said that?
Published in Trustnet
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.