Behavioral Biases And How To Overcome Them

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During his recent interview with Tobias, Mark Simpson, author of Excellent Investing: How to Build a Winning Portfolio, and manager of Danger Capital, discussed Behavioral Biases And How To Overcome Them. Here’s an excerpt from the interview:

Tobias Carlisle:
It’s very difficult because Ian Cassel, who we were talking about before, he’s done some analysis on, and this is quite common looking at how to hold those multibagger compounders over years and years and years. You do have to endure many of these gigantic drawdowns. Amazon famously has a 90% drawdown early on so I’m sure almost nobody has held it from IPO to date because of things like that. But equally you have to have that ability to recognize when it’s maybe got too far ahead of its… I honestly don’t know how to do that balancing that’s why I don’t do that, that’s why I’m a deep value guy because it makes sense to me and I frankly just cannot figure out how they do it, but I think it’s a nice segue into the weaknesses part of the book where you’re discussing the behavioral biases. So let’s just start with overconfidence and what is that and how do we overcome it?

Mark Simpson:
So most of us are overconfident. We believe that we are better at things than we actually are. If you go into room for all the people and ask them, “Hands up if you’re a better than average driver in this room,” 80% of the hands would go up, I think on average. And it’s natural to think that, to be confident in what you do, particularly if you’re experienced and you have specific knowledge and experience. One of the classic studies is I think a psychologist got, and this is like in the 1950s, so it’s been known for a long time, is ask other psychologists to do personality assessments on patients. And he gave them and they started off with a bare minimum of information in their file and then added more and more information. And the more information didn’t add any real extra ability for them to assess personalities.

Mark Simpson:
It’s very complex to judge somebody’s personality or neurosis or whatever from the information. So I think it started off at around 26% and they thought they’d got about maybe 30% right. At the end of the process when they’d been given all the information, their personality assessments had not improved in the accuracy at all, but they thought they were 50% confident in what they’d done. So all the extra information they’d done, and I think this is a real problem for investors because we tend to think, “Okay, the more research I do, the higher conviction I can have in that position. The more times I’ve met the management, I can go to 20 or 30% rather than my normal 10%.” And you add all this information and in reality, your judgment about the stock has not got any better, you’ve just become more and more confident in your own assessment and then something that was completely in their field. Take BP and the Macondo Well disaster, how many people foresaw a single well blow out was going to cost them $62 billion in fines and compensation?

Tobias Carlisle:
Is that what it came to finally?

Mark Simpson:
Yeah, that was the final figure.

Tobias Carlisle:
I had no idea it got as high as that, wow.

Mark Simpson:
If it wasn’t a super major, it would’ve put the company under basically any other company apart from Exxon or Shell, probably would’ve gone under for that level of damage.

Tobias Carlisle:
I was investing through that period and I remember that it’s sold off very sharply and Whitney Tilson went on television and said, “It’s overdone that they won’t be as big as this.” And I thought that’s probably right. Everybody does overestimate the scale of the crisis in the moment, but I had no idea that the final bill was 62 billion, maybe everybody panicked appropriately.

Mark Simpson:
Yes. Yeah. Except I guess the company did alright and survived and made the returns back. So even though it costs that much money, you look at long-term chart and it hasn’t really caused the damage you expect, but that is 62 billion that’s gone out of shareholders’ pockets and they’ve…

Tobias Carlisle:
In quantitative value we discussed two studies that are similar to the one that you discussed there. One is on horse race predictions and another one is on college football. So they asked some college students about college football, if they knew anything about it all and they said that they did. And then they had say 100 pieces of information and they randomized those pieces of information and they gave them 10 blocks of 10 bits of information about the games and so you got the first bit and you made your prediction on who was going to win and then you got the second bit and then you made a new prediction, but the person sitting to the left and right of you might get different information even though by the end, you all had the same information and people made different predictions and I think that the conclusion was that we anchor too much on the first bit of information that we get.

Tobias Carlisle:
So your decision was made on the first block and then everything after that was just you collecting for your, “I am right,” file to show that the decision was correct. So we don’t update our priors enough. And you talk a little bit about Bayesian probability in the book. I don’t know if it’s in this context, but that was the question I was going to ask you about the value investors. Is that a good approach for value investors, do you think to take some Bayesian approach where if your instinct is to get stuck into something and to dollar cost average down into it? In the case where you’re wrong, you’re finding this new information, you’ve got some probability, here’s your new bit of information, now you update it with your prior to have some process so if you get enough of these, eventually you’ve got some statistical reason for selling out of something.

