| "Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." |
| - Warren Buffett |
When I was still attending college over three decades ago I became fascinated with the evolving science of human ethology. Human ethology can be described as the biologically-based study of human behavior emphasizing empirical analysis which is set within an evolutionary frame work. Stick with me by the end of the article that definition will not seem so confusing.
The obvious reaction to the prior paragraph by most investors would be a resounding "Who cares?" To that I would answer Benjamin Graham cared greatly about such matters. In fact, I would argue that the most important part of his investment classic "The Intelligent Investor" was an early application of the study of human ethology as it applies to finance and investing. In today's terms that study is now referred to as behavioral finance.
Graham's concept of the bipolar "Mr. Market" was directly based upon observational data (empirical data). The fact that investors could exhibit such irrational tendencies depending upon their current mood simply could not be explained by rational thought processes; although efficient market proponents might still dispute that point.
Graham was among the first to document in writing that most investors make buy and sell decisions based upon their current state of emotion. He observed that exploiting that phenomenon could result in oversized market gains. He was successful in passing on that observation to the likes of Buffett, Kahn, Schloss and countless other value investors who have made their fortunes by taking advantage of Graham's empirical as well as analytical skills.
Graham's observations about emotion helped to spawn the emerging field of Behavioral Finance. Behavioral Finance attempts to uncover the biological and psychological aspects of investors which can explain the basis for stock market anomalies and deviations in stock prices. In other words, Behavioral Finance is a practical application of Human Ethology, a field which caught my interest so many years ago. It is indeed strange how "what comes around goes around."
Practical Application of Behavioral Finance
You may recall the old joke about the man going who goes to the doctor and tells him it hurts when I do this – the doctor replies don't do that. I never said the joke was funny; however it does raise an interesting question for students of behavioral finance. Specifically, why do investors tend to continually do things that damage the values of their stock portfolios?
The answer to the aforementioned question is that investors tend make poor investing decisions because they are biologically and psychologically programmed to make such decisions. Phenomena such as "fight or flight" responses, "herding instincts" or "loss aversion" directly affect the performance of one's stock portfolio in the event that the investor acts upon such impulses.
The goal of Behavioral Finance is to uncover the pre-programmed responses which tend to damage one's portfolio and teach investors to avoid making the same mistake repeatedly. Hopefully investors are more open to change by discovery than psychotherapy patients, Manhattan offices are not paid for with the money of patients who have been cured – just kidding.
Whitney Tilson's Practical Application of Behavioral Finance
In the Fall of 2005 T2 Partners published a paper entitled "Applying Behavioral Finance to Value Investing" http://www.tilsonfunds.com/TilsonBehavioralFinance.pdf. At the end of the article Tilson listed 10 tips for practical application of behavioral finance. I find the tips to extremely thoughtful and worthy of printing; I keep a copy of the tips in my office.
Tips to Applying Behavioral Finance
1) Be humble.
–Avoid leverage, diversify, minimize trading.
2) Be patient.
–Don’t try to get rich quick.
–A watched stock never rises.
–Tune out the noise.
–Make sure time is on your side (stocks instead of options; no leverage).
3) Get a partner – someone you really trust – even if not at your firm.
4) Have written checklists; e.g., my four questions:
–Is this within my circle of competence?
–Is it a good business?
–Do I like management? (Operators, capital allocators, integrity).
–Is the stock incredibly cheap? Am I trembling with greed?
5) Actively seek out contrary opinions.
–Try to rebut rather than confirm hypotheses; seek out contrary viewpoints; assign someone to taking the opposing position or invite bearish analyst to give presentation (Pzena’s method).
–Use secret ballots.
–Ask "What would cause me to change my mind?"
6) Don’t anchor on historical information/perceptions/stock prices.
–Keep an open mind.
–Update your initial estimate of intrinsic value.
–Erase historical prices from your mind; don’t fall into the "I missed it" trap — think in terms of enterprise value, not stock price.
–Set buy and sell targets.
7) Admit and learn from mistakes — but learn the right lessons and don’t obsess.
–Put the initial investment thesis in writing so you can refer back to it.
–Sell your mistakes and move on; you don’t have to make it back the same way you lost it.
–But be careful of panicking and selling at the bottom.
8) Don’t get fooled by randomness.
9) Understand and profit from regression to the mean.
10) Mental tricks.
–Pretend like you don’t own it (Steinhardt going to cash).
–Sell a little bit and sleep on it (Einhorn).
I continually remind myself of the top two tips: Be humble and be patient. The downfall of most investors and traders can be directly linked to those two deadly investing sins. Simply adhering to those two simple concepts goes a long way towards outperforming the market.Also check out:
