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Summary Beware of overconfidence – your predictions may be incorrect, prepare yourself. Don’t neglect competition – don’t fall prey to what-you-see-is-all-there-is. Avoid loss aversion/sunk costs – only hold stocks because you believe will outperform. Anchoring and adjustment – Ignore useless information as much as you can when valuing a stock. Humans are not fully rational beings. Most of the time, this irrationality serves a useful evolutionary purpose, but for investing, it can be devastating. The pitfalls laid out below are well-known concepts in behavioral economics. To get a better grasp of how they affect your investment decisions, they are illustrated with my personal experience. Beware of overconfidence Duke University conducts annual surveys among CFOs. Among other things, the CFOs are asked for an estimate range of the S&P 500 returns over the following year. They were asked to provide a value of which they were 90% sure it was too high and another that they would be 90% sure of that would be too low. This would provide a range of 80% accuracy. The findings are shocking: only one in three was correct, versus the 80% one would expect with such a prediction. Their range was too narrow and they were too overconfident. With many decisions that rely on estimates, this overconfidence can be dangerous. Being aware of overconfidence can help a lot. To the credit of the CFOs, they are not in a position where they can give a realistic 80% accurate forecast (which would be between -10% and +30%) because they are seen as experts and look clueless when they provide a very wide range. The best professional forecasters are aware of the low value of their predictions and share less of the overconfidence bias. One of the best sell-side analysts of the Netherlands told me once about analyst estimates: ‘we know one thing for sure: actual earnings won’t match the estimates.’ Don’t neglect competition Colin Camerer and Dan Lovallo observed that often in decision making people ignore competing possibilities and coined the term ‘competition neglect’. It can be illustrated with an example of eBay (NASDAQ: EBAY ). Many sellers let their auction end during peak-visit hours in the evenings to increase the price of the item they try to sell. They neglect the fact that normally auctions should have the same distribution as bids, and therefore bids per auction should not differ. Even worse, they ignore the fact that many people (competitors) use the same strategy. The consequence of neglecting this competition is a lower price obtained for the item as well as a lower probability of a sale ( this is a link to that study ). Investors can learn from this. Every time you study a business, be aware of the most obvious things the market will see. If people like IBM (NYSE: IBM ) because Warren Buffett invests in it, you should be aware that this is already reflected in the stock price. On a deeper level, it pays to see what the competitors of the business you study are doing. It is easy to get optimistic about a company when you only see the competitive landscape from its own perspective. One of such examples is R&D spending at GM’s (NYSE: GM ) competitors. GM has been lagging in R&D expenditure growth as I point out in this article . Not taking into account the increased competitive pressure from other automakers, will create a lot of room for disappointment. Avoid loss aversion/sunk costs The loss-aversion theory explains that people generally are more sensitive to losses than they are to gains. For investors, the relevant part of this theory is often closely related to the sunk-cost theory. After making a bad investment that turns out worse than expected Philip Fisher has described this in his book Stocks and Uncommon Profits as: “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” In my case this stems from anticipated regret. I know that if I sell a stock that is down over 30% and it rebounds thereafter that I will experience a great deal of regret. It is very hard to ignore this anticipated emotion. One way to deal with it is to just sell the stock and never look at it again, or sell half of the position to mitigate future underperformance. What I did in one case was going short on other stocks in the same industry that were overvalued compared to the stock I owned. Beware of anchoring and adjustment In making decisions in uncertain environments decision makers frequently make an initial estimate and then adjust this estimate when new information arrives. Anchoring can be the result of anything. Even when answering a simple question like ‘how many people live in Luxembourg?’, hearing a completely unrelated statement like ‘there are a billion butterflies in New York’ can influence you answer. For investors the question is ‘how much is stock X worth’ and the information we should avoid is the stock price in the market. I too often fall prey to this type of thinking. In this article on ING (NYSE: ING ), I remained conservative on my assumptions on growth, ROE, and discount rate in order to keep the target price closer to the market price. I now believe the same stock is worth over €15.50, versus €12.40 then (the +25% is roughly in line with the stock price appreciation since then), while operationally, the company is almost the same as it was 10 months ago. Hedge, always hedge This one is not directly related to any psychological concept, but it does have ties with overconfidence and ignoring what is out there. Never gamble when you don’t have to. Both of my two worst investments of the past two years could have been hedged. The first one is Ensco (NYSE: ESV ). I knew oil price was a risk but confident in fact that I had no idea where the oil price would go, I thought it would be a prudent thing to assume the futures market showed was the most accurate forecast. Perhaps it was, and of course it is not unreasonable to assume an efficient market when it comes to commodities. What I should’ve done, however, is recognize that the oil price was such an important part of the investment case that I was unfit to make that call without a view. Alternatively I could have chosen to hedge the risk, but instead I took a hit of over 50% on the investment. Luckily, I later started to hedge this risk and prevented much worse by doing so. In another case, I discovered that the ArcelorMittal (NYSE: MT ) mandatory convertible notes ( prospectus ) could be proxied by a bond and a long put and short call option on MT stock. My conclusion was that the note was undervalued compared to prevailing interest rates and options that would mitigate any exposure to Arcelor’s stock price. In fact, I saw an arbitrage opportunity. Instead of buying the notes and purchasing a put option while selling a call, I only bought the notes because I found the spreads on the options painfully high, and was tempted by the upside. Again, this investment turned sour and I suffer a loss of over 40%. If the spreads on the options really were too big, I should’ve refrained from buying the notes. How to cope with these behavioral issues? As the behavior is natural, it is hard to overcome. It is perhaps even impossible to overcome all of them. But knowing and acknowledging it affects you is half the battle and helps to put yourself back on the track of rationality when you need it most. Disclosure: I am/we are long MT, IBM, ESV, ING. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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