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

Tweet

First of all I must apologise to Readers for putting these initial paragraphs in. Today I feel unbelievably emotional (possibly powered by a bottle of Shepherd Neame ‘1698 Kentish Strong Ale’) as Thursday 21st April 2016 marks the death of Prince Rogers Nelson. I am really quite caught out by this - I have several Prince albums (or should I say ‘Symbol’?) and in a way I never realised just how big a Fan I am. This has whacked me way more than any of the recent Celebrity deaths we have endured - I guess he was a huge ‘Star’ for me when I was a kid (he was only 6 years older than I am) and he had a sort of mystical persona and charisma that just sort of hit me. He was largely reclusive and an enigma - the word ‘Legend’ totally applies. I remember him dancing in the ‘Little Red Corvette’ video and I had never seen anything like it - and of course Purple Rain, film and album, were just so unlike anything that had ever been created up until that point.

I am so lucky that I managed to see him live a few years ago at the O2 in Greenwich when he did something like 12 nights ‘in the round’ - it was a memorable concert and in many ways exactly what I would have expected from him - he was obviously much older but the energy and the passion was there.

At 57 years old and dying from Flu it seems, there is no doubt the World will miss out on all the stuff he would have made. Apparently he did something like 38 Albums in 39 years (I might have that the wrong way round) and I remember seeing a Documentary where he said he wrote a new song every day. He and his brother were working on an autobiography that was due out next year - we probably will not see this. I guess on the positive side, there is most likely a huge catalogue of unreleased material.

A sad day, but the Show must go on……….”This is what it sounds like, when doves cry……”.

WD.


This Part 3 obviously follows on from Parts 1 & 2 of this WheelieBlog series - might be best to read those first - scroll to the bottom and you can find links to them.

How can we avoid such Bias Errors?
By their nature, any Psychological Bias is very hard to overcome - in fact, most of our Biases we don’t even know we have. So, the first step is to recognise this Red Herring Bias - you may have got this far in the Blog and thought “Cor blimey guvnor, Wheelie has a point here, I reckon I have done this before” or probably more likely you might think “For god’s sake Wheelie, you have lost the plot on this one. Why are you wasting time writing this cobblers when you could be digging out a great stock for me to look into?”

If you recognise this trait in yourself, then carry on reading. If you think this is tosh, then you might as well stop reading right now !!

I am no expert on this, but my thinking is that whenever you uncover a new piece of Information about a Company, you must ask the question:

“Is this Important and Vital to the Investment Case on this Stock or is it utter Trivia and a Red Herring which can be ignored?”

It might be that you need to do more digging and fact-checking before you can answer the Question - but it should get you thinking and that in itself is probably a worthwhile thing to do. Part of the answer could be to speak to friends or perhaps ask an open question on Twitter or something. You could put the Question on a Bulletin Board for the Stock - obviously you need to be careful to think deeply about any responses you get back but it might help clarify your thinking. Someone might just call you a “right plonker……..”

Perhaps an idea would be to write down the Key Points of an Investment Stock and the ‘Red Herrings’, possibly in two columns. It should be possible to write just a couple of sentences for a simple over-riding Investment Case for any Stock you own (in fact, I think this was a technique Peter Lynch talks about in his book ‘One Up on Wall Street’ and I am sure I have seen Warren Buffett quotes along similar lines). If a particular fact does not come into the Simple Investment Case or if it doesn’t negate it in any material way, then it is probably a Red Herring and can go in the other column !! As a concept, it is probably a very good discipline to write down your exact reasons for buying a Stock - I don’t do this myself although of course my Website is in some ways a record of this kind of thinking - especially the ‘Trades’ page. I know many top Investors actually keep a file with sections for each of their Stocks where they file paper information and notes etc.

I guess we are trying to figure out if new Information is a Red Herring or a Black Swan……….

Thinking about Psychology
In a similar way to how I did a quick list of the Psychological Biases I think I am prone to, Readers could draw up their own list of the kind of Biases they suspect they are impacted by. Just thinking in this way will probably be hugely beneficial and if you have such a list you can then work on how to over-ride such Biases as you go about your day to day Investing/Trading activities. 

If you find this kind of thing interesting and you expect it to be useful, then it might be worth buying a Book on Investment Psychology - I am pretty sure there is one by Jason Zweig in Wheelie’s bookshop and of course Daniel Kahneman’s ‘Thinking, Fast and Slow’ is an extremely worthwhile read.