Mark Simpson:
Yeah, I think it’s good if you can actually quantify those things. I think if you can do that, that’s great, but I think for the vast majority of investors that’s probably too complex a process to apply or certainly to actually apply the formula. I think with the Bayesian approach is these two factors that you really need to be aware of. The first is base rates matter. So if you are going to invest in IPOs, then knowing that the average IPO under-performs in the following 12 months, it is an important base rate and if you bought two successful IPOs and they did really well, your tendency is to forget the base rate that well actually most management IPO at the top.

Mark Simpson:
They’re the most knowledgeable people and they’re the most willing sellers. And there is exceptions to that. I think you get IPOs where management don’t take any money out and all the money goes back into the company to grow, but the average, particularly private equity salaries and things like that, they’re the knowledgeable investor and you’re the patsy usually in those situations.

Tobias Carlisle:
They do a big recapitalization and pay themselves a big fat dividend, load the company up with debt and then IPO. That’s the one you got to be careful with.

Mark Simpson:
Yeah. And then it goes bust by two years later and they buy [crosstalk 00:47:36] a few years later.

Tobias Carlisle:
Yeah, that’s a great trick.

Mark Simpson:
And then false positives, the other one is the idea that if you have an idea of what the… You have some signal that says this is a good buy, it doesn’t just matter how often that signals that it’s a good buy and it is a good buy, it also matters that the times it signals and it isn’t a good buy and having an idea of the false positive rates as well as the base rates gives you the… It’s very important in medicine and diagnostic tests, having a high false positive rate for something like Coronavirus really isn’t a good test because if you test thousands and thousands of people, you’re going to get a lot of false positives and thus will dwarf the real cases of Coronavirus and now you’ve got thousands and thousands of people in isolation or in hospital who don’t have the Coronavirus and taking up beds for people who are genuinely sick. So in medicine, false positives are a real challenge particularly when you get big screening of lots of people.

Rip Off The Band-Aid And Sell Those Losing Stocks

Tobias Carlisle:
What’s loss aversion?

Mark Simpson:
So loss aversion is a case where we just don’t like to take losses. And you see this in people’s portfolios, usually by a long tail of small positions that people just aren’t willing to sell. And everybody is lots of us. I don’t think there’s anybody out there who’s truly calibrated to not mind taking a loss. And the strategies that people use to deal with this, in the book I suggest that everybody should have a lower portfolio limit. So everybody should just say, “If this drops below, say 1% of my portfolio, I’m just going to sell.” And I’ve applied this to my own portfolio and it’s really hard. Other people have stopped losses, so they say, “Well, okay, if something drops 20%, I sell out,” and that’s a stop loss. So I don’t think that usually works very well for value investors.

Tobias Carlisle:
It’s statistically not well supported on an individual stock name and I don’t think it works for value investors too. I agree.

Mark Simpson:
So for some people, this is never an issue because they buy something, it goes down 20%, they sell, it’s gone, but for me as a value investor I either average down or in an ideal world, I either sell, I should be selling or averaging down, but what you find is you get these positions that you go, “Oh, I’m not confident enough really to put any fresh capital in, but Oh, I also don’t want to sell it.” And it’s a classic sign of, “I’m loss averse. I don’t want to take a definite loss.”

Mark Simpson:
And we tend to roll the dice. We like to say, “Rather than taking definite loss, I’ll roll the dice and hope something works out.” But of course, if something’s 0.2, 0.3% of my portfolio, it could double, it’s daily noise so why am I still holding this? Why am I spending my time and my energy to actually do this? And I either say, “This really is my best idea and I’m going to buy more or this is loss aversion, I’m just going to sell and cut it out.”

Tobias Carlisle:
Do you know, that’s funny. I’d never heard that idea before of a lower position limit, but about two weeks ago, Jake Taylor on our other podcast that I do with those two guys, he mentioned the same idea. I think it’s a really good idea. I don’t know if there’s any statistical support for it, but it’s a good one. Good behaviorally.

Mark Simpson:
Yes. Yeah. I think I know where Jake got that idea from.

Tobias Carlisle:
Where did he get it? Did it come from the book? There you go. Congrats.

