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To kill a bias

Sometimes you have to become more detached from your decision-making by mechanising parts of the process prone to suffer from human psychological error.

I am sharing part of the June 2017 Futurewealth Portfolio letter with Moneyweb readers. I hope you will find it useful.

The first six months of 2017 is behind us. Let’s just say it hasn’t been the easiest six months of managing money I have ever had the privilege of experiencing. Rather than recount the exact ups and downs of the portfolio, and the political and economic events associated with these turn of events, I want to take a step back and tell you why I think the first six months of the year, although very unpleasant, were exactly the sort of thing I (we) needed to take our portfolio to new highs. It’s going to be a bit personal, but that’s the way it has to be – cutting out disease of whatever form is sure to be unpleasant on some level.

I am confident that what is going to create long-term wealth for us – in terms of our portfolio – is the soundness of my thinking, but even more importantly, the quality of my acting (decision-making). The first half of this year was the best course in the psychology of investing I have yet had. (My investment career got going in the financial crisis but I was a bull in a china shop – I wasn’t aware of the china – and luckily for me it turned out that I happened to be a bull in what turned out to be a very substantial bull market.)

There is a considerable body of research that tells us that our brains are not quite the organic organs of truth that we take them to be. On the contrary, our brains are like a teenager (the boy variety) doing homework, just enough to get the job done, while using all the shortcuts at (his) their disposal. The problem with shortcuts is not that they aren’t useful – ask the teenager – but that they end up leading us to beliefs that are short on the truth on many occasions.

The are many of these systematic shortcuts that characterise our thinking on many (most?) occasions: confirmation bias, hindsight bias, availability heuristic etc. (See the book, ‘Thinking Fast and Slow’, by Daniel Kahneman for an excellent discussion). I have known about these biases for a number of years, but these last few months have shown me that I have not quite integrated the findings of this nascent science with my own psyche. In other words, I knew about many of these biases, but I didn’t know these biases.

What I did not realise before now is that in many cases I was adding to my storehouse of investment-related beliefs but not similarly adding to my repertoire of making prudent investment decisions. The mistake I made was in thinking that this process happens automatically – you learn something, come to believe it, and then it’s part of you, you will do it. No, NO! What does it take to go from believing something to be the case, to systematically acting in line with these beliefs? To be honest, I don’t know, but I have a few ideas that I think will prove useful.

In my own case, I did two things.

Firstly, I made it a mission to critically reflect on my own psyche (desires, beliefs) vis-à-vis what I thought it would take to be a brilliant investor. I tried to see if I could find beliefs, desires, and behaviours in myself that were systematically keeping me from this goal.

[Note: It is important to realise that we are all different – obviously – but one always aims to be the best investor from or given who you are. In other words, all of us have a given set of psychological dispositions; you cannot be Warren Buffett or Peter Lynch, even if you want to be, although you can (and should) learn from them. If you do everything Warren Buffett does, you will probably not do nearly as well as what he does, because he comes prepackaged as Warren Buffett, while you come prepackaged as yourself.]

I unhappily found that I wasn’t the paradigm of rationality that I took myself to be. My particular cognitive fingerprints (biases) were all over the crime scene that was our portfolio during the last few months. For example, I was too hasty in buying Consolidated Infrastructure Group (CIL) and AdaptIT (ADI). I should have been more patient in adding to our positions there – my investment-related fear of missing out (FOMO) cost us dearly with respect to these shares. I made a crucial mistake in valuing CIL in the first place. I thought I understood the new valuation formula I was employing; as it turns out I did not, and as a result I overestimated CIL’s value by about a third!

Secondly, I thought of ways I could manage my own particular biases. How could I act against myself to become better at this activity I enjoy so much? In a way, I believe that to be a great investor one has to be true to oneself, but not to your whole self – one has to learn to invest and actively manage the process in accordance with your strengths, but additionally, it is crucial that one tries to find ways of managing your ever-intrusive weaknesses as well.

To manage cognitive bias, one should become more computer-like. Become more detached from your decision-making by mechanising parts of the process that are especially prone to suffer from human psychological error. To this end, I have instituted a set of rules (a simple checklist) that I have to follow when buying or selling a share.

I will still fear that a particular share I buy may shoot the lights out shortly, or fall from grace like a dark angel from heaven, but the rules will prohibit me from entering or exiting our whole intended position at once.

(See my article – Two questions and one attitude for the ‘checklist’ on managing the intentions one has to enter or exit a share in the first place)

Bottom line: I hate the rules, but the rules are great.  

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