This one came about as a flash of thought whilst I was watching ‘Question Time’ recently and getting more and more irritated as per usual - and trying not to throw anything hefty at my Flatscreen TV. It struck me that perhaps as many as 75% of the points made by both the Panel and the Audience were probably pretty much irrelevant to whatever subject was being debated - in other words there was an oversupply of ‘Red Herrings‘………(to be honest, they are stinky, boney, things, I would steer clear).
In classic Red Herring style, the point itself was probably factual and true (I think these are probably essential elements of a good Red Herring) but it wasn’t really material to the situation facing the Civilised World. I can’t remember if it was from the Panel or the Audience but someone made the point that “much of the problem was caused by the British when determining the Borders after WW1” - as you can see this is probably true but how does that really help the situation today? Of course it gets the usual cheer from the Audience and a huge chunk of the crowd claps and nods heads, but I am not convinced this really helps with preventing normal decent people getting blown up by Terrorists or forced into Slavery or whatever barbarity they fancy this week (Jeremy and Diane, if you are reading this, please don’t put any Comments or Tweet me or anything - this is just an example. We are concerned here with Investments not with your views on Trident or anything - thanks in advance).
I’m pretty sure this kind of thing is endemic in the world of Share Investing. There must be a European Union Red Herring Fishmonger Mountain of the stinky slippery little blighters.
Red Herrings in action
Here are a few examples of how Red Herrings can pollute the Stock Investment Case ocean:
- I regularly see comments that Royal Mail (RMG) is not growing and that this is therefore a big Red Flag to keep away. It completely misses the point in my view and is an utter Red Herring - what matters on RMG is Cost Cutting - the inefficiency is rife. In other words, RMG can continue to report growing Profits and rising Dividends even if Revenue stagnates or even falls slowly, and a rising Divvy will ultimately drive the Share Price higher (over the Long Term, the value of any Stock is a function of its Returns to Shareholders over time). In addition, RMG has a lot of Property that could be sold - expect more of this. So, the point here is that it is important to figure out what really matters and will drive the Share Price and what is just ‘Noise’ (Red Herrings) - and on the Psychology theme, the stance of disliking RMG because of lack of Revenue Growth might need to be carefully reconsidered.
- I am sure regular Readers will have seen various comments from me about the Pension Deficit issue - in essence I think it is pretty much nonsense and a huge Red Herring. It gives Investors a classic Daniel Kahneman ‘Fast Thinking’ excuse to quickly dismiss a potential Investment Stock - “oh, I can’t buy that because it has a big Pension Deficit” - whereas the reality is that I made a sweet 40% Profit on AGA Rangemaster (AGA) when it got a Takeover Bid despite an enormous Pension Deficit and time and time again I see people saying that Wincanton (WIN) has a huge Pension Deficit but the Stock just keeps going up and up. International Consolidated Airlines (IAG), formerly British Airways many years ago, also has an absurdly large Pension Deficit but the Shares have been rising for at least 3 years. Rather than just dismissing Stocks with Pension Deficits, maybe it would be worth Investors thinking about why they may not be the huge problem that many ‘experts’ would have us believe. In fact, just recently, Smiths Industries SMIN reported a halving of their Pension Deficit simply because they altered the Discount Rate used on the spreadsheet. There was another company that did a similar thing recently, but I can’t remember which one it was !! (I think it might have been KCOM). However, on the flipside, I think it was Molins MLIN that announced the other day they need to pay more into the Pension Fund - so I guess on balance it is about looking at the merits of each Stock. However, if the Pension Deficit reduction measures are already included in the Analyst Forecasts then perhaps it has already been allowed for.
- A great example of a Red Herring (in fact, a classic piece of useless and dangerous ‘Noise‘) is the current Financial Media obsession with the Chinese Stockmarket collapse. How exactly does China’s Market imploding affect my Shares in 32Red (TTR)? Of course it doesn’t, the 2 things are utterly unrelated - the China Market collapse is irrelevant. To make money on Stocks it is vital to ‘screen out’ all this Noise and Fear mongering which will scare you into Selling Great Stocks that you must Hold for the Long Term to really compound your Returns - your default position on any News should be NOT TO SELL. As I continually bleat on about, we must Run our Winners and hold on to them through thick and thin - it is critical to really make big money easily. This is really important - if you sell out of a Stock because of some Bulletin Board Fixation of the Week, then you will never get big winners.