Mark Simpson:
Because I went on his podcast and it’s one of the things-

Tobias Carlisle:
Ah, there we go. That’s great. That’s why you got to be careful man because ideas come back at you from lots of different angles even though there’s only one source. I was just like, “I’ve heard that idea twice. It must be good one.”

Mark Simpson:
I can now quote that, I’ve heard it on your podcast, on Jake’s podcast so therefore…

Tobias Carlisle:
Optimism bias. What’s that?

Mark Simpson:
So I think this is a more general case of overconfidence. So overconfidence is I am too optimistic about my own abilities and the things that I can control, whereas optimism bias is we just tend to be overly optimistic about everything. We think that the product of a company will be bigger than this, we’ll underestimate the amount of time it will take to develop and the amount of money it will take to market and it’s for good reason. If you’re an optimist, your typically more successful, more attractive, there’s lots of biological and-

Tobias Carlisle:
It’s pushed humanity forward for hundreds of thousands of years.

Mark Simpson:
Yeah. The guys who weren’t willing to leave their caves because they were scared. So the only people who aren’t overconfident are the clinically depressed. You don’t want to trade that off.

Tobias Carlisle:
They’re clearly assessing their risks.

Mark Simpson:
Yes.

Tobias Carlisle:
We should listen to them more.

Mark Simpson:
Yeah. So probably if you want a risk manager, get a clinically depressed risk manager too.

Tobias Carlisle:
Yeah, you got to be careful with the flamboyant risk managers.

Mark Simpson:
Yeah.

The Dunning–Kruger Effect And How It Applies To Investing

Tobias Carlisle:
I had a thought when you were talking before about the overconfidence bias, I don’t know if you have any discussion of Dunning-Kruger in the book, but the Dunning-Kruger… Do you have a discussion in there? What’s Dunning-Kruger? Let’s talk about Dunning-Kruger.

Mark Simpson:
I briefly mentioned it, I think because… So Dunning-Kruger is this idea that the skills required to assess competency are the same as the skills of competency themselves. So the truly incompetent are doubly cursed because they’re both truly incompetent and unable to see their own incompetence. So it’s why you get the guy in the office who everybody thinks is terrible, but he thinks he’s the best performer, the highest guy, everybody loves him. So it can be quite annoying in a work context, but as a portfolio context, it really is that thing, and I think I talk about it in relation to some of these behavioral biases. My theory is that you’re much better off making rules for your portfolio like a maximum portfolio or a minimum portfolio limit, then you are leaving it to your discretion. And the reason is Daniel Kahneman, who won the Nobel prize for all of his research in this area, they asked him “Has it improved your decision making?” And he said, “No, it’s just made me better at spotting the mistakes in other people.”

Tobias Carlisle:
That’s funny. I think that Dunning-Kruger also impacts in us that when you learn a new skill initially you think, “Well this is quite easy.” And then a little bit later you think, “No, this is insurmountably hard and I’m terrible at it and there’s no hope.” And then you gradually get better. So you’re just overcoming that part where you don’t know how bad you are, then you do know how bad you are and then you start getting better.

Mark Simpson:
Yeah. I think that probably mirrors a lot of people’s investing journeys because I’ve got a mathematical background. So when I first started investing, I could do the discount cash flows, I could do that stuff. So I do discount cash flows for things and then of course, something from that field that I haven’t seen at all would completely wipe out, the company and you look back at the files you created, these complex models and you’re just like, “What was I thinking?”

Mark Simpson:
I missed the wood for the trees and it’s that effect that you go through this investing of, “Oh, hey, I can do it. I can read Ben Graham and analyze a balance sheet or do a discount cash flow.” And then you go through the process of, “Oh, no it’s not enough to be good. I have to be better than everybody else. I need an edge.” And then you go through the process of making all these mistakes and trying to overcome those by trying harder and as I found, it just doesn’t work. You need the rule, you need the…

Tobias Carlisle:
Yeah. I couldn’t agree more. I agree with all of that. And I think that I’m like Daniel Kahneman I suffer probably more so to all of those things than everybody else and so it helps to have the rules there. And I was just thinking before about the loss aversion. I’m thinking of a particular stock in my portfolio that I’m dreading selling, but I know that I’m going to have to rebalance it out at some stage. I don’t want to mention it because I don’t want to give it too much more heat. There’s…

Mark Simpson:
Just do it. Rip the bandaid off.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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