The following text carries on from the bit in Part 1 about Perfect Information - apologies, I don’t think I chopped the Document up very well !!
From the text that I have just typed, the conclusion I draw is that a lot of people lack confidence in what they are doing when deciding what Stocks to buy. For many people, I guess a huge part of this is down to inexperience and obviously the only remedy for this is time and sticking at it and learning. You need to accept that you will make errors and that these are a good thing as they mean you have opportunities to learn. You learn very little from the Trades that go well - it is the screwed up Trades which really teach us about how to make Money (and beat us with a hot cattle prod just to make sure we really remember the Lesson).
Just make sure you hold enough Stocks so that when the odd one or two go badly wrong, they do not hurt your overall Portfolio too much. Diversification is a Free Lunch - don’t turn your nose up at it !! (even if it is them stinky Herrings). Of course, many Readers will use Stoplosses and that is just another method of Risk Management in reality.
Linked to the lack of experience is also an inability to accept failure (I know because I definitely have this trait). There is a simple test here - would you feel able to Tweet out a Sell of a Stock if you lost 80% on the Trade? If you don’t think you could do that, then you might have a problem with accepting how things can turn out. Of course experience helps here but you need to face up to your Cock-Ups and admit to the world when you get things wrong - believe me, it is really cathartic and it forces you to confront an error and to analyse what went wrong thoroughly and what Lessons you can learn to reduce the chance of a repeat - although you must accept that sometimes you need to learn the same Lessons over and over again.
It is no good just brushing a Mistake under the Psychological Carpet and pretending it didn’t happen - you are fooling no one but yourself and you are not making the most of a superb Learning Opportunity. In addition, just think of how you can help other people by sharing your screw-ups so that they hopefully learn from your experience if you share it via a Tweet or whatever your chosen medium is.
Remember, it is the performance of your overall Portfolio that counts, not the individual Trade performances that make that Result up.
What Risk Management techniques can help?
There are many straightforward Risk Management techniques that can help overcome the problem of not having Perfect Information and being comfortable with not being able to know everything:
Accounting for Red Herrings
I am convinced that this ‘Red Herring’ bias is a huge problem in the minds of many people from an Accounting background - I see it time and time again that people from this specialism are obsessed with minor things that really are unimportant - it cannot help their investing. I guess Accounting is a naturally Risk-averse Profession and it is no surprise that scepticism is the mindset with which many Accountants approach possible Stocks for investment. However, this is an extremely dangerous pre-disposition as it means that the Upsides of a Stock are quite often overlooked or not given appropriate weighting in terms of importance.
Viewed at in the Kahneman ‘Thinking, Fast and Slow’ prism, this ‘First Impression’ bias of dislike by our Fast Brains can be extremely hard to dislodge and there is a huge risk that many Accountants will fall foul of ‘Man with a Hammer’ syndrome - “to a man with a hammer, every problem is a nail.”
I get the suspicion that the default approach for people with a taste for Accounts is to go straight into these before really understanding the Business - and with how our Minds work, this means that the First Impression picked up will dominate and be hard to shift. If the Accounts look ‘messy’ then the mindset is that this is a bad Company and it will be hard to turn that around psychologically - even if in fact the Company is a cracker and on a very low valuation. Conversely, a decent appearing Set of Accounts could hide a Business that is about to go quickly downhill due to technological change that will not be apparent in the backward-looking Accounts.
Don’t get me wrong, it is vital that Investors have a very good understanding of Accounts and how to read them - however, you cannot focus on this at the exclusion of all else if you want to consistently make money. You need to have a broad view of all Business disciplines and even more importantly you must have a very good understanding of Investing Tricks and Risk Management - this latter part will feature hugely in a future blog about a ‘Monkey with a Pin’.
It strikes me that the importance of Accounts diminishes as you go up the Market Capitalisation size spectrum. Investing in small AIM Stocks can really benefit from a deep understanding and focus on the Accounts but trying to understand the Accounts of a FTSE100 Mega Cap is probably a total waste of time - the numbers are all made up and hugely out of date due to the hierarchical constraints of such enormous organisations. In addition, there are huge numbers of Market Participants poring over the Accounts of large businesses and it is unlikely that you will spot anything that they cannot - with small companies you might be able to discover something of importance.
To keep things simple, the important thing to focus on is Cash Flow and Cash Generation - is Debt rising or falling or does the Company have an increasing Cash Pile? I don’t think people need to get over-obsessed here - if you stick to Quality Businesses that pay dividends and have established Track Records then the likelihood of problems is very low. If you buy junky ‘WheelieBin’ type stocks then you will get loads of problems in the Accounts but the simple fact is that on Quality Companies the rate of Accounting related failures is very, very low. In nearly every case of a Company failing it is usually a problem of too much Debt.
OK, I now apologise to the whole Accounting Profession !!
The simple reality is that we all have our own Psychological Biases and we must recognise these and think carefully about how they affect our Investment Choices and actions.
It is time for me to get on the couch and have the Psychologist’s Lamp shone at me along with the Vulcan Mind Probe questioning. I am pretty sure I have the following Psychological Biases and there are probably many more besides:
I am sure I have countless other Biases but it is making my Brain hurt writing these down and I am probably turning myself into a paranoid nervous wreck.
That’s it for Part 2, now I better start writing Part 3 before I go even more off the topic !!
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