#71 The Value of Patience: Daily Investor’s Biases
Mistakes, reflections and path for improvement
Market fluctuations and the relentless flow of economic news can quickly push investors toward rash decisions.. The psychology of the investor plays a critical role, often, or always, underestimated. This article delves into the complexities of our biases and how these influence our financial choices, illustrating with personal experiences and real cases that highlight both mistakes and uncertainties.
From the impulse to act upon discovering a promising new company, to recognizing and rectifying mistakes, to the crucial task of holding onto winning investments, we'll explore how self-reflection, patience, and a long-term view are indispensable tools in any investor's arsenal.
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Investing is an art. Investing is confortable. However, investing is extremely complex. It doesn't require rolling up your sleeves for physical labor or any specific qualifications. Even a monkey could invest, potentially with better returns than us. Yet, effective investing demands time, knowledge, and experience. Despite these attributes, success isn't guaranteed. The investment landscape is largely shaped by the underlying human psychology that influences our decision-making processes. It is no secret that Charlie Munger often emphasized the role of psychological biases in influencing investor behavior. These biases, deeply embedded in our cognitive processes, can lead us astray, causing decisions that aren't always in our best financial interest.
Daniel Sun Zhang, CXO of Teqnion, introduces some of these biases investors face in his book "An Investment Thinking Toolbox". His work is a collection of mental models and frameworks designed to equip investors with the necessary tools to navigate the treacherous waters of investment psychology.
Among the myriad biases discussed by Munger and Zhang, some of the most prevalent include confirmation bias, where investors seek information that confirms their pre-existing beliefs; loss aversion, a tendency to fear losses more than valuing equivalent gains; overconfidence, which can lead to an inflated sense of one’s investment acumen; anchoring bias, where decisions are overly influenced by initial information; and the recency bias, where recent events are given more weight than historic ones, including FOMO. Each of these biases, and many more, if unchecked, can severely impair our ability to make rational investment decisions.
Recognizing and overcoming these biases is not just an academic exercise but a practical necessity for long-term success in investing. It requires a vigilant and disciplined approach to critical thinking and decision-making, where one continuously questions assumptions, seeks diverse perspectives, and rigorously tests hypotheses against empirical evidence.
The path to investment nirvana is both challenging and rewarding. It's a never-ending journey, offering invaluable lessons not just about the markets, but about ourselves. By recognizing and addressing our psychological biases, we open the door to more informed, objective, and ultimately, hopefully, more successful investment decisions.
1. The challenge of keeping the winners running
Loss aversion: this bias causes investors to fear losing the gains they have already made, leading them to sell their successful shares too early. Loss aversion is compounded by the fear that an investment that has been performing well might suddenly drop in value, prompting investors to prefer securing immediate gains over risking potential long-term profits.
Disposition effect: this bias refers to the tendency of investors to sell assets that have increased in value to realize gains, while holding onto assets that have decreased in value in hopes they will rebound.
One of the most challenging aspects I've been facing lately, and of which I am fully aware, is the ability to keep my winners running.
It's important to note that each investment style has its own biases, and some may not apply to others in the same way. For instance, a value investor—someone who follows the Graham method or the early days of Buffett's approach of buying cheap, undervalued businesses, often referred to as cigar butts—does not need to let their winners run indefinitely. This type of investor knows the intrinsic value of their assets, and as the stock price reaches this value, they should start selling. This is a clear strategy and such investors shouldn't make the mistake of holding beyond this price point (all else being equal). This is quite different from an investor who expects the price of their stocks to appreciate along with the underlying business value creation.
Assuming we invest in businesses we believe are extraordinary and expect to continue compounding value in the long term, the quandary becomes more pronounced. Recently, after witnessing incredible appreciations in companies like Constellation Software or Amazon, I've increasingly questioned what I should do with them, especially now that their valuations might seem a bit stretched. Both CSU and Amazon have demonstrated exceptional ability to create sustained value. Yet, the value investor's handbook suggests buying below intrinsic value and selling above it. This dilemma has been plaguing me.