There are various ‘Trading Tricks’ and Rules that we can adopt to help overcome our Biases - such things as Adding to Winners, Stoplosses, Weighting to Volatility, etc. I covered these quite a bit in Part 2 under the section ‘What Risk Management techniques can help?’ and I will explore these more in my forthcoming Blog about the Pin and the Monkey, when it finally sees the light of WheelieWebsite electrons.

What are the Risks in focusing on Key Points and disregarding Red Herrings?
Something to be really careful of is Anchoring Bias. It is quite possible that you decide that a factor around a Stock is of Key Importance and you base your decision to buy largely around this. It could be that you are wrong and the Stock turns out to be a duffer because something you thought was a Red Herring actually turns out to be critical - or it could be that you are right initially, but a factor you see as Key turns out to change over time and the Stock becomes a duffer because you are psychologically anchored to that factor. It is important to think about Investment Cases constantly and to test your Key Factors over and over to make sure they are still valid. Obviously if you know people who you can bounce such ideas off against it is a big help.

For an example of how things change, the Key Investment Case for Kodak for decades was about their dominance of the Colour Film Photography Market - however, with the advent of Digital Cameras, their Business disappeared almost overnight. Investors who were psychologically anchored to Kodak’s perceived advantages, would have got totally spanked (no Kippers for them - more like Coley Portions !!).

Technical Noise
Something I have not mentioned up until now is ‘Noise’ that is more ‘Technical’ in its nature and to do with Market Price movements and Technical Analysis (TA) patterns. etc.

On a very simple level, the minute by minute fluctuations and gyrations of a Stock’s Price are a form of ‘Noise’ that is irrelevant to people Trading or Investing on longer time horizons; but to a focussed Day Trader, then maybe a 5 minute Signal is of importance.

My own approach is to really work on a smallest ‘Time Unit’ of 1 day and I try to only make Trading Decisions outside of Market Hours when I have a fresh Candlestick from the latest Trading Day and I am insulated from the emotional roller coaster of the Intraday Trading Noise generated by all the continual wobbles of the Prices. I guess for any Trader it is critical to understand what their minimum Time Unit is. Taken more to an extreme, for many Long Term Investors, it might be appropriate to only trade on Weekly Information.

Regular Readers may have noticed that I have a very set and established collection of fairly simple Technical Indicators and Oscillators etc. that I use over and over again on all of my Stocks and Indexes and even things like Oil and Gold. I have found over time that these are tools that work very well and are simple to apply - I am sure many Readers have their own favourites and for people newer to the game, I expect they will gradually build up a ‘toolbox’ of their own chosen TA stuff.

Note in the above para I deliberately used the word ‘simple’ - I think this is a critical point and it is very related to the concept of Noise. My view is that one of the biggest dangers of using TA tools is that you can easily fall into the trap of over-complicating things and getting yourself in a right muddle. It is far better just to limit yourself to perhaps 5 Key Indicators and forget all about the other junk you use - it is just making things harder in every way. If you are unsure which ones to use, then just use the simple ones I use and build on these as time goes on.

A classic issue with Technical Analysis is the theory that Prices move in a ‘Random Walk’. Personally I disagree with this as I have seen over many years how Prices tend to trend either Upwards or Downwards or Sideways (often in ’waves’ of movement - not those ‘Elliott Wave‘ things though) - so I do not accept the Random Walk idea. However, this could of course be a Psychological Bias on my part and I could be fooling myself - these ‘Trends’ might in reality be just Noise. Our Brains are wired to look for patterns and similarities, and we are all to keen to accept such concepts that maybe in reality do not exist.

In a similar way, I am pretty happy with the idea that Prices tend to ‘mean revert’ - the beauty with Technical Analysis is that using Moving Averages does allow for this concept to a large extent - but I am sure it is something I must factor more into my thinking when analysing Charts.

Macro Noise
I won’t talk about this in any great depth, but I just wanted to stick a bit in about Noise than emanates from all the Macroeconomic ‘News’ we are bombarded with every second as Investors / Traders. Up until now I have barely mentioned this key area in this Blog, which is why I thought something was needed for completeness. 

