I recently read an article from one of my financial subscriptions, The Motley Fool, and felt it to be a great read for my clients. I am therefore, attaching it for you to read. I hope it will be as meaningful to you as it was to me.
William C. Heath, CFP®
Battle Your Brain: How to Become a Less-Biased Investor
THE MOTLEY FOOL – JANUARY 2016
Successful investing is less about what you know and more about how you act. You’ve probably never heard of Mohnish Pabrai. And there’s a reason for that. Pabrai is one of the most successful investors of the past 20 years. One dollar invested in his hedge
fund in 2000 would be worth more than $7 today, versus $1.78 in the S&P 500. And that’s “after my ridiculous fees,” as Pabrai jokes. Why have you never heard of him? I first learned of Pabrai from a friend in 2007.
There was almost nothing written about him at the time. He wrote a book in 2006, but no publisher was interested, so he self-published a handful of copies. I discovered that Pabrai lived near me, gave him a call, and asked if I could interview him. He graciously agreed. I came to his office expecting to see a normal hedge fund arrangement: dozens of well-dressed analysts, rows of Bloomberg terminals, TVs tuned to CNBC. But I found something completely different.
Pabrai manages more than half a billion dollars entirely by himself. He became one of the world’s best investors with a desk, a filing cabinet, and a nap room. “I have a hard time getting past the day without the nap, so the nap is a must,” he says. Pabrai was the antithesis of most hedge fund managers. This made me even more fascinated in his success. So I asked him what his secret was. “Control over my emotions,” he said. “That’s it?” I asked. It’s huge,” he said. “It’s all you need. You’d be surprised.” Pabrai isn’t a successful investor because he has more information than everyone else, or because he’s better at math than everyone else, or because he knows more about business than everyone else. He’s successful because he has won the battle with his brain. The reason you probably haven’t heard of Pabrai is because he has such control over his emotions that he has little desire for fame. I don’t think he feels the need to be on CNBC or have his face on the pages of The Wall Street Journal. He’s emotionally grounded enough to be content reading at his desk.
Successful investing has little to do with what you know and almost everything to do with how you act. This report will attempt to be instructive. How, exactly, do you overcome these flaws? How do you become more like Pabrai? A few years ago, I interviewed Daniel Kahneman, a Princeton psychology who won the Nobel Prize in economics. I asked him if humans can overcome biases or if they are deeply ingrained flaws that we’re stuck with — whether Pabrai is a freak of nature, essentially. “They can be partially overcome, yes,” he said. “There are ways people can become better thinkers.” He elaborated on how this applies to investors: I think it is very important not to encourage people to do things that are likely to expose them to regret. The potential for regret is something that investors should know about themselves. “How much am I going to suffer if this decision of mine doesn’t work out?” “How easily am I going to think, ‘Oh, I made a mistake’? How prone am I to think that I made a mistake?” It’s a big variable, and really worth discussing, I think, with clients because part of the inability to stay the course … you have to inoculate yourself against regret. At its core, overcoming cognitive biases is about
inoculating yourself against regretful decisions. This is, of course, easier said than done. And tackling this subject for every personality would be impossible. I see three areas that consistently cause investors huge amounts of regret:
Where you get your information
Who you talk to about your investments
How you keep yourself accountable to your goals
Let’s go through each one.
1. Where You Get Your Information
Twenty years ago, only a few media outlets dominated the dissemination of financial information:
The Wall Street Journal, New York Times, an early version of CNBC, and Louis Rukeyser. Today, those outlets make up a minuscule fraction of what’s published (and Rukeyser is no longer with us). Financial media has exploded, with hundreds of outlets providing thousands of opinions each day. Though that’s mostly a good development, it can also be dangerous if you don’t know how to use it. The truth is that, while news coverage has grown exponentially in the last two decades, the amount of news has not. Today’s financial media offers copious amounts of drivel, gossip, rumor, innuendo, and nonsense. As author Nassim Taleb once wrote, “The calamity of the information age is that the toxicity of data increases much faster than its benefits.” To avoid bias, therefore, it is vital that you as an investor know how to navigate this world. Finding reasonable information is about more than using reputable sources. Consider this quote from a December 2008 front-page Wall Street Journal article: Igor Panarin posits, in brief, that mass immigration, economic decline, and moral degradation will trigger a civil war next fall and the collapse of the dollar. Around the end of June 2010 or early July, he says, the U.S. will break into six pieces — with Alaska reverting to Russian control. California will form the nucleus of what he calls “The Californian Republic,” and will be part of China or under Chinese influence. Texas will be the heart of “The Texas Republic,” a cluster of states that will go to Mexico or fall under Mexican influence. Washington, D.C., and New York will be part of an “Atlantic America” that may join the European Union.