Then, as if by fate, my colleague Leandro @Invesquotes from Best Anchor Stocks invited me to have a chat with Pulak Prasad, fund manager of Nalanda Capital, a fund exclusively focusing on Indian equities, which has achieved a 20.3% CAGR (net of fees) over the last 15 years. He's also the author of the insightful book, "What I Learned About Investing from Darwin."
During our delightful conversation, we discussed this very issue. His approach, though well-known and philosophically aligned with mine, prompted me to reconsider: adopting the business owner's perspective. This mindset involves looking beyond short-term fluctuations in stock prices and focusing on the long-term intrinsic value and growth potential of the business. It simply assumes that we can't predict whether a company will remain "overvalued" for two months or ten years, but we can sense that the company will continue to create value at a certain rate.
Successful investing isn't just about picking the right stocks; it also requires the psychological strength to "let your winners run," even when every fiber of your investor being urges you to take profits and exit. The investment histories of companies like CSU and Amazon highlight the importance of patience and long-term vision.
Understanding the balance between rational decision-making and emotional investment in stocks is crucial. Enthusiasm for a company's potential shouldn't blur the lines of objective analysis. Often, people develop an emotional attachment to their investments, treating them like sports teams they support unconditionally. This can lead to justifying poor decisions or ignoring significant missteps by management.
It's essential to maintain a clear boundary between being a supportive investor and becoming an uncritical fan. Effective investors support their decisions with solid reasoning and are always ready to re-evaluate their positions based on new information. They recognize that management can make mistakes, but what is critical is how those mistakes are handled—whether they are acknowledged, corrected, and not repeated. This nuanced approach helps safeguard against the risk of holding onto stocks based on outdated or overly optimistic assessments when market conditions or company fundamentals have changed.
The fine line involves a constant balance: being sufficiently detached to make objective decisions while engaged enough to stay informed and responsive to new developments. This balance defines sophisticated investment strategy, where emotional attachment does not cloud judgment, allowing investors to make decisions that align with their long-term financial goals and risk tolerance.
2. The challenge of recognizing and acting upon mistakes
Confirmation Bias: This occurs when investors seek out information that confirms their existing beliefs or hypotheses, disregarding or discounting information that contradicts them. This bias can make it difficult to recognize when an investment decision was wrong because it leads to ignoring adverse signals.
Status Quo Bias: This is the preference to keep things as they are rather than change, even if there are clear signs that a change is necessary. In investing, this might manifest as holding onto a losing investment longer than is rational because changing course feels uncomfortable.
Sunk Cost Fallacy: This bias leads investors to continue a failing investment to justify past decisions and investments (costs) that cannot be recovered. It can prevent them from cutting their losses in situations where they should.
Anchor Bias refers to the tendency for individuals to rely heavily on the first piece of information they receive (the "anchor") when making decisions. In the context of investing, once an anchor is set, all subsequent judgments or decisions are made by adjusting away from that anchor, and there is a bias toward interpreting other information around the anchor.
Price Anchoring: Investors might anchor to the price at which they originally bought a stock. If the stock's price drops significantly, instead of re-evaluating the stock based on current market conditions and fundamentals, the investor might be inclined to hold onto it until it returns to the original price, even if this is unlikely.
Valuation Anchoring: An investor might anchor on a specific valuation metric (like P/E ratio) at the time of their initial analysis. Changes in the company's fundamentals or market dynamics might render this metric outdated, but the investor could fail to adjust their valuation, leading to poor investment decisions.
Historical Performance Anchoring: Investors may anchor to historical returns of an investment, expecting these patterns to continue despite changes in the market environment or company performance.
When faced with market fluctuations or unfavorable news about one of our investments, our initial reaction can often lead us to make hasty and likely erroneous decisions. We aim to preemptively rectify mistakes, essentially selling off before "the market catches on," in a bid to dodge greater losses. Naively, the immediate impulse to react to market shifts or news about our investments can precipitate rushed decisions, potentially harming the long-term performance of our portfolio.
