What are the human weaknesses to capitalize on when it comes to investing?
The sum of market capitalization of all the companies listed on the stock exchange at any one time is what investors as a whole would want to pay for it at that time. However, this value and of each individual companies keep changing from day to day. This post is going to talk about some of the bias in judgment and weakness in behavior when it comes to investing for many investors, bias and weakness which you can exploit if you are aware of them and know how.
In fact, there is a well known asset management company managing assets for institutional investors, known as LSV asset management, focusing on investing in value equity by “systematically exploiting the judgmental biases and behavioral weaknesses that influence the decisions of many investors.”
Monkey see monkey do
What you can learn from history is that people don’t learn from history. Of course, learning from history is a rational act. However, humans are essentially emotional creatures.
Most of us, even for myself, like to rationalize when we make mistakes. This is especially so when it comes to money, we can avoid feeling regret when at the end of the day, the decisions are wrong when we followed conventional wisdom or what everyone else is doing.
In addition, many so called professional fund managers prefer well-known companies is precisely because of this reason. They are less likely to get retrenched should well known companies do not perform as well. This will “wrongly equate a good company with a good investment irrespective of price.”
Since most of the trades are done by institutional investors like mutual fund companies, it follows that why most low price-to-book ratios achieve better returns by a great margin than popular stocks.
Investors are irrational because investors are humans, not robots.
Modern finance and even economic theories make a lot of assumptions about investors which are not true to a wide extent in real life,
1. Investors are rational.
2. Investors consider all information when making decisions and there is perfect information
3. Investors are risk adverse.
Look at the following economic choices and think about how closely it relates to stock investing,
Given a choice of
a. Guaranteed gain of $300
b. 25% chance of winning $3000
Most would choose choice a.
Given a choice of
a. Guaranteed loss of $300
b. 80% chance of losing $3000
Most would choose choice b.
Expected value = probability of event X value of that event
By looking at the expected values, most would be irrational.
In other words, a guaranteed win cause them to become risk adverse while a guaranteed lost cause them to become risk takers.
You can see this in stock trading when most people refuses to cut losses.
Why is that during the dot com bubble, when most average investors lose money but Warren Buffett increase his net worth by a high margin?
Investors become irrational when the exciting dot com companies caused them to be too over confidence and cash out from old economy stocks for Warren to invest in. Most investors “ignore statistical evidence”, such as high prices will erode returns.
Tendency to extrapolate the past too far into the future
We see this in Newton’s Second Law, most of us accept the gospel truth of F=ma, for all values of F (=force), a (=acceleration) will also increase accordingly by multiplying by m (=mass). Until Albert Einstein question whether this extrapolation is correct in physical reality, that is after a certain point, successive increase in force leads to lesser and lesser increases in acceleration for a constant mass, the limit is speed of light.
Whether Apple computer can continue its outstanding success from now rests a lot on its future products launches, compared to Microsoft, Steve Jobs is the key. Remember the time when Steve Jobs was ousted from Apple, there is no new innovative products and the company revenue and stock prices nose dives.
This is in sharp contrast compared to Coca-Cola and Procter and Gamble, when earnings (and stock prices) can safely extrapolated into future. People who drinks coke now, most likely will do so in future. We still need most of the products being sold by Procter and Gamble in future also. This is in addition to brand loyalty.
Over confidence in own abilities
In general, we like to feel that we are better than others. It is good to have high esteem. But this translates into fund managers and investors belief that they can outperform the market. However statistically speaking, most do not perform better than the market.
Higher confidence does not necessarily correlate with higher success, especially when it comes to investing, greater knowledge and knowing when to apply the knowledge does. Asking good questions after having acquired the knowledge does.
The following probability exercise shows that using intuition in estimating probability may be seriously wrong.
What is the probability that a 20 year old man who does not involve in casual sex or any other risky sexual behavior but really got infect with HIV if he obtains a positive result on an Aids test?
Using the following data,
1. Out of 10 000 20 year old mans, one man got HIV.
2. The test is accurate 99.8% of the time.
3. False positive for the HIV test is 0.01%
The answer is 50%, but intuition tells you otherwise.
The greatest enemy is ourselves.
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