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The Psychology of Investing

May 8, 2005

Today, I'd like to discuss one of the most important topics in investing: psychological discipline. It has been found by social and cognitive psychologists that humans make systematic, predictable errors in their thinking. As a value investor, you must go against human nature and avoid those errors. Otherwise, it will be almost impossible to outperform the market.

Let's take a look at two ideas: anchoring and herd-like behavior.

Anchoring:

What do you suppose a 747 weighs? I'll give you a hint: it's less than 10 million pounds (that's about 4.5 million kilograms). The answer is at the end of this document.

I didn't say whether 10 million pounds was an accurate estimate, so my number should not have influenced your guess. But current theories in psychology suggest that it did (Kahneman and Tversky 1974). When we make estimates, we start at some initial number, which is known as an "anchor," and adjust this upward or downward to arrive at a final guess. If the original anchor is inaccurate, it can lead to poor guesses.

Between 1995 and 2000, the S&P 500 increased at an annual rate of 28.6% per year. Many investors used that number as an anchor, and guessed that future returns would be similar. And so for a while, the market just kept increasing at an unsustainable rate. The average PE of the stock market skyrocketed, and the intrinsic value of corporate America increased far less than the market.

As value investors, we know that if a stock's price increases faster than its intrinsic value, its future expected return will drop. So as the stocks soared during the dot com bubble, expected returns should have decreased. Instead, most investors expected high returns to continue forever. (Interestingly, a similar thing is currently occurring in the real estate market).

This idea can be applied to the analysis of specific companies. Suppose your friend Will owns a motorcycle company, and suppose that this company has been growing at 20% per year for the past 20 years. Now, you have no idea why the company has been growing at 20% per year. What's your estimate of the company's future growth rate?

Many investors would use the previous 20% number as an anchor. They might reason, "well, the company has been growing at 20% per year, so I'll be conservative and guess 15%." But if you don't know why the company has been growing at 20% per year, you don't have a good reason to predict even 15% growth. 15% growth is very difficult to achieve over the long term, and very few companies achieve it. So, you will need a very good reason to support your growth expectation. In this example, you have little reason to believe that company will grow at all. So, perhaps you shouldn't predict any growth. It's a bad idea to use past history alone as evidence that a company will grow at a very high rate.

Herd-like behavior:

Stock analysts are well-educated people who have learned a lot about investing. So why did so many of them get caught up in the dot com bubble? Buffett provides an explanation in his 1984 letter to Berkshire Hathaway's shareholders:

"Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)"

Now, individual investors won't get "fired" if they do poorly. And yet, common investors make the same mistakes. Another area of psychology can explain this: regret avoidance, which is part of an idea known as "counterfactual thinking" (Kahneman and Tversky 1982).

If you make an unconventional investment decision, and if that decision turns out poorly, you will likely feel regret. You will probably wonder why you made such a dumb decision in first place. On the other hand, if you make a conventional decision (like, investing in pet's.com during the late 90's) and that decision turns out badly, you can say, "well, I can't be blamed for this, because everyone else thought pets.com was a great buy." Investors tend to make conventional decisions, because doing so minimize future feelings of regret. This doesn't occur on a conscious level, but if all of your friends like a certain company, you may inadvertently use over-optimistic estimates in your analysis. Think in your past -- was there some investment that, after you bought it, seemed to drop for no reason? When it dropped, did you think, "I shouldn't have invested in this company?"

If you were perfectly objective, your analysis should have been the same before and after the stock's drop in price (as long as the stock really did drop for no reason). Your analysis of a company's future results should be the same, regardless of whether it is trading at $20 per share or $50 per share. So, either your evaluation of the company was wrong when you bought it, or your evaluation is wrong now. Either way, you need to correct your thinking. When you are deciding whether to buy a stock, think to yourself, "what will happen if the stock mysteriously drops 50%? Will I regret my purchase today? Or will I regard today's purchase as a rational decision?" If it's rational to buy a stock today, then looking back on your purchase 10 years from now, you should still view it as a rational decision.

By the way, a 747 weighs about 800,000 pounds.

References:

Kahneman, D. and Tversky, A. 1974. Judgement under Uncertainty: Heuristics and Biases. Science, Volume 185, Issue 4157, 1124-1131.

Kahneman, D., & Tversky, A. 1982. The simulation heuristic. In D. Kahneman, P. Slovic, & A. Tversky (Eds.), Judgment under uncertainty: Heuristics and biases, 201-210. New York: Cambridge University Press.