I've imposed a rule on myself never to act on news, be it positive or negative, for at least a week. It's remarkable how our perspectives can shift after a week of reflection. This time allows us to read, ponder various viewpoints, critically examine our beliefs, and challenge our assumptions.
In the past year, I've sold three positions—more than usual and more than I'd prefer—due to mistakes I've recognized. One was even sold just weeks after purchasing. In one instance, I acted and sold according to my rules; in the other two, I acted too late and fell prey to multiple previous biases.
I will not name any of the companies because I do not want to influence anyone with my decisions or discuss specific companies, as that is not the purpose of this post. The goal is to realize that recognizing and acting on errors is a rational exercise that we must constantly impose on ourselves. Despite being aware of the biases we might fall into, we invariably succumb to them.
Mistake #1: A company with a strong acquisition track record has seen its stock price falling for a couple of years, due to interest rate hikes and some one-off events from COVID. I decided to invest based on valuation, although some aspects of the management's ownership did not convince me. After this, the CEO steps down with little disclosure of the reasons, and two managers who recently joined take over as CFO and CEO. Neither has a track record in similar business models (especially acquisitions). Fortunately, I was able to speak with them. The conversation was unconvincing, and I had no certainty that the business would continue to operate in the same manner. I considered the stock cheap, but I was essentially blind to whether the company could continue to create value. Would I buy this company now if I weren't already invested? When the answer was no, the decision became clear. After two weeks of reflection, I realized all the biases I was succumbing to and decided to act.
Mistake #2: A company in an emerging country with an asset-light model, boasting a great 15-year track record in public markets, managed by a team of three brothers owning 60% of the company, had a PE ratio of 7 and a 7% dividend yield. Sometime after my investment, I discovered an old short report accusing the management of using shell companies for investments, then selling them to the company at a markup. I read it, confirmed it could be true (hard to know for sure), but decided to do nothing as it was an old report. The company reports only twice a year. Suddenly, in its latest annual report, the results were terrible with a significant drop in revenues and earnings. Few explanations were given, and there was no rationale on how the company would improve. Moreover, a new incentive plan for managers was approved for potential projects, etc. The stock fell 40%, and I faced the mistake of not having acted sooner. (In my defense, it was a company I analyzed at the beginning of my career when I was still a novice and had only looked at a couple dozen companies compared to thousands now.) However, it was a grave error not to keep an open mind and critically evaluate each investment every day. We must remember that every day carries an opportunity cost. Every day we decide which companies we are buying, not selling, and which ones we are not buying.
Mistake #3: Another absolutely rookie mistake. And don’t think even the most accomplished investor don’t fall on them. Remember Munger words: "I regard Alibaba as one of the worst mistakes I ever made. In thinking about Alibaba I got Charmed with the idea of their position on the Chinese internet. I didn't stop to realize they're still a goddamn retailer". Coming back to the case, with post-COVID monetary injections and low-interest rates, many companies, including my investment (widely followed on Fintwit), embarked on acquiring other companies to become a decentralized platform for creating XXX. Acquisitions were clearly expensive, funded by issuing shares and a lot of debt. After all, debt was cheap. Again, this was a case of a company with a founder holding a large share package, likely acting in good faith. I was aware that the acquisitions were being made at a hot point in the cycle, at high prices, and using debt that would eventually need to be repaid, in a cyclical sector. However, I did nothing. What followed is probably no surprise. Interest rates rose, some products did not perform as expected, and the company ended up with a pile of debt that needed to be repaid, along with rising interest costs diluting the FCF. There was no choice but to sell subsidiaries at depressed valuations.
The mistake was not anticipating these events. The error was not selling when the market was hot and management was not being cautious with long-term capital allocation. The mistake was buying more when management had already shown multiple errors in judgment, simply because the stock price was cheaper, and assuming it would recover.