- Telecom Plus TEP is another one that has had some silly trivia about the Gas Price it charges to customers being too high - I don’t see this as material because people don’t sign up to TEP to buy cheap Gas - it is because they buy from a friend or someone they trust and they are buying lots of Utility Services on one unified bill. I sometimes wonder if a lot of this stuff is just put about by people who are Short and are trying to drive the price down.
- On Pets at Home (PETS) the Investment Case is a Monopolistic dominance of the Market and the Rollout of New Stores and Vets4Pets and Grooming Rooms - pretty much anything else is Red Herrings (my mate @SmallCappy tells me you can get very nice Tanks to put your Herrings in at PETS).
- Before the VolksWagen CO2 emissions cheating scandal, the Investment Case for VW was its peerless Platform Sharing where various Car Models across the Group (including Audi, Seat, Skoda, Porsche etc.) were able to share the common MQB Platform and the interchangeably of parts was a huge Cost Reducer (no doubt the Emission Cheating Software was common across all the models !!). Other minor considerations were pretty much irrelevant - they were Red Herrings.
- This is more of a general point about small Resource Stocks. The sad fact is that very very few Mining or Oil Explorers ever get anywhere - yet people are generally fixated by these things, believing them to be wonderful ‘investments’. I know, because I used to think that way until I realised what a hiding to nothing I was embarked upon. These are a classic tale of ‘Noise’ and our own ‘Confirmation Bias’ leading us to lose Money. You buy an Oil Explorer after reading loads and loads of stuff on them and doing your ‘Research’ and by just doing this, you have already emotionally started viewing this Stock in a favourable light. Then you hear all sorts of Bulletin Board silliness (Noise) which supports your view EVEN THOUGH IT IS OFTEN UTTERLY IRRLEVANT INFORMATION and this just eggs you on. The promotion and ramping that goes on with these Stocks is plain outrageous and only the small number of Traders who are in on the game ever win - most of us Punters just get cleaned out. Don’t fall for it - stay well clear or if you really must try to throw your money away, then do it with a tiny percentage of your Portfolio.
Put simply, I suspect many people (and I include myself because it is really part of the Human Psychological condition) are really prone to over-weighting the importance of such Red Herring ‘Facts’ in an Investment Case for a given Stock. Where possible, I think we all need to recognise this Psychological Bias and to make sure we focus on a few Key Facts that really are material and of vital importance - and most crucially are the elements that will drive the Share Price upwards.
I guess a lot of this is ‘Confirmation Bias’ where we have a set opinion on something already (for example, we might already really like a Company) and so we look for other ‘Facts’ which support the opinion we already have. Whether it is really pertinent or not is just brushed aside by our ‘Fast thinking’ brains and we are reinforcing our strong opinion that is already held.
Linked to this, we conveniently gloss over factors that are against our already strong opinion and probably use other quite irrelevant ‘Facts’ to help negate these factors. If you have read Daniel Kahneman’s ‘Thinking, Fast and Slow’ you may recognise the idea that we very quickly form opinions on everything and this ‘first impression’ is very hard to dislodge and change - it can only happen after lots of contrary evidence and careful ‘Slow thinking’.
The other problem that arises from these ‘Red Herring’ Facts is that they add to the prevailing background Noise that is of very little help to us as Investors and more often than not is a very negative influence on how we trade our Positions. It is critical to let our Winners run as we probably all know, but harder to do in practice - a big part of this is the Noise that puts the fear of the Lord into us and makes us take snap judgements about a Stock we hold and sell it far too early. This is an extremely common error.
It is so easy to confuse ‘Noise’ with ‘Signal’ -the latter are factors that really drive the Stock Price over the Medium and Long Term whereas Noise can impact things Short Term and actually create Buying Opportunities if we understand a Stock well and are fully aware of the Risks. If you were to react to all the Positive and Negative News about a Stock you would be constantly buying and selling and fairly quickly destroying your Capital in a frenzy of over-trading.
When you hear about a new piece of information, it is vital that you think slowly and carefully and don’t make a rush decision - sleep on it and really think things through. Does it really impact your Investment Case? If you get into a habit of writing down a few simple sentences about why you bought a Stock at the time of buying, when new information comes along you can look at these buying reasons and think about if they are affected. Think also about Confirmation Bias and your own psychological tendencies and act according to a properly thought through Decision.
A self-defeating quest for Perfect Information?
