For Investors, Red Herrings are a ’poor’ Diet - Part 2 of 3

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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:

• Diversification - if you hold a small number of Stocks, then you need to know more and more about each one of them, because the Risk of getting it wrong can be terminal for your Portfolio. For example, if you hold 8 Stocks with similar Weightings and one blows up, then you can get hit for 12.5% - which is a big hit when you are looking for perhaps 15% Annual Return Compounded. If you hold 25 Stocks, then if one goes bang, you only take a hit of 4% - in fact, you could have 3 go bang before you reach the problem that the Smaller Portfolio has to contend with. Diversification is a rare Free Lunch in Investing - don’t ignore it (I deliberately repeated this as it is so important). Related to this is the idea of buying Stocks from different Sectors, Investment Strategies, Geographies, Market Capitalisation size, etc. It is also worth considering that if Perfect Information is unattainable, are people with small focused Portfolios just fooling themselves? Is it over-confidence?
• Stoplosses - as you probably know, I am not a huge fan of Stoplosses although I do use them in some rare circumstances. However, if you feel unable to commit to Buying Individual Stocks because you feel you don’t know everything and are scared of losing money (Risk Aversion?), then maybe a Stoploss approach will help reduce your anxieties - maybe a 15% Stoploss or similar will do the job. However, if you do use Stoplosses, make sure you are very careful with timing your Entries into the Trade as I am of the view that Stoplosses will only work if combined with a finely honed Entry technique - this could involved Scaling In. This is just something to consider and I will add that my current thinking is that Stoplosses can only work as part of a Rules Based systematic approach that is honed over many years (and possibly back-tested) - without this, it could turn out to be very frustrating I suspect.
• Adding to Winners - I love this, and I think it is a huge part of how to be successful in the Markets. When you buy a Stock and it starts to go up, buy more of it. That way you are backing your Winning Ideas and you are starving your Losing Ideas - if the Stock does nothing or goes down, just leave it be. This means that over time, your Winners become a bigger Weighting on your Portfolio and your Losers dwindle - so they have less impact. Technically, it means you are taking advantage of Positive Momentum and reducing the drag on your Portfolio of Negative Momentum. It is very simple, but again few people seem to really grasp this and make it work for them. Look at it this way - when you buy any Stock you are acting on the Information that is available to you and you have been able to collect in a reasonable amount of time (we are all constrained by various time pressures of Life like Families, Work, Kids, Health Issues, Social Life etc.) and you hope/expect that it will do well for you. But you cannot know that it definitely will - with time and experience you get better at knowing what tends to work but you can never be 100% sure - it is a case of buying and then crossing your fingers. However, by Adding to your Winners it is like you have bought a Stock you thought was good and then the Market has confirmed your choice - so you are not just using your own Investing Skills you are drawing on the wider knowledge of the Market to confirm to you that you are in fact right. Adding to Winners helps to make the most of the Power of Momentum which you will have no doubt seen me bang on about lots of times before - hell, I am almost boring myself !!
• Averaging Down - careful and well timed Averaging Down can really help improve Returns - this is not something to rush into and many Traders would be violently opposed to this technique (the Trader Mafia will be after me again), but used appropriately it can definitely make the best of a situation that may have got off to a poor start.

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. 

My WheelieBiases
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:

• Over optimistic - I am naturally a Bull and expect Stocks I buy to go up - although in practice they usually go down. This is dangerous because my optimism probably gets me into ‘Value Trap’ type Stocks which are on fairly low Price/Earnings (P/E) Ratios (perhaps 8 to 12) which are often cheap for a reason. However, experience has taught me over many years that I tend to make a lot more money on such cheap Shares and buying Stocks on high P/E Ratios (I guess around 18 to 22) has never worked for me. I am pretty sure this over optimism leads me to sometimes overlook negative aspects that I should be more concerned about - this is very contrary to the whole subject matter of these Blogs !!
• Too Trusting - I tend to be daft enough to believe anything Company Directors say and this is probably a big flaw in my Investing Character. For life in general, I would say such a Trusting Nature is a good thing but for investing it is probably a weakness - I need to be more critical and less willing to believe what Directors say.
• First Impressions bias - I am concerned that I am too easily influenced by my initial thoughts when I first read about a Stock. I very quickly seem to ‘compartmentalise’ it as either Good or Bad and as per Daniel Kahneman’s writings, my worry is that these initial biases are affecting my judgement. This is not something I have worried about before as I had not even realised I was doing it, but since reading Kahneman’s Book I am now starting to wonder.
• Stereotyping - readers will have probably picked up on my aversion to High Risk, speculative, type Shares like the stuff festering away in the WheelieBin. However, there is a probably Psychological Bias at play here on my part - in effect I am ‘stereotyping’ all these kind of Stocks as Junk when in fact, amongst the smelly stuff, there might be one or two decent Stocks (I doubt there will be many more than this !!) This bias manifests itself as me very quickly dismissing WheelieBin Stocks and it will be my ‘Fast Brain’ which is undertaking this stereotyping - 99% of the time it is a very good stereotype to have and probably keeps me out of many Sewers but it does run the risk of missing the odd beauty. Of course, the answer to overcome this bias is to not dismiss things straightaway and to use Risk Management tools such as a stoploss and/or small Position Size to ensure any Losses are contained.
• Mean Reversion - I have just finished Daniel Kahneman’s chapters on this and it is pretty clear to me that he has a point. In essence, everything in life tends to ‘Mean Revert’ - i.e., outstanding performance or at the other end of the spectrum, extreme underperformance, tends to revert back to the average - and our Fast Thinking Brains are very poor at spotting this phenomenon, even when our Slow Brains are focussed on trying to correct the error. I think I probably suffer from this Bias but I have not yet really had the chance to think much about it - I have only really become aware of the problem since reading Kahneman’s book !! I am now much more aware of it and will be looking out for examples and thinking about how it affects my judgements. An instance that comes to mind quite easily, is that I see forecasts for Company Earnings and Macroeconmic Growth everywhere - chances are that they are very wrong as such things do not continually rise into the future - they Mean Revert and it is normal for there to be slower years.
• Loss Aversion - this is an extremely common bias and is probably inherent in all humans - in simple terms it means that we are relatively more upset by taking a Loss on something than we are pleased by making a Gain. For myself, this probably manifests itself by my failure to cut Losers early enough (Stanley Gibbons SGI was a recent example of such a balls-up) and it probably leads me to Hedge my Portfolio far too readily when Markets get iffy - I am not totally sure how much Loss Aversion affects me but it is clearly there somewhere. I will try to put more focus into spotting where this is leading me to make errors and  will work on how to correct them.

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 !!

Cheers, WD.