The Emotionally Intelligent Investor

The Emotionally Intelligent Investor

Ravee Mehta

 

• Behavioural biases
  • Fall into 3 categories:
    • Self-defence mechanisms against feeling shame, regret, and fear
    • Irrational reactions to stress and overloading of the brain’s capacity for rational thought
    • Vulnerabilities caused by fluctuations in mood
  • Risk aversion – humans are twice as averse to losses as to comparable gains
  • Holding losers too long & selling winners too early
    • Human nature to want to feel like we made the “right” decision
    • Not being right can lead to shame and regret
    • The risk of a small gain evaporating can carry a higher psychological penalty than the happiness from earning significantly more money on the investment
  • Taking excess risk after losses
  • Herding
  • Anchoring
    • Investors often don’t want to buy a stock after it rises 10% despite still viewing it as materially undervalued
  • Overly focussing on win/loss ratio
    • A portfolio can still have a hugely positive return with a win/loss ratio of <50%
  • Overconfidence
  • Hindsight bias
    • Nassim Taleb affirms that we regularly revise memories and even invent new ones to prove to ourselves that we were right
    • Good way to get around this is to keep a diary of your decision-making process and how you felt at the time – i.e. confident/worried etc.
  • Status quo bias
  • Overlooking very low probability events
  • Association bias
    • If we realised a gain on a stock, we are inclined to buy it back if it gets close to the original purchase price
  • Short term focus
    • An immediate gain gives you a jolt of dopamine that you cannot get from a delayed reward
    • The anticipation of loss is much more painful than experiencing it – proven by researchers
• Strategies for dealing with our avoidance of share, regret, and fear
  • Have a sounding board – other people are often much better at seeing you about to make a mistake than you are
    • Can also improve your conviction when taking a contrarian position
  • Stop losses
  • Trim a small amount of winners
    • May not be the most optimal money making strategy but it placates their fear of regret
  • Don’t overcommit
    • Can make you overconfident and susceptible to depression
  • Visualise failure and its causes
    • Don’t just write down risks, actually imagine how they may come to fruition and how it would make you feel
  • Be regularly on the lookout for flaws in your thesis
    • Soros actively seeks out flaws
  • Be more open minded to other opinions
  • Avoid excess reputational risk
    • Makes it more difficult to change your mind
• Using the right philosophy for the right situation
  • Value investors usually start their investment “fighting the pendulum.” However, once momentum turns in favour of the business, it is important to either sell or adjust your philosophy to a growth style
  • Value investors typically justify their investments using valuation support. However, valuation should only be a secondary factor for companies and industries that have been benefiting from favourable long term trends. Instead, the investors bet should be derived from a differentiation with respect to consensus earnings expectations or how they think the factors that have been in the company’s favour can get even better
  • Value investors got burned buying homebuilder stocks leading into the GFC because they were on low multiples
    • However, they had been benefiting from declining mortgage rates and increasing house prices
    • Therefore, they were clearly benefiting from positive momentum and as such required a growth investing framework – can the momentum continue for longer than is currently implied or will they beat on earnings?
    • By 2010, homebuilder stocks were down significantly and because earnings had declined they were no longer trading on attractive multiples
  • Rules for growth investing approach
    • When investing in stocks that have been beating consensus of which clearly have momentum in their favour he uses a stop loss
    • Does not average down
    • Averages up as it becomes a winner
    • Constantly on the lookout for a change in momentum
      • If after beating estimates for a number of quarters, he will sell if they miss
    • The thesis should be based on some differentiation with consensus expectations either with respect to earnings or the sustainability of growth
  • Rules for value investing approach
    • Initially asks himself why he wants to bet against the current momentum
    • Trading at a discount to valuation or have a view on the timeframe within the momentum will shift?
    • If primary reason is valuation, then no stop loss
      • Determines a very low price at which adding is a “no-brainer”
    • If based on catalysts that will shift the momentum, sells if nothing occurs in the expected timeframe
• Uncertainty
  • Most people take a small position or none at all, then add to it as uncertainty declines
  • The issue with this technique is that it is common…
  • The overall market does the same thing at the same time so you wind up buying at higher prices as the uncertainty is reduced
  • As an investor, you get “paid” for taking on that uncertainty