In normal times, when Markets are pretty happy and chugging along nicely, I tend to find that Macro News is of very little worth and I don’t pay much attention to it, apart from reading Chris Dillow’s bits in Investors Chronicle every week and sort of noting the Headlines as they fly across Twitter and Bloomberg or whatever. However, when things get a bit more serious, like in the current Markets when the Major Trends are down and there is a huge amount of Uncertainty and Worry, I tend to be more aware of Macro stuff and I hunt out what I think are the really important elements. For instance, at the moment I think Negative Interest Rates (NIRP) and the risk of Recession are the big factors - I am therefore focussed on this kind of Macro News and only glancing at most of the other stuff. Of course Brexit will soon become an issue as we get nearer the Vote in June. As I mentioned in Part 1 of this Blog Series, I pay little attention to China because I think we are probably wasting our time trying to understand it - in simple terms it is screwed, but we can never really figure out when the blow up will come. I have a draft blog on the impact of NIRP with regards to Cash - this should be released in coming weeks.

My Approach is much more driven by what the Charts are telling me - so the Indexes and things like Oil and Gold tell me everything I need to know really. When the longer Moving Averages like the 200 day are falling, then it is not a great time to be Long of Stocks. The same applies to all Assets really (except the VIX which moves inversely of course !!).

Conclusion
As I mentioned right at the start of this Blog Series - I intended them to be about ‘Noise’ and how important it is to filter it out from our thinking but as the Blogs developed in draft form, it was clear that Psychology was very much relevant here also.

A key part of successful Stock Investing is to cut out Noise - it is one of Robbie Burn’s (The Naked Trader) key themes - keep things simple. Red Herrings are a prime example of Noise. In addition, it is vital to be able to identify Noise in the first place so you can accurately excise it from your thought processes.

I have no doubt that as time has gone by and I have become more experienced in the game, I have got hugely better at ignoring Noise - this is something other very long in the tooth Investors have also said to me and it is clear that experience makes you more relaxed about stuff. To a large extent you realise how little is under your control and you get more relaxed about going with the flow of the markets.

Factors that are Red Herrings and Key Crucial Factors to an Investment Case are specific to each of us as Investors and the skill is to over time work out what kind of factors really matter and which ones don’t. Even after many many years of Investing we will still get this wrong and it is vital to use Risk Management Techniques as I have outlined earlier in this Blog Series. However, I would probably be justified in saying that just by thinking about things in these terms it will help give Readers an Investing Edge.

I just think some people’s brains are wired to sniff out Red Herrings - this might be Nature or Nurture, but it is there nonetheless. I don’t think I am wired this way and it might be that by doing various Careers and a multi-discipline Degree like Business Studies has enabled me to minimise any Red Herring sniffing that the WheelieBrain may be prone to do. For whatever reason, I think I have always been quite good at cutting to the chase and focusing on what really matters, in all aspects of my life. I guess I am very much a ‘Problem solver’ and this naturally makes me Cut to the Chase.

OK, I will admit to waffling on a bit in the odd WheelieBlog (or six).

I have touched on the quest for Perfect Information in Part 1 and ‘Paralysis by Analysis’ - it is clear that people who fixate on Red Herring type trivia will suffer from these afflictions, and consequently find the whole Investing game very stressful.

I hope you found these Blogs useful and I have got you thinking - from the Feedback I have already received on the first two parts I am pretty sure this has been the case. Make sure you catch the ‘Monkey with a Pin’ one which should appear in a few weeks time as it goes into similar themes in more depth.

Thanks for your attention and patience, WD.


Related blogs that you might find worthwhile reading:

Pension Deficits
http://wheeliedealer.weebly.com/blog/aga-and-mlin-is-pension-deficit-thinking-in-deficit

Stoplosses
http://wheeliedealer.weebly.com/blog/to-stoploss-or-not-to-stoploss-that-is-the-question

http://wheeliedealer.weebly.com/blog/stoplosses-for-wimps

High Level or down in the Weeds?

http://wheeliedealer.weebly.com/blog/are-you-up-in-your-helicopter-or-down-in-the-weeds

What is your Edge?
http://wheeliedealer.weebly.com/blog/what-is-your-edge


Averaging Down
http://wheeliedealer.weebly.com/blog/is-averaging-down-the-root-of-all-evil

Links to the first two Parts of this Blog Series:

http://wheeliedealer.weebly.com/blog/for-investors-red-herrings-are-a-poor-diet-part-1-of-2

http://wheeliedealer.weebly.com/blog/for-investors-red-herrings-are-a-poor-diet-part-2-of-3