Warren Buffett gave an important lecture at Florida University on 15 October, 19981. An eager MBA student asked him about his involvement in the rescue of one of the most spectacular hedge fund blow-ups in financial history.
A fund by the name of Long Term Capital Management had great success making money from the arbitrage of bond securities from 1995 to 19982. ‘LTCM’ was invincible and some of the smartest men in America were in charge.
The fund was a behemoth. $126 billion in assets under management. No less than $10 million to be part of the action. Initial success was attributed to the genius of its founder, John Meriwether—a former high flyer on the Salomon Brothers trading desk.
And he was in good company. The principal shareholders of LTCM were Nobel prize-winning economists Myron Scholes and Robert Merton plus 13 other men.
These men, “if you take the 16 of them, they have about as high an IQ as any 16 people working together in one business in the country, including Microsoft. An incredible amount of intellect in one room,” said Buffett.
But they blew up. And they blew up big. By September 1998, the company’s risky trades brought it close to bankruptcy.
LTCM’s size meant it was ‘too big to fail.’ The U.S. Federal Reserve had no choice but to step in. The pending collapse was going to spark a global financial crisis. The call to Buffett pleading for help came next.
Buffett found it fascinating, “…they’re not bad people at all; but to make money they didn’t have and didn’t need, they risked what they did have and didn’t need. That is just plain foolish; it doesn’t matter what your IQ is. If you risk something that is important to you for something that is unimportant to you it just doesn’t make sense,” said Buffett 3.
Many of LTCM’s shortcomings can be attributed to basic human biases common to all of us. The average investor can benefit greatly by being aware of some of these unusual patterns of thinking.
Following is a sample of the common biases and heuristics that get us into trouble when investing. No matter your IQ. We conclude with some advice to help overcome these biases.
It’s our job as value investors to be aware of irrational thinking and moments of wonder.
As Buffett warned in his lecture, “the downside, especially if you are managing other people’s money, is not only losing all your money, but it is disgrace, humiliation and facing friends whose money you have lost.”
What is a Heuristic?
A heuristic technique, often called simply a ‘heuristic’, is “an approach to problem solving that employs a practical method not guaranteed to be optimal, perfect or rational, but sufficient for reaching an immediate goal.” 4 An activity like investing comes to mind.
Where finding an optimal solution is impossible or impractical, heuristics can be used to speed up the process of finding a satisfactory solution. Think of them as mental shortcuts that ease the cognitive load of making a decision.
Examples include trial and error, a rule of thumb, an educated guess, an intuitive judgment, a guesstimate, profiling, or common sense.
It’s basically making decisions when there is uncertainty or unknowable information. The result can sometimes be irrational decision making and unusual thinking patterns.
Prior to the work of some smart Israeli men in the 1960s and 70s called Daniel Kahneman and Amos Tversky, the predominant view in the field of behavourial finance was that humans are ‘rational’—not ‘irrational.’
Tversky and Kahneman began work on a series of papers examining ‘heuristic and biases’ used in ‘judgment under uncertainty’ and began to think otherwise.
Following are some examples of different types of heuristics and biases and how they can affect your investing habits.
The Availability Heuristic
The availability heuristic is a mental shortcut that relies on immediate examples when evaluating a specific topic.
If you see a story about a shark attack on the news then you’ll automatically think the chances of dying of a shark attack are greater. But reality says you have more chance of dying from falling airplane parts. 5
An example in finance is Franklin Templeton’s Annual Global Investor Sentiment Survey 6. In 2012 they asked individuals how they believed the S&P 500 Index had performed in 2009, 2010 and 2011.
66 percent of respondents said they believed the market was either flat or down in 2009, 48 percent said the same about 2010 and 53 percent also said the same about 2011.
In reality, the S&P 500 saw 26.5 percent annual returns in 2009, 15.1 percent annual returns in 2010 and 2.1 percent annual returns in 2011.
This meant lingering perceptions based on dramatic, painful events like the Global Financial Crisis in 2008 were still impacting investors’ decision making three years on.
Staying in cash during this period out of fear means investors left a lot of money on the table.
The Illusion of Understanding
This bias is powerful when it comes to investing.
It’s based on the premise that good stories provide a simple and coherent account. But they can lead to a sense of inevitability… ‘This or that had to happen exactly as it did, because this and that happened before.’ It is coherent. It is a story.
Investors don’t seem to care whether the story was correct… ‘Just that it was made up by someone sounding authoritarian’—like a stockbroker.
