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:

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

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