Keep in mind, the economy was falling apart in December 2008. And this was The Wall Street Journal, America’s most prestigious financial news source, so people took this seriously. You may have yourself. After years of trudging through the financial media, here’s how I would dissect a story like this today to ensure it doesn’t bias my behavior.
(a) Who Is Igor Panarin?
A quick search would have shown that Panarin, a Russian political scientist, has a history of making outlandish predictions. He first presaged the same six-part American disintegration in 1998. In previous years, he augured what he called the “New British Empire,” the “New Eurasia,” the “Eurasia Union,” and
a new global currency — none with any success. This is vital to know, because you instantly realize that this prediction tells you more about Panarin’s personality than his objective analysis of the economy. Predicting collapse is just what he does. It’s who he is. If you get to know enough financial pundits, you’ll find this is a recurring theme. People who are currently bearish on stocks — Peter Schiff, Marc Faber, John Hussman — have by and large been bearish for decades. Bulls like Jeremy Siegel have been bullish for most of their careers as well. It’s a reflection of their personalities. After you learn the background of pundits and analysts, you are less likely to take them as seriously as you did before. You will learn that most analyst are athletes in a full-contact sport called punditry. Realizing this helps prevent you from being biased by their views.
(b) If Panarin Is Right, What Should I Do About It?
Let’s say America is about to break apart into six pieces. Or let’s say the analyst predicting a market crash is right. What should you do about it? For most long-term investors, the answer is almost always nothing. If you need to sell stocks next week to cover your mortgage, knowing if the market is going to crash next week is vital. If you’re investing for the next 15 years, what the market does next week is irrelevant. If you are a day trader or hold short-term options, whether a stock beats quarterly earnings is really important to you. If you’re a long-term shareholder, it shouldn’t be at all. The worst trait of the financial media is its inability to recognize that investors have different time horizons, which makes it impossible to offer blanket advice. Yet it does all day long. Very few sources of information come with a warning that says “This advice is intended for a 62-year-old investor with at least 10 years to invest.” Instead, it’s given as “The market is going to crash and you should sell.” The truth is that the person writing this information has no idea who you are, what your goals are, or how long you have to invest. Even if their prediction turns out to be accurate, you should not assume it is applicable to you and your goals.
Because it rarely is. To prevent media from biasing your financial decisions, my sincere advice is: Consume less of it. It does not have to be more difficult than this. In his book The Information Diet, Clay Johnson writes: It’s not information overload, it’s information overconsumption that’s the problem. Information overload means somehow managing the intake of vast quantities of information in new and more efficient ways. Information overconsumption means we need to find new ways to be selective about our intake. It is very difficult, for example, to overconsume vegetables. We also have to distinguish between information and analysis. Company annual reports, economic data, and conference call transcripts have information. Pundits and analysts provide analysis. In my research, successful long-term investors favor information over analysis by at least a 10-to-1 margin. Most people are good thinkers, but are gullible to being persuaded by pundits who are trying to grab attention. If you go for the information and ignore the pundits, you will have a better time coming to smart, unbiased decisions. Stock picks, board posts, and articles within The Motley Fool’s community are a great resource because they are the closest bet you have to reading material that aligns with your goals, strategy, and investment philosophies. They are as close as you will get to vegetables. Outside of the Fool, I would advise favoring books over articles. There are lots of bad books and lots of great articles. But books are more likely to be thought out, thorough, fact-checked, and edited than most articles. They are also more likely to make you think, rather than act, which is exactly what you want information to make you do.