In his book Thinking Fast and Slow, Daniel Kahneman said, “I have heard of too many people who knew well before it happened that the 2008 financial crisis was inevitable. 7
This sentence contains a highly objectionable word, which should be removed from our vocabulary in discussion of major events. The word is, of course, knew. Some people thought well in advance that there would be a crisis, but they did not know it.”
Kahneman says, there is no real understanding in stories—only the illusion of understanding. By focusing solely on the events of a story that make sense we forget about all the random occurrences. And were they any different, the final result may have been completely different too.
Humans need stories to comprehend complex ideas. But stories won’t give us the truth, just a coherent made-up selection of events.
The Illusion of Understanding is very similar to one of the principles from Nassim Taleb’s book, The Black Swan, called the Hindsight Bias.
Taleb says in hindsight, nobody expects X (the GFC for example). But, “after X has happened lots of experts will show up to tell us it was clear this would have to happen for so and so.”
The Endowment Effect
To demonstrate this unusual bias, participants—in a study conducted by Daniel Kahneman and his peers—who were given a Swiss chocolate bar were generally unwilling to trade it for a coffee mug. In contrast, those first given the coffee mug were generally unwilling to trade it for the chocolate bar. 8
It was suggested by Kahneman and his colleagues that the endowment effect is, in part, due to the fact that once a person owns an item, forgoing it feels like a loss, and humans are loss-averse.
Those who inherit share portfolios from deceased relatives exhibit the endowment effect by refusing to divest those shares, even if they do not fit with that individual’s risk tolerance or investment goals.
Another example outside of finance is an individual who may have obtained a case of wine at a decent price.
If an offer were made at a later date to acquire that wine at a marginally higher price, the endowment effect might compel the owner to refuse this offer, despite the monetary gains that would be realised by accepting the offer.
This bias suggests we often overestimate the probabilities of unlikely events. We give them too much clout in our decisions.
We are more afraid of dying in a terrorist attack than from a heart attack, or being in a plane crash than a car crash for example.
In other words, we both overestimate and overweight small probabilities. This was uncovered by Tversky and Kahneman’s in their work on Prospect Theory. 9
If you didn’t add any companies to your portfolio after the GFC then this bias might explain why. You may have been reeling from the psychological impact or plain scared of entering the market again.
Truth is the odds of another GFC type event had never been lower post-GFC.
History now tells us this period was a good time to be buying quality businesses.
Framing bias occurs when people make a decision based on the way information is presented, as opposed to making decisions based on the facts themselves. 10
In finance, investors may react to a particular opportunity differently, depending how it is presented to them. Consider the following example. Which scenario frames the earnings of a company better?
‘Earnings per Share (EPS) were a $1.25, compared to expectations of $1.27.’
‘Earnings per Share (EPS) were a $1.25, compared to last quarter, where they were $1.21.’
Same information. Different frame.
Clearly, option two does a better job of framing the earnings report. The way it’s presented—as an improvement over the previous quarter—puts a more positive spin on the EPS number.
You need to be aware of some of this trickery as a long-term value investor. It’s especially prevalent in the language of annual reports and analyst reports.
We’re all guilty of this one. Once we have a theory, we seek confirming evidence. This is called ‘confirmation bias.’
“We fall victim to epistemic arrogance, becoming overconfident about our ideas and failing to account for randomness,” according to author Nasem Taleb.
To make theories work, we “smooth out the jumps in a time series or historical sequence, looking for and finding patterns that don’t exist.” 11
It is also known as ‘tunneling.’
In other words, you may start looking at all the reasons for buying a company and ignore all the reasons why you shouldn’t. It’s like wanting to buy shares in a favoured company and looking for all the positive ‘Buy’ recommendations and ignoring the ‘Sell’ reports.
Just remember, it’s prudent to look at the reasons why you shouldn’t buy shares in a company too.
This bias drives fund managers and CEOS up the wall.
It is the tendency to blame external forces—like a fund manager—when bad things happen and give yourself credit when good things happen.
When you beat the benchmark for any given year it is due to your skill at selecting the top fund managers or supreme companies.
When you lose it’s due to the incompetent fund manager or stockbroker and their flawed investment philosophy. Fund managers aren’t off the hook though. They are guilty of blaming the macro economy and movements in interest rates, currencies, droughts, Brexit, housing prices, the Euro crisis, Asian crisis, Trump tweets or any other causes, no matter how esoteric.
Whatever the reason, they all have in one thing in common: they are impossible to disprove as a factor. 12
Be sure to take responsibility of your investment decisions if you plan to be in this game for the long-term.