These personal examples try to highlight the importance of swiftly acknowledging when an investment isn't unfolding as planned or when the environment that supported the initial decision has shifted. Whether the initial analysis missed a critical factor or circumstances have evolved unexpectedly, the ability to adjust our strategy is essential.
This reflective and methodical approach not only helps mitigate the adverse effects of cognitive biases on our investment decisions but also reinforces discipline and focus on fundamental principles. Patience and humility to recognize and learn from mistakes, adjusting our actions accordingly, are qualities all investors must cultivate.
3. The challenge after discovering a new and unknown expensive great businesses
Fear of Missing Out (FOMO): This bias occurs when investors fear that they will miss out on the profits that others are apparently making. This can lead them to make hasty decisions, such as buying stocks at high prices without proper analysis, simply because they see others buying them.
Overconfidence: This bias leads investors to overestimate their knowledge and predictive abilities. Overconfidence can make investors hold onto their choices without acknowledging the market's dynamic nature, believing they can time their entry and exit perfectly based on their predictions.
Undoubtedly, one of the toughest challenges I've encountered recently, and am fully aware of, is maintaining calm when I discover businesses that I believe are well-managed, with significant potential for continued growth and value generation, but that I consider somewhat overvalued—or rather, the market is discounting my same considerations of success in their growth strategy and thus valuing them as such. I struggle to wait for the valuation to become more reasonable, or to provide a greater margin of safety because, obviously, I don't want to miss out on the opportunity.
This fear of "missing out" can be overwhelming, especially when we see the stock prices of such companies continue to rise in our absence.
This challenge highlights the importance of maintaining a balance between greed and fear, two powerful emotions that often influence investment decisions. Patience, in this context, is not just about the ability to wait for the right moment to invest but also about resisting the pressure to act impulsively based on the fear of missing out.
The key lies in trusting our analysis and the conviction that the opportunity will come. Thus, I've been waiting for years until some of them reach valuations I consider appropriate, while watching them rise and rise. I'm sure I'm not the only one :).
How do I manage to hold back? What seems to work best is being able to keep looking at more and more companies to achieve a long list of companies you'd want to own. That's why it's so important not to narrow down the universe and to have one wide enough that the markets offer opportunities because, let's face it, the market is right most of the time and constantly seeks to adjust profit-risk ratios.
By not limiting ourselves and exploring a broader spectrum of companies, we increase our chances of finding those not-so-obvious gems to the general market. Accepting that the market is right most of the time forces us to be meticulous in our analysis and patient in our wait.
Waiting for the market to present the right opportunity requires not only a deep understanding of the intrinsic value of the companies on our list but also the serenity not to act hastily based on short-term market movements. Building this long list of opportunities is not a one-time effort, but a continuous process of review and update. It is an exercise that forces us to be constantly learning and adapting, expanding our circle of competence and refining our ability to assess companies from a critical and grounded perspective.
Inspired by the reflections of Luis Torras and his Sustack: Chestnut Street, it becomes evident that patience represents the greatest challenge for investors. This concept is so fundamental that it could be the cornerstone of a treatise on finance, as Torras suggests:
If one day I write a book about finance, I will title it "The Value of Waiting" or "The Patient Investor". The less one tinkers with the portfolio, the less macro information is consumed, and the more one cultivates the virtue of patience, the better the long-term results.
In finance, we should do as in medicine, and not talk about "clients", "participants", "investors", or "LPs", but simply refer to them as "patients"; putting the emphasis on this virtue without which it is not possible to accumulate capital.
The result of an investment usually manifests itself in a surprising, even violent (non-linear) way, but it is not the fruit of chance: good fundamentals and long-term are everywhere. As Ortega summarizes: "The urgent thing is to wait."
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This was great - thank you.
Thank you for the wonderful writeup. As an investor, I face with these challenges pretty often and I am working towards learning, improving and growing along the way.