2. Who You Talk to About Your Investments
New York Times columnist Carl Richards has a great saying. A financial advisor, Richards says, is someone who puts a gap between you and stupid. Even brilliant investors are tempted to fall for biases and do dumb things with their money. An advisor’s job is to look you in the eye, shake his head, and walk you back from the ledge. One of the leading causes of biased financial decisions is confirmation bias. It’s the tendency for investors to seek out advice from people who already agree with their views. I attend a lot of financial conferences, many of which are theme-based — macro conferences, gold conferences, dividend conferences, and so on. What astounds me at these conferences is how closed off they are to differing opinions. If you attend a gold conference and say anything negative about gold, you will be treated as an ignorant outsider and avoided. People think they attend conferences to learn something new, but I’ve learned that’s not really the case. They attend to have their views confirmed by other people. It is pure confirmation bias. And it’s dangerous. Kathryn Schulz, author of the book Being Wrong: Adventures in the Margin of Error, once explained: The first thing we usually do when someone disagrees with us is we just assume they’re ignorant. They don’t have access to the same information that we do, and when we generously share that information with them, they’re going to see the light and come on over to our team. When that doesn’t work, then we move on to a second assumption, which is that they’re idiots. They have all the right pieces of the puzzle, and they are too moronic to put them together correctly. And when that doesn’t work, we move on to a third assumption: they know the truth, and they are deliberately distorting it for their own malevolent purposes. So this is a catastrophe. If you don’t surround yourself with people who disagree with your views, you’ll never realize that you can be just as biased — and wrong — as everyone else. And you’ll keep making the same mistakes. Part of The Motley Fool’s investing ethos is a culture of encouraged debate. We not only accept dissent when making stock picks but encourage it. Junior analysts can — and do — tell their bosses why they’re wrong. This is how we fight confirmation bias. But there’s something we can’t do for you, our members: prevent you from buying more stocks when the market is bubbly and selling out when it crashes.
One of Kahneman’s pieces of advice to avoid biases is to have an advisor who is in a different emotional state than you are. This is how individual investors can avoid confirmation bias. You should have a trusted person in your life — a friend, a relative, a co-worker — who you run financial decisions by.
This person should know you well. They should know your goals and your flaws. But they can’t be emotionally attached to your financial decisions. Their goal is to provide a trusted, yet unbiased,
opinion of your decisions. They put a gap between you and stupid. For the past seven years, I have shared my personal financial plan with fellow Fool Matt Koppenheffer. I trust Matt, but he thinks differently than I do. He’s not nearly as emotional as I am in some areas, sees risks that I don’t, and offers a point of view that I could never come up with on my own. It is a perfect arrangement for avoiding biases, because while I trust Matt, I don’t agree with everything he says and he doesn’t always agree with me. That is exactly what you want. Rather than confirm my views, Matt makes me think and puts a gap between me and stupid. Every investor should have someone like this.
3. How You Keep Yourself Accountable to Your Goals
One of the most important lessons I’ve learned about investment biases is that people are terrible at predicting their future emotions. Every investor I know says they’ll be greedy when others are fearful. They never assume that they themselves will be the fearful ones. But someone has to be, by definition. No investor wants to think they’ll panic and sell if stocks fall 20%. They’re more likely to say that a 20% decline would be a buying opportunity. This is the right attitude, but the reason there will be a 20% crash is specifically because some investors choose panic selling over opportunistic buying. My experience is that most investors who say they’ll be greedy when others are fearful soon realize that they are the “others.” It has to be this way: When everyone thinks they’re a contrarian, at least half will be wrong. When investors are bad at predicting their emotions, sticking to their financial goals becomes difficult. I can say I plan on investing $500 a month each month for the next 30 years. Or I can assume that I won’t sell when the next market crash comes. But those goals rely on the assumption that I can behave the way I’d like to in the future. And that’s a dicey assumption to make. I have found that the best way to get a realistic picture of my future emotions is to document my past emotions. You can do this by keeping an investing journal. Every investor, no matter how active or passive, should have an investing journal. It doesn’t have to be elaborate. Just document how you’re feeling when you make investment decisions. If you keep a detailed journal of your feelings and emotions when making investment decisions and review it over time, I think you will notice that how you expected to feel when the market falls, or surges, is far different from how you actually feel. This is easy for me, because I’m an investment writer. All of my thoughts and feelings are documented on Fool.com. I’d like to think of myself as a contrarian investor. I’d like to think a market crash is a wonderful thing to take advantage of. I want to be Mohnish Pabrai. But when I look back at articles I wrote in 2008 and 2009, as the market was crashing, I have to admit: I was more scared and pessimistic than I thought. If I’m honest, they show that I have a lower risk tolerance than I think I do. And I never would have known this unless these past feelings were in writing. Admitting this is part of the reason I choose to hold quite a bit of cash in my portfolio. I don’t want to pretend that I have a high risk tolerance that, objectively, is probably a fantasy. Right now, with the market near an all-time high, that would be easy to do. To prevent bias, I want to look at my past behavior and realize that it’s probably a good indication of what my future behavior will be. I would recommend every investor write down their feelings. A few sentences a few times per year. Keep this journal active for years, throughout different market conditions, and be honest with yourself about what you find. It could be the best tool you have to avoid future regret.