• Writing a journal
  • When we write about our emotions and how they impacted our decisions, we effectively create a bridge between our rational left brain and our more emotional and creative right brain
  • Focus on mistakes and what you did well
  • Unless you take the time to reflect on your core beliefs, and why certain decisions were made, you risk being an investor that has a good sales pitch but mediocre returns
  • Monitor your physical changes because they can identify issues before you can comprehend them
    • Soros learned to connect acute back-pain with his intuition for sensing danger
  • Learn to read your emotions
    • If a negative development occurs and you feel shame in selling at a loss, that indicates you’re holding an investment for the wrong reasons
• Using empathy to develop an edge
  • You should try to understand what the current shareholders and potential buyers of a particular security are thinking before you make any investment decision:
    • What does the current shareholder base look like? Is it mostly comprised of value investors who usually bet against the current moment and take a longer-term view or growth and shorter term investors who typically sell after poor results?
    • What are the longer-term shareholders thinking and feeling?
    • What are the shareholders who recently bought the stock thinking and feeling?
    • What is a potential buyer of the stock thinking and feeling?
    • Is there high short interest?
      • What are current shorters thinking and feeling?
      • What are potential shorters thinking and feeling?
    • What is management thinking and feeling? Do they have an interest?
• Using charts can help identify how investors are “feeling”
  • A resistance level is a price that stocks may struggle to break through
    • It represents a price where many investors seek to “break-even”
    • The more time a stock spends churning near the resistance level, the stronger the level tends to be – because new shareholders have an average cost near the level
    • Duration and trading volume near a resistance level impacts how strong it is
  • A breakout is when a stock trades through a resistance level
    • Especially important when accompanied by high volume and/or overly negative sentiment
      • A market that is highly sceptical about a breakout has more potential buyers than sellers
    • The prior resistance level now becomes a support level
    • Breakouts usually occur when something fundamental changes
    • The more volume that accompanies a breakout the better chance the stock will go higher
      • Because it creates more new shareholders with an average cost higher than the old resistance
    • Bull markets tend to top out when the leading group of stocks start underperforming
• Reading people
  • Facial expressions that don’t match the language
  • Not maintaining eye contact can indicate lying
  • Nervous reactions – for most people, telling lies induces stress
    • Shifting weight to a different leg or starting to fiddle
  • Covering their mouth when speaking
  • For a right-handed person looking up and to the right is done when trying to imagine or make something up
    • e. try and imagine a break-dancing hippo
  • Other signs to consider
    • Taking credit for things out of their control (positive things)
    • Avoiding blame for bad decisions
    • Talking very positively about the future and ignoring serious issues in the present
    • Dismissive of serious risks in their business
    • Overuse of technical jargon or buzzwords
    • Incorrect use of articles
      • In 10 easy ways to spot a liar, Mark McClish states, statements that incorrectly use “the” when the indefinite articles (“a” or “an”) are more appropriate, increases the odds that a person is lying. i.e. “The man pulled out the knife”
• Using Intuition
  • Is only valuable if it concerns something in which you have ample experience
  • Remind yourself of your emotional biases
  • Ask yourself whether the investment reminds you of a previous situation
    • You should try to take the time to link your gut instinct to previous patterns
    • If you can’t remember any previous investment you should be hesitant
  • Know the security and your risk/reward
  • Bounce ideas off someone else
  • Maintain freedom to change your mind and set up trip wires
    • Trip wires are events that should not occur if your thesis and intuition is correct

His top 10 points of the book:

1. Investing success does not come from supressing emotion
2. Self-awareness is the first and most important step in becoming a better investor
3. Humans have investing vulnerabilities. Know yours and set traps to limit their impact
4. We are constantly changing, introspection should be a daily, weekly, monthly task
5. Choose an investment philosophy that suits you
6. Trading success involves recognising and taking advantage of others mistakes. This requires empathy
7. Technical analysis is a tool for empathising with current shareholders
8. Management teams should be self-aware and trustworthy
9. Intuition is not a sixth sense, it is based on pattern recognition
10. Intuition is best built through objectively reviewing prior decisions