In his "psychology of human misjudgment" talk, Charlie Munger (Trades, Portfolio) outlined 18 different psychological biases that cause people to make bad decisions. Unfortunately, investors cannot avoid biases.
There's no surefire strategy to prevent our brains from making these mistakes. However, we can make ourselves aware of the biases and adopt a constant state of vigilance to ensure we're not submitting.
Different investors may have different strategies for dealing with these biases. One approach is not going to work for everyone.
Still, I have found that one of the best ways to avoid getting caught up with biases myself is to avoid spending too much time idolizing top investors and analyzing hedge fund holdings.
The psychological biases
There are a variety of biases that can develop due to spending too much time analyzing fund investments.
The most common and easy to understand is envy. Munger said of envy and jealousy in his talk:
"I've heard Warren [Buffett] say a half a dozen times, 'It's not greed that drives the world, but envy.' And you go through the psychology survey courses, and you go to the index: envy, jealousy, in a 1,000-page book -- it's blank! There's some blind spots in academia, but it's an enormously powerful thing."
It is easy for one to become envious of a successful fund manager who has achieved significant returns. And it doesn't just apply to fund managers.
If an investor has made a lot of money from one particular asset or security, others may become envious. This can lead to poor decisions if investors try to catch up by taking positions they do not truly understand.
Then there's the bias of over-influence by authority. Many individual investors might look at hedge fund managers and think, "These guys are Wall Street champions. What they do has to be the best!"
This over-influence by authority can lead investors to make poor decisions that they wouldn't necessarily make.
To use one example, how many investors were so enamored by Eddie Lampert's track record that they followed him into Sears (SHLDQ, Financial)? How many investors followed Bill Ackman (Trades, Portfolio) into Valeant?
There's also what Munger called "failure to obtain deserved influence caused by not properly explaining why." He explained:
"We all know people who've flunked, and they try and memorize and they try and spout back. It just doesn't work. The brain doesn't work that way. You've got to array facts on the theory structures answering the question 'Why?' If you don't do that, you just cannot handle the world."
Generally, fund reports and 13Fs only reveal that a fund holds a position. They do not explain why. Even if they do, fund reports only usually provide a small snapshot. This could lull readers into thinking they know why they should buy the asset.
By trying to memorize the facts without understanding the valuation framework and figures used to construct the final investment analysis, readers are flying blind.
When developing one's own investment analysis, building the framework is vital for the whole process. Without this framework, it is virtually impossible to adapt if the situation changes.
Different biases can then take control. Simple denial or the bias from consistency and commitment tendency can drive investors to double down on errors without knowing why they're making a mistake.
There is a whole range of psychological biases that can impact an investor's decision-making process.
All of the above could result from reading just one hedge fund letter, which proves how aware we need to be of ourselves and our mental biases.
Keeping a check on these psychological biases is not easy, but knowing they exist in the first place is the first step.
Disclosure: The author owns no stocks mentioned.
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