Anchoring relates to the use of irrelevant information on which to make a decision—investments or otherwise. One excellent example is that of two similar products, both priced at $99.00. Item one, however, is ‘on sale’ and has been ‘reduced’ from $150.00. Consumers will generally purchase item one as they are anchored by the original price.
The historic value of securities also misguides investors who focus on their ‘anchor point’ (e.g. lowest recent price, price at which they ‘meant to purchase’ etc.), notwithstanding that the anchor point has no correlation with the current valuation or target return.
Warren Buffett admits anchoring is one of the biggest mistakes he has made. He has been caught many times sitting back “sucking his thumb when he should have been buying stock in a great company.”
In other words, Buffett waited to infinity for the stock to move down to his ‘anchored’ level, or an earlier price at which he had considered purchasing.
This bias leads you to believe that you are less likely to suffer from misfortune and more likely to attain success than your peers. In short, we are often more optimistic than realistic. 13
Take marriage, for example. In the Western world, divorce rates are higher than 40 percent. Two out of five marriages end in divorce. But newlyweds estimate their own likelihood of divorce at zero.
Even divorce lawyers hugely underestimate their own likelihood of divorce. Although the sunniest optimists are just as likely to divorce as the next person, they are also more likely to re-marry.
This bias has brought many intelligent hedge fund managers unstuck when it comes to leveraging a portfolio. Not to mention DIY investors who leveraged-up during the bull market from 2002 to 2007.
If you take account of your natural tendency to think you are untouchable when it comes to investment failure then you’re more likely to stick to fundamentals. And less likely to think you, or your tipster friend, are infallible.
The Better than Average Affect
This bias suggests we consider that we are smarter and more capable than we really are. We are blinded by our own incompetence it seems. 14
This idea was put forward by Eilath Giladi and Yechiel Klar at Tel-Aviv University in the late 1990s. They found a person will tend to rank themselves above a group’s average performance level. This explains why 90% of drivers think they’re above average drivers.
If an individual is asked to assess their own skill at driving compared to the rest of the group, they are likely to rate themselves as an above-average driver.
Furthermore, the majority of the group is likely to rate themselves as above average. Research has found this effect in many different areas of human performance, including investment. The principals of a fund from the 1990s called Long Term Capital Management come to mind.
It pays to focus on capital preservation before thinking about how much more money you’re going to make in comparison to your peers.
As Warren Buffett likes to say when managing a portfolio, “rule no.1 is don’t lose money, rule no.2 is don’t forget rule no.1.”
Are We Doomed When it comes to Investing?
If you think an intruder is in your house at night and you need to do something based on intuition then good. Intuition is heuristic in nature and in most day-to-day situations heuristics serve us admirably.
And it’s a great we can look at grey areas in everyday life and develop theories when information is missing. This type of thinking requires a heuristic approach.
But investing can sometimes be counter intuitive (“be greedy when others are fearful, and fearful when others are greedy,” says Buffett) and biases and heuristics can be a thorn in your side when this counter-intuitive thinking is required.
Buying companies you understand goes some way to overcoming the knowledge gap, or grey area. Stick with your circle of competence and reduce your natural bias to make up stories about companies you know nothing about.
Doing so “narrows it down by 90%” said Buffett during his speech at the University of Florida. 15
Buying for the long-term also helps overcome things like the attention bias. If you believe a company can stand on its own two feet for the next 10 years then you’re not going to give much weight to a company’s recent third quarter earnings report, or be misled by some clever framing techniques.
Doing your research and ignoring the hype on Wall St helps alleviate the effects of the self-serving bias. If your investment turns bad after doing your own research then you’re more likely to take responsibility for your investment choices. Plus, you’ll stop taking every share tip flooding your inbox.
And start looking at your investments through the eyes of a business owner. This helps dismiss the short-term exuberance or excessive fear engulfing us each day in the financial media. This helps alleviate the attention bias.
Getting caught up in the media hype means we end up buying overpriced companies or selling great businesses when we should be doing the opposite.
Strength in Humility
Perhaps the best lesson from value investing is remaining humble. This will ensure you don’t fall into the trap of becoming overly optimistic about a company’s future or your own personal wealth.
Stay humble and you can ride the down periods and buy good companies at a discount to their intrinsic value when share prices fall. Don’t be the one selling when you get spooked by another financial commentator predicting the next market calamity. It might be the biggest mistake you make.
If you’d like to hear about Leyland Private Asset Management’s approach to long-term value investment then please get in touch with us today. We’ve helped a number of wealthy families and business owners preserve their wealth through good times and bad. We invest for the long-term and our clients remain with us for the long-term.