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