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The art and science of investing (Part 1)

The art of investment management: know when to strictly follow a model’s guidelines and when to digress from it.

In the next few weeks I want to share a number of core ideas with you that informs much of my investment decision-making. I hope you find these short reminiscences informative.

Confirmation bias is the devil in the details

All of us have beliefs about the world, our relation to it, and most other topics we are more or less familiar with. Some of our beliefs are held very strongly, and others are changed at a whim. For example, you will presumably find it quite a challenge to amend your belief that you are in fact reading this sentence at this moment, but you would probably reconsider your beliefs regarding tomorrow’s weather by a mere glance out of tomorrow’s window.

One can say that the rational person changes, or should change, his or her beliefs when the evidence on which those beliefs are founded change. The problem with being human, and there are probably many depending on who you are, is that we are not exclusively rational, but also happen to be exquisitely emotional.

Our emotionality is an essential part of what makes us human, but it often lets us down when it comes to forming or letting go of beliefs that don’t match reality. The investor, being human, is no different on average from any other person when it comes to emotionality. We too experience true discomfort when the market tumbles and get all giddy when a stock appreciates significantly. We are not immune to greed and fear. We are different from the amateur investor not because we don’t experience emotion but because we have a set of beliefs that help us to respond differently to these obstacles to rational decision-making.

The professional investor is somebody who changes, or should change, her beliefs when the economic facts upon which her investment beliefs are founded change. The problem is that emotionality is such a core part of being human, so finely ingrained in our every action, including our belief formation, that the task of correcting for the deceitfulness of emotion is the single greatest challenge facing every investor.

Simply put, we hardly ever look at the facts without feeling or even look at all the relevant facts because of those same feelings. We find it very uncomfortable to change our beliefs, especially when we feel strongly that the beliefs we hold are true. It seems that we have an unconscious default position to excessively discount evidence that conflicts with what we already believe. This default position is called confirmation bias and it is a formidable enemy.

The only effective way that I know of countering the ever-present dangers of confirmation bias is to have a worked out system with which evidence is sought and decisions are made. In other words, have a model that tells you a purely intellectual story (as far as possible) about how investing works, and which provides you with clear guidelines on when to invest in, or divest from, a particular business.

The art of investment management is to know when to strictly follow the guidelines of the model (providing some protection from confirmation bias), and when to digress from the model because it is always an incomplete representation of economic reality (dangerous because you may be fooling yourself).

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