In my previous article, I described one of the biggest fears as an value investor: buying too soon on the way down from often very overvalued levels. I shared my thoughts on reasons why we tend to buy too early, the most powerful one being the combination of a few human psychological biases that Charlie Munger (Trades, Portfolio) laid out in his Harvard speech.
1. Bias from contrast-caused distortions of sensation, perception and cognition.
2. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.
3. Bias from the non-mathematical nature of the human brain in its natural state as it deals with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list.
4. Bias from over-influence by extra-vivid evidence.
I’d like to share with readers how I cope with this fear of buying too early. Let’s deal with the market-wide crash first. People often worry about buying too early because they think the market is going to crash. What if you bought a stock just before the market crash?
I don’t worry too much about market crashes at all. First of all, I know a market crash is always likely. Statistically speaking, a market drop of 15% or more happens every six or seven years. This is the nature of the game and we just have to live with it. Secondly, market crashes are great for prepared value investors. There are only two things that can happen after a market crash for someone who’s prepared. Either the world is going to end or you will make a lot of money. If the world ends, then all things won’t matter.
Now let’s deal with the fear from the bottom-up perspective. First of all, before I even move on to the next step, I force myself to be consciously aware of the psychological biases that are in force. This should be a habit. You should have a psychological checklist. Only after you have gone through this checklist should you move on.
As I mentioned earlier, very often the reason we suddenly become interested in a stock is a sharp drop in the price that invokes the contrast bias, vivid evidence bias and deprival super-reaction syndrome. This is such a powerful combination of biases that we often feel an urgent impulse to act because the anticipation of rewards makes our body to release dopamine, which enables us not only to see rewards, but to take action to move toward them.
Now that we are aware of our emotions and biases, we need to ask ourselves a few questions – am I being the patsy on the poker table? Do I understand why everybody else is selling the stocks? Do I have evidence that I understand why everybody else is selling?
There are a lot of reasons why investors dump a stock. To name a few:
- Temporary problems such as guidance miss or one-off event that adds uncertainty.
- Industry wide concerns that blow the whole industry off.
- Growth managers are dumping a stock because the company is only going to grow 12% a year instead of 15%.
- The business model has changed so the fundamental of the business in the future has changed dramatically.
I would say reason 1 and 3 above are less worrisome, whereas reason 2 and 4 are serious concerns that need to be addressed. You can’t just address them by forming an opinion using first level information and thinking. I certainly learned this the hard way.
When I started investing, I had the tendency to quickly form an opinion without properly backing it up with evidence. But I became a better investor because now I realize that we should not form an opinion too quickly without having done the research to know enough about a company. I feel comfortable to acknowledge that I don’t know enough to have an opinion on most stocks traded on the New York Stock Exchange.
When I do have an opinion on a stock, I’d like to have what I call the second level-opinion, which is opinion well-thought and properly backed up. If you start cultivating the habit of forming second-level opinions and refrain yourself from expressing first-level opinions, which are often intuitions, you may be able to see things clearer and better in the end. Once you have figured out why the stock drops so much and have a good amount of evidence, then you can make a much better decision and lessen the fear of buying too soon.
In the end, I would add that there is nothing we can do to guarantee that we are right. Everything that I listed above can only improve the odds that we are not too wrong. There’s a lot randomness in the market that can make the less likely events happen more often than we would want to see. As Elroy Dimson at the London Business School puts it: “Risk means more things can happen than will happen.” We can only cope as best as we can. Over the long run, randomness will be smoothed out and you will get what you deserve.
I look forward to hearing readers' thoughts on this subject.