Tag: heuristics

In his path breaking book – Thinking, Fast and Slow; Daniel Kahneman (Psychologist, Nobel Laureate in economic sciences) explains the two systems in our brain that govern our decision making. System one which is fast, automatic, intuitive & instinctive, based on heuristics, biases etc. And system two which is slow, analytical, objective, controlled and based on critical and logical thought. Both have their purpose. For example, when you are crossing the road or driving a car during which you need to take spontaneous decisions, you need to function based on system one decisions. However, in your investment decisions there is absolutely no case for system one.

If you are a long-term investor, every single investment decision must be based on logical, critically analysed, and validated decisions. In the long run, for a diversified portfolio, delaying few investment decisions by days, weeks or even months till you are convinced about the opportunity is not going to make much of a difference. For example, whether you had bought the Tesla stock in 2014 or 2017 or 2018, you would have made multi-bagger returns. Also, if you miss one good opportunity in one stock because of delays in decisions, with thousands of stocks listed in the markets you will be presented with another good opportunity soon. Hence, there is no reason to buy stocks on a rush of adrenaline.

Here are some steps you can take to improve your stock investment decisions.

Understand your risk tolerance

In an era of mobile trading apps where you can open a trading account sitting in your couch, buying a stock on impulse is one of the easiest things to do. However, what won’t be easy for many is dealing with the loss. So, you need to take more precautions in your investment decisions if you cannot take losses on the chin. The point here is that investors may not be adept in assessing their risk tolerance well. Many realise they cannot take stock market volatility only after facing losses, by when it may be late. According to the concept of loss aversion, a widely prevelant cognitive human bias, the pain of losing is psychologically about twice as powerful as the pleasure of gaining. Hence, it may be better to err on the side of caution if you are in doubt, by limiting your exposure or taking the mutual fund route rather than direct stock investing.

Maintain an investment journal

Every time you invest, make a note of 3-5 reasons/assumptions based on which you bought a stock. And every time you assess the performance of the investment, compare your original assumptions with the actual events that played out that influenced the stock performance. This way you can see if you are able to analyse the stocks/sector well and also revisit/revise the assumptions before you want to add to positions or average in case of losses. If your originally assumptions were wrong and you still want to average, maybe you are getting this investment wrong unless you have improved your investment skills and can make better assumptions the second or third time.

If you are a long-term investor, there really isn’t much of case for you to follow markets on a daily basis unless that is part of your profession. With smartphone at our constant disposal to check stock prices ticker by ticker, too much of stock/market related noise can build a subconscious bias that will influence your buying and selling decisions without you being aware of it. There are thousands of listed stocks whose prices change every few seconds and constantly checking these movements and trying to make sense can get exhausting. Avoid this habit. Maybe following up on your investment related news flows on a weekly basis in leisure during non-market hours and assessing portfolio performance on quarterly or monthly basis may be a better way.

Invest based on rules

Warren Buffet has stressed how the most important quality to be a successful investor is the temperamental quality, and not the intellectual quality. Unfortunately most people lack in temperamental ability when it comes to investing in stocks. Even stock market geniuses have paid the price for not keeping temperament in check. Jesse Livermore, who is considered one of the greatest traders of all times and whose strategies are still followed and studied widely even decades after his time, had many blow ups and eventually committed suicide. The lack of temperament makes all the difference.

One way to deal with the issue of temperament would be to have a clear investment rule book that will bring in discipline. For example, you can have rules like – one, you will always ensure no single stock makes up more than 5-7 per cent of your portfolio; two, you will average only after a decline of 25 or 50 per cent from your previous entry point in a stock; three, you will invest only once every month, etc can help bring in discipline and ensure you do not make investing mistakes driven by temperament. Once you have the rules, you have to ensure you follow it. For example, if your rule is you will average only on a 50 per cent decline and you average on a 30 per cent decline it implies you may have temperamental issues. That would be a sign your biases are taking over.

Analyse the pay-offs

Every time you make a decision, analyse the pay-offs. Markets offer different kind of opportunities at different times. There are times when markets may offer a pay-off such as a possibility of 10 percent upside versus a 50 per cent downside or a favourable 20 per cent downside versus a 50 per cent upside. While one could be tempted to go for the 10 per cent upside in a low interest rate regime, a clear analysis of the pay-offs will help deal with biases and lead to a more optimal decision. If you are investing with a belief markets always go up, then you have a serious problem when it comes to investing. If you do not have a clear idea of the pay-offs/risk-reward, do not invest.