Once a Blog is finished and I upload it into the Wheelie Website, one of the tasks is to assign a ‘Category’ or two for it. On this particular Blog I am not sure what to classify it as - I guess it is really about Investor Psychology and to a smaller extent about Investment Analysis………(ok, if you were expecting culinary advice you will now be very disappointed). Whatever the Category, I think it is largely about the importance of identifying and cutting out Noise.
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).
One such example arose whilst they were discussing the potential bombing of ISIS in Syria (now you can tell how long ago I started on the drafts for this Blog Series - I have been really struggling to finish it to a reasonable standard - I think I lost my thread long after I started out on it - sorry if this is obvious in the final published version !!).
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:
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:
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:
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,
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