Investing is a dynamic activity. Few (if any) individuals can rightfully call themselves “natural” stock market operators. Even the great Warren Buffett (Trades, Portfolio), the long-standing doyen of value investing, was a novice once, and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) was not built in a day. Most of the greatest investors in history had to learn their trade through education, experience and – perhaps most importantly – introspection.
How, then, can investors work to improve their performance? One answer may lie in the realm of cognitive science. By improving one’s mental model (or mental map) of the world, one can glean superior insights and thus deliver superior returns.
Shane Parrish: Think better by thinking broadly
How people think about the world is shaped by their experience and expertise. This is especially true in regards to how they approach and think through problems. Individuals rely on their experience and education to guide their decision-making, which is often a good thing. However, according to Shane Parrish, a respected expert on mental models best known for founding Farnam Street, increasing degrees of educational and professional specialization may serve to limit individuals’ ability to fully conceptualize complex subjects:
I think we're unconsciously using models all the time. But when we're doing it unconsciously, it's not as valuable as consciously going through the toolbox or a catalog of ideas and picking the ones that fits best. Education is increasingly specialized. If you go to university and get a business degree, you learn to think like a business person. And that's a great lens into the world, but it also has blind spots. You don't learn to think or see like a mathematician, a biologist, a physicist. A lot of those subjects are not something we're interested in learning, but the core ideas apply across disciplines and help us not only solve problems, but avoid them.
In a dynamic industry such as the stock market, which is more like a living organism or ecosystem than a static entity, extreme specialization can result in serious blind spots. Being able to draw on multiple viewpoints or ways of thinking can improve mental clarity and help individuals develop a more accurate mental map of the world and the market.
Investors must learn to think through a number of lenses if they expect to succeed over the long run. The market is a complex and ever-evolving entity. Investors who allow their mental frameworks and educational specialties to tie them down will always have more difficulty reacting to new realities.
Joe Wiggins: Don’t just look for the facts that fit your thesis
Investors’ mental models may be deficient for reasons other than narrowly-focused educations or experiences. Individuals are also prone to confirmation bias. No one likes to be wrong, and admitting one is wrong can be harder still. According to Joe Wiggins, a multi-asset fund manager for Aberdeen Standard Investments, investors can develop blind spots due to this natural psychological behavior:
We often think that the additional insights from detailed research are improving our decisions, but in many cases they are simply making us neglect the base rate (whilst erroneously increasing our confidence). Our starting point should always be a consideration of the reference class or general evidence that frames a particular scenario. We can then revise this (usually modestly) if we obtain relevant information that is specific to our case.
Value investors often undertake expansive research projects in order to build a coherent investment thesis. This is usually a very good thing, since conclusions tend to be more rigorous when they are backed by extensive research, rich data sources and deep analysis. Unfortunately, not all such efforts pay off. Sometimes things simply do not play out for a company in the way the investor expects.
This is where the danger sets in: An investor can become emotionally attached, or otherwise psychologically blinkered, to their original thesis. Thus, even when things do not go according to plan, some investors opt to stay the course, or even seek out new supporting data while excluding contradictory information. Investors who succumb to such psychological blinkers, or who indulge in active thesis creep, will usually find that their real returns fall short of their warped expectations.
Verdict
The key to lasting success as a value investor lies in the mind. A flexible, expansive mind will adapt to changing circumstances without concern for past theses or conclusion. Likewise, investors who cultivate multiple channels of knowledge, either personally or through others, will find more frequent success in the market.
Ultimately, those who best understand what is really happening, both within individual companies and across the broader market and macroeconomic environment, will enjoy the greatest investing success. Cultivating such mental faculties is, of course, easier said than done. But it is clearly well worth the effort.
Disclosure: No positions.
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