Sunday 17 January 2016

Striving for Rationality: Cialdini, Kahneman and Howard Marks

I recently read Kahneman's 'Thinking Fast and Slow' (again) and Robert Cialdini's 'Influence' for the first time on holiday over the new year. I have alway been fascinated by how the brain works and how to understand decision making.

Thinking about thinking > thinking.

After all, a workman has to understand his tools and an investor's greatest tool is that of his brain. Failing to understanding how your brain works and the influences you face in decision making puts you at a serious disadvantage to others that do.

These two books, Marks' memo and a recent investment I made in TGS towards the end of 2015 has led to this post.

It seems reading these books couldn't have come at a better time with the recent performance of all risk assets in the past month. All I see is negative articles, red tickers and panic. Also coincidentally, Howard Marks writes a memo on just the subject here. I've listed a few quotes below from the piece:

As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment.

One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity.  Their failings take two primary forms: selective perception and skewed interpretation

If I could know only one thing about an investment I’m contemplating, it might be how much optimism is embodied in the price.

One could argue psychological traits and certain temperaments are more important than financial acumen, as realistically, most people can pick up accounting or financial books and learn.

Selective perception and skewed interpretation refer to the biases of perceiving info in the way we wish that reinforces our own view and only forming unbalanced views.

Kahneman refers to selective perception as confirmation bias. We naturally look for views that reinforce rather than oppose our own.

Cialdini highlights the power of social proof in influencing decision making. In times of uncertainty we look to others to guide decisions, sometimes this means the market itself. Herding and panic then follows.

Investor psychology and market sentiment are factors joined at the hip and an understanding seems crucial to success. "Be greedy when others are fearful" and all that...

I find myself going through a mental process before securities I find that are undervalued:

  • IV < price significantly, so I buy right? 
  • How much more undervalued can this get? 
  • Wait, stick to the process. Do not attempt to time. Move cautiously. 
  • Oh, shock, too early

My recent investment in TGS led me to delve deeper into weighing sentiment into decisions. TGS, a company I analysed here, is down around 25% from my entry after nosediving last week's Q4 update. Obviously it is too early to evaluate whether the investment itself was a mistake, although I sure could have got a better price if I had realised some basic psychological tendencies I was facing during the decision:

Overconfidence and confirmation bias - Kahneman explains how we are overconfident in our own views and we underestimate factors that are outside our control entirely. I became overconfident in my estimate of IV (having collected years of data and hours of research) and underestimated the power of external factors, oil prices and investor sentiment around oil.

I do not try to predict oil prices or time markets, although I feel I made a significant mistake in understanding investor sentiment. I misunderstood the power and length of trends. They last longer than we believe/want and the downside risk was much higher than upside potential in short-term in this instance. Although being disciplined and sticking to the process is crucial, I believe my original process has underweighted sentiment. Checklist updating...

What I really find fascinating about psychological concepts of investment is that I feel I have a fairly good grasp of some biases I am under during decisions but yet I seem to always underestimate the power of some tendencies. Learning from mistakes and carefully going through the psychological aspects of every decision will help in the road to rationalism.

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