Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 10 “The Most Important Thing Is…Combating Negative Influences” Mistakes, Portfolio Management, Psychology
“Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”
Marks’ comments perfectly describe why portfolio management is so difficult. The portfolio management decisions that occur after idea diligence & analysis are more art than science – intangible, manifesting differently for each person depending on his/her mental makeup. This also makes it particularly susceptible to the infiltration of psychological behavioral biases.
This underlies my assertion that merely having good ideas is not enough. In order to differentiate from the competition and to drive superior performance, investors also need to focus on portfolio management, and face the associated (and uniquely tailored) psychological obstacles.
“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing – these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.”
Howard Marks provides a few psychological factors that lead to mistakes:
- Greed – “Money may not be everyone’s goal for its own sake, but it is everyone’s unit of account…Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble.”
- Fear – “The counterpart of greed…the term doesn’t mean logical, sensible risk aversion. Rather, fear – like greed – connotes excess…more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.”
- Willing Suspension of Disbelief – “…people’s tendency to dismiss logic, history, and time-honored norms…Charlie Munger gave me a great quotation…from Demosthenes: ‘Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true’…the process of investing requires a strong dose of disbelief…Inadequate skepticism contributes to investment losses.” I wonder, is denial then just a more extreme form of confirmation bias?
- Conformity/Herding Behavior – “…even when the herd’s view is clearly cockeyed…Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.”
- Envy – “However negative the force of greed might be…the impact is even strong when they compare themselves to others…People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.”
- Ego – To a certain extent this is self-explanatory, but I will further explore this topic in another article in relation to Buffett’s concept of the “inner” vs. “outer-scorecard.”
- Capitulation – “…a regular feature of investor behavior late in cycles. Investors hold on to their conviction as long as they can, but when the economic and psychological pressure become irresistible, they surrender and jump on the bandwagon.”
Psychology, When To Buy, When To Sell
“What, in the end, are investors to do about these psychological urges that push them toward doing foolish things? Learn to see them for what they are; that’s the first step toward gaining the courage to resist. And be realistic. Investors who believe they’re immune to the forces describes in this chapter do so at their own peril…Believe me, it’s hard to resist buying at the top (and harder still to sell) when everyone else is buying…it’s also hard to resist selling (and very though to buy) when the opposite is true at the bottom and holding or buying appears to entail the risk of total loss.”
“In general, people who go into the investment business are intelligent, educated, informed and numerate. They master the nuances of business and economics and understand complex theories. Many are able to reach reasonable confusion about value and prospects. But then psychology and crowd influences move in…The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer.”
“Inefficiencies – mispricings, and misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from others, you need to be on the right side of those mistakes.”
Investing is a selfish zero-sum game. Mistakes, on the part of some, must occur in order for others to generate profits. Mistakes of others = your opportunity
Luck, Process Over Outcome
During the Tech Bubble,“Tech stock investors were lauded by the media for their brilliance. The ones least restrained by experience and skepticism – and thus making the most money – were often in their thirties, even their twenties. Never was it pointed out that they might be beneficiaries of an irrational market rather than incredible astuteness.”