Friday, April 06, 2007

Rationality and how to maintain it

Two of the biggest obstacles to successful investing are irrational thinking and not learning from the past. During a bear market, people act as if everything will go flat forever. The same applies to a bull market. Biases such as these fall into the category of heuristic simplification.

Another major bias is when people have a few success, they immediately attribute themselves to their prowess as an investor, rather than to luck. This is called self-attribution bias.

But whatever their names – what is important is not to get caught by them.

One of the most effective ways to achieving this is to start a stock book. Putting it simply, a stock book is a place where you write down the reasons why you are buying or selling a particular stock. It is also a place where you can keep all the relevant information about the companies you are interested in. It can be as simple or as complex as you like.

When I start to get interested in a particular stock, I can go to my stock book to see if there is any material on the company I gathered before. When I look at the old material I had gathered, the company had made various forward looking statements and so I can gauge whether or not they have lived up to them.

Another important way for using your stock book relates to buying stocks. Before you buy, write down the main reasons why you are doing this. What is it that you particularly like about the company? What is its market position or niche? What do you think will take place in the future?

Take your time to write down your thoughts in these types of areas. There are two main benefits for doing this. The first is that it sharpens your thinking about why you are taking a particular action. You are more likely to buy for rational reasons. If not, at least you will know that you are not being rational.

The second reason is that it helps to improve your skill in making decisions in following years. Often we buy a stock for reasons that are vague and only partially thought through. The problem with this is that, even if the investment is successful, it is no help for making the next decision, or any others after that. The best you can deduce from it is that you were lucky once and perhaps you will be lucky again. But bear in mind, “not everyday is a Sunday.”
You may be satisfied with this approach when you are investing comparatively small amounts of money. But I like to think that no matter where you are now on the wealth scale, it won’t be long before you are investing significant amounts of money. When that happens, lackadaisical methods will no longer be enough.

Putting it simply, you may be prepared to invest $1,000 on a hunch, but few people would be willing to do the same with $100,000 or more. So it is always better to cultivate the correct attributes early in the stages. Just as a human, it is easier to cultivate good quality when young. You don’t leave it till later to learn because in human nature, it is hard to change habits. As the saying goes, “Chain of habits are too light to feel until they are too heavy to break.”
Another advantage is that if we are clear why we bought a stock, we can test in later years if our reasoning was sound. If the price went up, it reinforces our reasoning. If it did not go up, then we can look back at our logic and perhaps locate steps where we went wrong. This may help us to avoid the same mistake in the future.

Warren Buffett is a great supporter of being clear why you bought a particular stock at a particular time. Recently a group of students paid a visit to the “Sage of Omaha”. In response to one of the questions, Buffett replied:

“My partner Charlie Munger and Tony Nicely at Geico are always rational. 160 IQs can say stupid things that sound good. People do silly things, whether they have 120 IQ or 160. You can always improve your rational thought. Rationality is the only thing that helps you. One thing that could help would be to write down the reason you are buying a stock before your purchase. Write down “I am buying Microsoft for $300 billion because…” Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational.”
Note that Buffett talks about buying all of Microsoft. This fits in with his strategy of acting as if you are going to buy the whole company. Once he puts a price on the entire company, then he can put a price on individual shares.

Peter Lynch, the record-breaking former manager of the Fidelity Magellan Fund also recommends that investors are always very clear about why they make their purchases. In One Up On Wall Street he wrote:

“Before buying a stock I like to be able to give a two-minute monologue that covers the reasons I”m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you”re able to tell the story of a stock to your family, your friends, or the dog (and I don”t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation.”

With few exceptions, people are not rational. Neither do they learn from history. With a stock book you have a chance of getting ahead of the game by overcoming both of these habits.

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