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Cognitive biases and some good and bad investment habits

In my previous blogs, I walked through my portfolio history to give a feel for how I decide my allocations. I hope also that you will get out of this is a feeling for my cognitive biases and people’s generally. I have a number of observations to make about good and bad habits, some learnt from others, some from my own bad experience. For any of you who have read about behavioural finance some of this will be very familiar.

Selling

The real challenge for you as an investor is to be disciplined and not be emotionally invested. One of the most difficult decisions is to sell when you are losing. I think the thing that has most improved my investing is the habit of selling things EARLY, when they are not performing as I expect.

The natural trap we fall into is to hold onto funds that have gone down.You don’t want to sell because your ego wants to be vindicated when it goes back up, so you stay in.These very natural human responses are our enemies. We must leave our emotional selves behind when we invest. When you start being wrong – sell. You can always buy again, but things going down get momentum too. It may take you a long time to earn your money back.You will probably end up selling when you’ve got your money back so you can get off the emotional roller-coaster.So, no gain. You have wasted a lot of emotional energy watching a loser instead of changing your thinking and finding winners.

Build into positions, don’t go all-in

Another technique which has worked for me is not taking big bets. Take small ones, build into positions. It’s easier to cut a small loss when you haven’t emotionally committed to a position and you can say I was testing the water. Keep building but don’t believe you’re right, just not wrong yet. A big problem about making a big first investment is that you have bet on an asset and also on your timing.What do you do if it goes down or wobbles?With a small initial investment, you may feel able to run with it for a while and take a bit more of a loss.I like to hold small investments in things I’m not sure about as it focuses me on them and makes me keep watching them.As they perform and my confidence builds I can build my position.The performance of all my best investments looks worse than it should as my average entry price is much higher than my initial entry cost as I’ve kept buying at higher prices.I’m very happy with that.

Keep a diary – remember why you bought. What was your investment thesis?

Circumstances will change. What was the right idea will become wrong as the world changes. As Keanes said, “when circumstances change, I change my mind”. A position is only right until circumstances change. For me I try to take bets that will be good for years. I have no illusions though: I’ve just bought a small cap fund and I’ve given it a 3-month horizon. I think the sector is already overvalued. That doesn’t mean it won’t get more expensive, but I’m going to watch it closely – it’s a high risk, and unusually for me, a short-term bet. My US exposure has the same status in my mind, but I’m getting ready to start shifting my allocation to better risk rewards. The fragility of Europe means that at any point, an event like an Italian election, which could threaten the Euro could completely change my outlook and I mean completely.

Don’t pay entry fees

There are some other rules I haven’t discussed yet, like not paying entry fees.A fund you’ve paid an entry fee for is like a bad relationship you are too lazy to get out of. It may not be good but you are invested, you don’t want to give up.

One of the big benefits of the developments of fund supermarkets is that entry fees, which used to be common, are now almost completely optional.Buying almost any fund through a platform like Hargreaves Lansdown should be fee free.You will only have to pay a bid offer spread.Some funds which are high performing and have a high reputation – like CF Odey’s Absolute Return Fund or Aberdeen’s Emerging Market Fund may have a substantial fee of up to 4% for new investors.

I never pay fees but I was invested in the CF Odey Fund when the fee was imposed on subsequent investment.I dislike fees because they tend to make us emotionally committed to a fund.This is a problem when selling early is such an important discipline.Even though I hadn’t paid the fee it really affected my willingness to sell. The trap has worked!

So, what happened? Mr Odey has been very bearish since Brexit was announced. He’s also been very wrong. I still have an investment, but I have been seduced into keeping it: I didn’t want to take my money out because I didn’t want to pay to get back in, so I left it in much longer than I otherwise would have done, based on performance. It also stopped me realising capital gains, as I didn’t want to pay to get back in.The Odey fund has not been a disaster for the last couple of years, but I could have made better returns redeploying.

Confirmation bias

Another way to say this is, the quickest way to become an extremist is to hang out with extremists.A natural human weakness is confirmation bias, we seek out information which confirms our world view, rather than data which throws it into doubt.This requires us to constantly read things by people we don’t agree with and to look at new data released and say, “does this mean that I am now wrong?”This links to the diary and a clear investment thesis.If you know why you are doing something, the market may give you a clear message to stop when your assumptions change. All the disciplines I’ve talked about here involve us taking emotion out of the process and trying to be rational. Does this mean that you can’t trust your “gut instinct”? George Soros has said that his unconscious processing of the data he reads gives him signals, like back-ache. He has admitted to relying greatly on “animal instincts”, saying the onset of acute pain was often “a signal that there was something wrong in my portfolio”.

Is this his unconscious processing sending him messages in an unconventional way? Maybe your bad mood or unease is your unconscious telling you it’s processed the data in a different way to your conscious mind and that it’s time to sell. This sounds rather romantic and a “cop out” but to my mind it’s just another sort of data to interpret. I think that ideas and investment theses are like clothes. You try them on and see if they fit and feel comfortable. You may ultimately get your most cogent signals from listening to these non-rational cues.Ultimately you are making a judgement. These decisions don’t have clear-cut go/no-go results like arithmetic.

 
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