Today’s post is our second visit to a popular UK investing book from last year – The Sceptical Investor by John Stepek.
Chapter four of John’s book is about why amateurs have a big advantage over professionals.
He quotes Chuck Prince of Citigroup, early in 2007:
When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.
He stood down nine months later.
As John says:
Everyone in the financial industry from banks to wealth managers to advisers to journalists makes money from activity.
If markets are going wild then you had better be involved or your clients are going to wonder why you’re not making money when all the other banks and funds are.
Fund managers are judged on their quarterly performance, and can’t afford to fall down the league tables.
- They are paid according to their assets under management, so they have no desire to see outflows.
John quotes Michael Aronstein of Comstock Partners:
The system is just designed to channel money to people who make themselves easy to understand. You get the money because of the way in which people can categorise you.
This career risk is also the explanation behind why some many so-called active funds are actually closet indexers.
Better to wait until the market panic begins. Even if you can’t get out before everyone else does, you’ll all go down on the same ship - so your own errors will be obscured by everyone else’s.
This gives rise to the type of investor that John calls a “fully invested bear”.
As Keynes put it:
It is better for [one’s] reputation to fail conventionally than to succeed unconventionally.
John stresses the contrarian advantage that this affords the DIY investor, but for me this knowledge is only the first of three steps.
- We are not forced like institutional investors to participate in bubbles.
But we still need to work out when to get out of a market.
- And, which is perhaps even more difficult, when to get back in again.
I have more on the advantages of the DIY investor here.
The next chapter is about how difficult it is to overcome your own desire to run with the herd.
John refers to greed and fear as the expansionary and contractionary impulses.
- You want to either protect what’s yours, or grab a bigger slice of the pie.
He says that both are driven by the knowledge that one day you will be dead.
We are programmed to run with the crowd because it’s safer. Even today, and even in the most advanced societies, life is unpredictable and full of potentially lethal threats.
All animals have a `fight or flight’ instinct [but] only humans have an ever-present awareness of the inevitability of our own extinction.
Which means that we crave safety and certainty.
- To get them, we need both greed and fear.
The search for certainty makes us look for patterns and rules, and seek out causality (and mistake correlation for the same).
Some rules are physical (fear of heights and poisonous animals and vegetables) but more are social.
- Even money is a construct whose value depends on everyone accepting it.
Leaving your `tribe’ incurs definite costs in return for uncertain gains, so switching out of a world view that has so far proved relatively successful is a huge risk.
Our desire for certainty and acceptance discourages us from going against the prevailing wisdom, particularly when it’s espoused by `people like us’.
Thoughts of death make us defend our existing world view and cultural standards more aggressively against `outside’ views.
And having your world view attacked will bring thoughts of death and vulnerability to the surface.
The second problem is that:
Our craving for explanations makes us suckers for a good story. This tendency is something that Nobel-winning Yale finance professor Robert Shiller calls the “narrative fallacy”.
John offers four ways to remain apart from the crowd:
1 – Get comfortable with being uncomfortable.
Jeremy Grantham and Ben Inker found that investors are much keener to buy stocks when profit margins are high:
Investors would dependably pay up for high margins, which would then decline, whacking them on the way down.”
According to John:
Investors also pay more when inflation is low and GDP growth is relatively stable. In short, the closer to perfect that economic and corporate conditions are, the more investors are willing to pay for a given level of earnings.
The way I look at this is as a form of short-termism.
- People want to believe that current conditions will persist forever, and there will be no mean reversion (let alone over-shooting to the opposite side of the mean).
Grantham’s behavioural model explains all US bubbles since 1925, apart from 1999, when prices were too high to be explained by comfort factors alone.
Investors’ tendency to extrapolate today’s conditions far into the future means that the expansionary impulse is strongest when conditions can’t possibly get any better.
Howard Marks of Oaktree Capital says:
Most great investments begin in discomfort. The things most people feel good about - investments where the underlying premise is widely accepted, the recent performance has been positive and the outlook is rosy - are unlikely to be available at bargain prices.
2 – You will never be popular
John uses “The Emperor’s New Clothes” as an example – only a child can overcome the desire to be part of the in crowd.
John also talks about motivated ignorance – something that any user of Twitter will be familiar with:
People’s desire to be part of a `shared reality’ is so strong that they’ll go out of their way to avoid hearing an opinion that disagrees.
John quotes George Orwell:
People can foresee the future only when it coincides with their own wishes.
You need to be aware that there are no rewards (other than financial) for being right when everyone else is wrong.
Many sceptics see themselves as `outsiders’. The archetypal investment contrarians tend either to fall into the angry young man stereotype (hedge fund managers) or the worldly-wise old man, tutting at the folly of the world, stereotype (Warren Buffett and Howard Marks, for example).
You have to have confidence in your own analysis and the ability to take the opinions of others with a big pinch of salt.