Apart from the Kahneman type biases we hold for ‘first impressions’, I guess it’s hard to say precisely how such a Bias can occur in our Brains - and the chances are that it is a different causation, motivation, mechanism etc. in all of us. I have studied Psychology to a low level at college but not enough to really be able to get anywhere near explaining the Textbook reasons.
From an Investing viewpoint, I would guess that one of the main reasons for seeking out and giving too much importance to Red Herring Facts is that we all want to find out everything we can about a potential Investment Stock. However, this search for 100% perfection in our understanding of a Stock gives rise to the Red Herring problem but also is a total fantasyland anyway.
I do not think it is ever possible (and arguably it is not even desirable) to know 100% of the Information existing about a given Stock. In fact, I can be pretty sure in my assertion that even the CEO of a Company would not know anything like 100% of the information about their Business - so how on earth could we as primarily Desk Researchers ever expect to know everything?
This seeking for perfection has a very dangerous side-effect that I have noticed in many Investors which is ‘Paralysis by Analysis’. The search and desire for Perfect Information means that the Investor never actually Buys anything !! I suspect many people reading this Blog now will be able to recognise this trait in themselves.
The sad, sorry, reality is that we must all as Investors learn to accept that we can never have 100% Perfect Information. To me, this is a Pareto Rule concept - I like to get 80% of the Information in 20% of the Time and my Risk Management Techniques keep me safe for the 20% of Knowledge that I could never actually achieve and it would take me weeks and weeks of intense research even to try.
The game we are in is about Risk Management and it is Probabilistic. We have to become comfortable with Risk and how to control it and we need to accept that anything we do with our Investing Activities is entirely a balance of possible outcomes. We need to Invest in a way that we maximise the Positive Possible Outcomes and minimise the Negative Possible Outcomes. One such Risk is that we must accept we can never have Perfect 100% Information and we must be comfortable with dealing on Imperfect 80% Information.
Our task as Investors is to accept that we can never have Perfect Information and we must manage the Unknown and Unknowable to ensure we are successful. We must weight the Investment Odds in our Favour. One way of thinking about this is to consider that the success of any Investment we make probably depends on the following elements:
- Stock selection - 20%
- Timing - 15%
- Valuation - 20%
- Trading Techniques (add to Winners etc.) - 20%
- Discipline and Psychology - 20%
- Luck - 10%
These are entirely guessed and made up percentages but it is intended to just get you thinking about it and represent how relatively important each element is. This should clearly show how unimportant it is to try to have 100% Perfect Information - in fact, you would do far better just by making sure you do the other elements well rather than the Stock Selection part. As a slight aside, it has often struck me that you could be a ‘Monkey with a Pin’ on the Stock Selection part, but simply by using rules like Adding to Winners and having a spread of Stocks, you could outperform most Investors (I suspect many Traders would agree with this). However, that is the subject of another Blog further down the tracks.
Just to clarify before we move onto Part 2, I am not saying by any means that we should just ignore detailed information etc.; what I am saying is that our default position should be to think extremely carefully and slowly about any new information that arrives - making snap-judgements and fast actions is not a good way to make money if you are an Investor - for Traders, it is different, you need to act fast in that case. Better still, if you are a Trader, try to create Rules that remove ambiguous Decisions entirely and make your Trading automatic as much as is possible. My Rule of only making Buy or Sell Decisions outside of normal Market Opening Hours plays into this theme in a big way and forces me to carefully think things through.
However, something we must be extremely careful about is bias in the ‘information’ we receive - we need to ask ourselves questions such as:
- Is the source credible?
- Is this a source we know well and trust the opinions of?
- Is there a real basis of fact here or is it just conjecture or bias from the source?
- Is the new information relevant to what will drive the Share Price over the medium to long term or is it just short term Traders’ Noise?
- Does the source have an Agenda?
- Are we interpreting this information correctly? Is our Brain being ruled by its ‘Fast thinking’ bias?
- Is this typical of the kind of information that just shakes out Weak Holders of a Quality Stock and prevents them from maximising Momentum gains?
- Are you just being shaken out of a Great Stock that is still in a lovely Uptrend Channel?
- Does this new information negate the Key Reasons why you bought the Stock in the first place? (refer back to your List of Reasons for Buying).
- Etc. etc.
Part 2 should appear soon, in the meantime, check out these sort of related WheelieBlogs:
Beware of Opinion:
That’s it for Part 1, now go and wash your fingers,