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You are not as smart as you think you are

June 13, 2009
Our emotions are our biggest enemy, at least when it comes to investing. We should all know this. If you don’t, stop making your own investment decisions right now.

Our emotions lead us to do the opposite of what we should be doing. They lead us to buy high and sell low. They make us excited when we should be scared, and scared when we should be excited. They make us slaves to the stock market; they let the market become our master.

The market is there to serve us, and not the other way around. It is okay to have emotions; we’re human, after all. But what we really need is an investment process. This is system of rules that we follow that keeps emotion in check.

Now, I hate republishing old articles. But a few, the ones that focus on the process, I’ll recycle (and improve upon) for a long, long time. I wrote the following article, in 2007. I included it in my book. I’ve shared it with readers in the past. And I even wrote the flip side of it in October 2008, addressing the impact of a cyclical bear market on out psyche by cyclical bear market.

I’m not offering it now to provide a hidden message that I think the current (cyclical) bull market is over. I don’t know that. I just want to remind you (and me) that a rising market has an impact on our psyche, our analysis and our decisions, and we need to be aware of it.

You are not as smart as you think you are;

psychotherapy for (cyclical) bull markets

Lately I’ve been getting this powerful feeling that everything I touch turns to gold. Every time I buy a stock, it goes up. Did I finally figure out the stock market game? Did I find a secret way to follow Will Rogers’ advice: Buy stocks that go up, and if they don’t go up, don’t buy them.

No, I didn’t get much smarter, and my stock-picking skills haven’t improved that much over the past year. I was simply a willing participant in the latest (cyclical) bull market. A bull market makes you feel smarter than you are the same way a bear market makes you feel dumber than you are.

Feeling smart makes you do the opposite of what you should be doing. The euphoria of the golden touch is a dangerous thing because it can make us careless. We forget about risk since we haven’t seen it in a while and focus only on the rewards. You have to actively make yourself aware of the four-letter word R-I-S-K!

How do you do that? My favorite way is to remind myself how dumb I am. I pull out an annual return report of a company on which I lost a boatload of money and masochistically try to read it from cover to cover, reliving my errors.

We all have these stocks, the ones we lost a lot of money in because we were overconfident. We tend to forget about them during a bull market. But I suggest you remember them now, so you’ll have fewer of those names to remember in the future. Risk is still there; it is just hiding under the joyful sentiment of the bull market.

Believe me, it will show its ugly face. It is just a matter of time.

Discipline counts

In a bull market, it is easy to forget about selling discipline and then turn into a “buy and forget to sell” investor. Every time you sell a stock, you look dumb because it usually goes up afterward.

I recently sold several stocks, shamelessly, paying absolutely no attention to the fact that after I sold, they went higher. I don’t feel smart about that decision. However, when I bought those stocks, I set valuation targets. When they approached the targets, I quickly reviewed their fundamentals. They had not changed much. The decision was obvious — sell.

Cyclical bull markets teach us not to sell, while cyclical bear markets teach us not to buy. If you let the market tell you what to do, you have no process.

But the bell doesn’t ring when bull or bear markets are over.

You cannot worry about marking the “top” in every sell. My objective is not to buy at the “bottom” and sell at the “top.” My objective is to buy a great company when it is cheap and to sell it when it is fairly valued! I suggest you do the same.

Vitaliy Katsenelson

contrarianedge.com

About the author:

Vitaliy Katsenelson
Vitaliy Katsenelson is Director of Research at Investment Management Associates and teaches at the University of Colorado. To read more of his articles visit www.ContrarianEdge.com . His book Active Value Investing was published by John Wiley & Sons in September 2007.

Visit Vitaliy Katsenelson's Website


Rating: 3.9/5 (10 votes)

Comments

Gangstarr
Gangstarr - 5 years ago
Tell it like it is Vitaliy. Your contributions are greatly appreciated. Found the insights in your book to be on point and on target.
nport
Nport - 5 years ago
Thank you Vitally. Excellent article.
ma.gen.email
Ma.gen.email - 5 years ago
One has to be careful when one encounters views that conform to one's own cherished hypotheses, even those with evidentiary support. So at the risk of susceptibility to conformation bias, I'd say this message (“you are not as smart as you think you are”) is worth repeating ad nauseam. Since most of our decisions / knowledge appear to be originating at an unconscious level and seem to be stamped with a seal of ‘I know this to be true' even before it percolates into our conscious awareness, reminding ourselves that we are not as smart as our assumptions warrant us to be is no easy task.

I can relate to your experience of price ascension after process-mandated selling causing frustration (and related emotions/feelings). Also, I like your remedial process (for overconfidence) of forcing yourself to re-live your incorrect decision making process, although I am not sure whether this will work in all cases. While “unknown unknowns” have received a great deal of attention in light of their devastating consequences in the recent market events, my experience has been that “unknown knowns” - assumptions that we make outside of our conscious awareness, but nevertheless influence our decisions, perhaps by affecting the starting point of the decision -- are just as potentially devastating. Perhaps this forced re-living exercise might help one uncover these "unknown knowns" -- and thereby enable us to devise strategies to surface them earlier in the decision process so that we can consciously evaluate their validity.

Thanks for publishing this helpful article.
arurao7
Arurao7 - 5 years ago
Marty whitman recently said that 'it is easy to know when some security is under-valued or over-valued, but it is very difficult to know what is fair-value'. I think even buffet typically tries to only sell when something really over-valued (think Petrochina). this old style buy-low-sell-fair-value concept is great in thought, but not very practical. It is extremely hard to know when something is of fair-value.

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