Being right when everyone else is wrong is not the goal. Making money is the goal. As long as you do that, you’ve succeeded.
3 – Buy facts not stories
The best time to sell a story is when the story is already popular. And that’s the worst time to buy an investment.
Don’t listen to stories - check the data out for yourself.
You don’t have to do much [research] to be better informed than the typical investor. The average US company’s annual report is only downloaded 29 times on its day of release.
4 – Know your history
Our collective ability to imagine that we exist at some unique moment in history, in the face of all evidence to the contrary, is quite staggering.
Very often, what’s deemed `unthinkable’ and `unprecedented’ in the heat of the moment has in fact happened in a very similar manner in the surprisingly recent past.
Ray Dalio of Bridgewater Associates says:
Many surprises come because things never happened in one’s lifetime before. So it’s advantageous to look beyond one’s lifetime or beyond one’s own experiences to understand how the world works.
John also point out that knowing history can help you to build patience:
[Being] a sceptical investor inevitably involves being wrong for at least a short period of time. If you’re betting against the market, then by definition the market won’t go your way in the early stages of that bet.
In chapter 6, John talks about psychology, and BF Skinner in particular:
Skinner believed that our behaviour was largely dictated by our environment, and our experiences of interacting with the world.
Skinner has a lot to say about learned behaviour, but as John points out, he ignores genetics.
Skinner didn’t see us as being much different to trained animals - positive reinforcement (good things happening) would make us repeat an action. Negative reinforcement (bad things happening) would put us off doing something.
The good think about Skinner was that unlike, say Freud, he focused on solutions rather than (hidden) causes.
- Which is very useful when it comes to overcoming the psychological quirks which get in the way of successful investing.
John runs through some of the biggest behavioural problems in investment.
- We have more on this topic here.
1 – You are terrible at judging what is relevant
Here John is talking about anchoring – the use of irrelevant information to make an estimate of an unknown quantity.
The most common example is the use of a current, recent or purchase price to work out what a stock is worth today.
- This contributes to the major problem of investors not cutting losses.
Another issue is availability, where the ease of calling an event to mind affects our estimate of its probability.
- This leads to the recency effect, where we assume that things have just happened are likely to keep happening.
A third issue is framing, where the way that information is presented affects its interpretation.
- The classic example is the presentation of the effects of medical intervention in terms of either lives saved or deaths caused.
2 – You are too highly evolved
By this, John means that we struggle with simple random patterns.
- Pigeons and rats learn more quickly to bet on green when it is presented randomly for 80% of the time.
- Humans look for an explanation (a pattern – an order in the universe) that will allow them to win all the time (which is impossible).
3 – We fear losses more than we value gains
This loss aversion is another explanation of why people don’t cut losers.
4 – But we are also too optimistic
Hope (greed?) makes us dream of big gains and take on poor investments.
- Note that the expectation of gains is stronger than their achievement.
5 – We think we are right when we are wrong
We prefer to ignore inconsistencies rather than resolve them, and seek out confirmatory information.
- We all believe we are better than average, and we justify our decisions by looking at the favourable outcome (hindsight bias).
- We like what we already own (endowment effect).
Fast and slow
John explains about Kahneman’s two thinking systems – fast and slow.
- The fast system makes all the mistakes, and you need to force yourself to use the slow one (system two).
You need to create an investment process that prevents you from making big behavioural errors in practice, even if in theory that means embracing some inefficiencies along the way.
Before you buy or sell anything, you should be forced to sit at your desk, make a conscious decision to open your broker’s website, and fill in your password and the rest of it (don’t let Google save the details for you), before you can act on the trade.
To prevent the impulsive System 1 process from taking over, you have to slow down and put up obstacles to taking rapid action.
Similarly, avoid consuming the news unconsciously, because it will influence your emotional state. You should read selectively and in a deliberate manner for research.
Do your research, write out a plan, and only then open your account and act on that plan.
As John points out, this is a lot like eating / drinking / smoking less.
- We all know what’s the right thing to do, but we need to form habits that help us to do it.
John has some other good suggestions:
- Focus on the downside
- Have an auto-pilot
- This means take as many decisions as possible in advance.
- You might want to use a stop loss.
- Keep an investment diary
- Make sure to make an entry before you make a trade.
- Include the source of an idea and its rationale, plus a return target and a time-frame.
- Have some idea of what would make you sell.Q
- Have a regular (portfolio) review process.
That’s it for today.
- It’s been a nice read, and there’s little to take issue with.
- But I’m starting to worry that the won’t be much actionable information in the book, at least for the experienced investor.
We’re now about forty percent of the way through the book, which suggests there will be another three articles.
- Up next are the media, incentives and humility.
Until next time.
Article credit to: https://the7circles.uk/the-sceptical-investor-2-diy-crowds-and-psychology/