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Avoid these mind traps and stop hurting your returns.
BY Kevin Godbold - Published in Investing on 8 December 2011
In September 2005, I wrote on the Fool's Royal Bank of Scotland discussion board:
"Please explain to me what I have missed, but I can only see the share price going further down and, until it does, there is no value, because it is already where it is likely to recover to!"
At the time, I believed the bank's business had a cyclical nature and that earnings were at the top of the cycle. Needless to say, I didn't hold the shares back then.
However, in June 2007 I bought some, almost perfectly timing my purchase to coincide with the start of the calamitous plummet to today's levels! Regrettably, those RBS shares remain in my portfolio to this day. So what went wrong? Why did I end up acting against my earlier conviction?
Portfolio enemy number one
It's clear that the threat to my portfolio came from me -- I was my portfolio's worst enemy. It wasn't the credit crunch, it wasn't the recession and it wasn't the company. The banana skin in this case was that I'd fallen into a mind trap that psychologists call 'groupthink'.
Around the time of my purchase, RBS looked cheap on conventional value measures. Investors were talking of it being a 'square share,' meaning that its dividend yield was the same as its price to earnings ratio, with the yield being high and the P/E being low. The share was appearing on lists of value shares all over the internet and many articles extolled its value credentials. I gradually succumbed to my perception of the majority view, forgetting earlier cyclical concerns about the share.
Groupthink is a particularly dangerous decision-making trap, in my view. It's likely to occur because it latches onto our deep social identification mechanisms, even though we may be unaware it is happening. But achieving a consensus view that drowns out opposition can lead to disastrous results.
In my case, adopting the second groupthink idea of starting a 'diversified' high-yield portfolio in 2007, without regard to cyclicality, magnified the disaster. Haplessly, I bought Lloyds Banking, Dixons Retail, Taylor Wimpey and Kesa Electricals, too, while being aware of legendary fund manager Peter Lynch's teachings on cyclical investing -- not my finest investing hour!
A different logic
Groupthink is just one of several mind traps that psychologists have identified under the broad heading of cognition -- how we think, process information and remember. It's all about how the mind works and how it can, as in my case, work against us.
Of course, problem solving and decision making is a huge part of what we ask our minds to do, and those activities are particularly relevant to the activity of investing. Logic plays a big part in that, but studies have shown that human logic is often different to pure logic, such as that performed by a computer. That doesn't mean human thinking is always irrational in terms of social awareness and probabilities, but it does lead to another set of dangerous mind traps broadly categorised as heuristics.
Heuristically challenged
Our socially and experience-influenced logic can lead us to take cognitive short-cuts, or heuristics, that can result in us making decisions that may not be the most sensible ones. One way that this might occur is through the heuristic of availability.
For example, I chose my duff high-yielding shares, in 2007, from options that sprang immediately to mind. Their recent appearance on value lists and articles was fresh in my mind, and I failed to consider the wider universe of investment options available. My expectations were influenced by recent experience of high dividends -- I could have thought harder about my investments, but didn't.
Entrapment is another heuristic. When we've put a lot of effort into a course of action, it's hard to change because it means what we've done is useless. The fact that I'm still holding all the shares mentioned, despite massive capital loss and a desert of dividends, means that I've fallen squarely into that trap. The shares could've been sold at any time, after all, they didn't go from hero to zero in one night while I slept -- I was asleep in other ways, and had ample opportunity to cut my losses.
One to save us
Fortunately, it's possible to train ourselves to think in a way that helps us avoid falling into the mind traps created by expectations, assumptions, short cuts and fuzzy logic. A chap called Edward de Bono developed a powerful technique called lateral thinking, where people try to solve problems by 'thinking outside the box.'
Lateral thinking isn't a fail-safe way of making correct decisions, but it does help to expand our range of options and has helped to popularise the term 'brainstorming'. Had I used it in 2007, my money could still be in the bank, or be invested in a new house... or even be multiplied by shorting cyclicals!
I'm hoping that lateral thinking and awareness of these mind traps will make me less of an enemy and more of a friend to my portfolio in future!
Source: http://www.fool.co.uk/news/investing/2011/12/08/your-portfolios-worst-enemy.aspx
BY Kevin Godbold - Published in Investing on 8 December 2011
In September 2005, I wrote on the Fool's Royal Bank of Scotland discussion board:
"Please explain to me what I have missed, but I can only see the share price going further down and, until it does, there is no value, because it is already where it is likely to recover to!"
At the time, I believed the bank's business had a cyclical nature and that earnings were at the top of the cycle. Needless to say, I didn't hold the shares back then.
However, in June 2007 I bought some, almost perfectly timing my purchase to coincide with the start of the calamitous plummet to today's levels! Regrettably, those RBS shares remain in my portfolio to this day. So what went wrong? Why did I end up acting against my earlier conviction?
Portfolio enemy number one
It's clear that the threat to my portfolio came from me -- I was my portfolio's worst enemy. It wasn't the credit crunch, it wasn't the recession and it wasn't the company. The banana skin in this case was that I'd fallen into a mind trap that psychologists call 'groupthink'.
Around the time of my purchase, RBS looked cheap on conventional value measures. Investors were talking of it being a 'square share,' meaning that its dividend yield was the same as its price to earnings ratio, with the yield being high and the P/E being low. The share was appearing on lists of value shares all over the internet and many articles extolled its value credentials. I gradually succumbed to my perception of the majority view, forgetting earlier cyclical concerns about the share.
Groupthink is a particularly dangerous decision-making trap, in my view. It's likely to occur because it latches onto our deep social identification mechanisms, even though we may be unaware it is happening. But achieving a consensus view that drowns out opposition can lead to disastrous results.
In my case, adopting the second groupthink idea of starting a 'diversified' high-yield portfolio in 2007, without regard to cyclicality, magnified the disaster. Haplessly, I bought Lloyds Banking, Dixons Retail, Taylor Wimpey and Kesa Electricals, too, while being aware of legendary fund manager Peter Lynch's teachings on cyclical investing -- not my finest investing hour!
A different logic
Groupthink is just one of several mind traps that psychologists have identified under the broad heading of cognition -- how we think, process information and remember. It's all about how the mind works and how it can, as in my case, work against us.
Of course, problem solving and decision making is a huge part of what we ask our minds to do, and those activities are particularly relevant to the activity of investing. Logic plays a big part in that, but studies have shown that human logic is often different to pure logic, such as that performed by a computer. That doesn't mean human thinking is always irrational in terms of social awareness and probabilities, but it does lead to another set of dangerous mind traps broadly categorised as heuristics.
Heuristically challenged
Our socially and experience-influenced logic can lead us to take cognitive short-cuts, or heuristics, that can result in us making decisions that may not be the most sensible ones. One way that this might occur is through the heuristic of availability.
For example, I chose my duff high-yielding shares, in 2007, from options that sprang immediately to mind. Their recent appearance on value lists and articles was fresh in my mind, and I failed to consider the wider universe of investment options available. My expectations were influenced by recent experience of high dividends -- I could have thought harder about my investments, but didn't.
Entrapment is another heuristic. When we've put a lot of effort into a course of action, it's hard to change because it means what we've done is useless. The fact that I'm still holding all the shares mentioned, despite massive capital loss and a desert of dividends, means that I've fallen squarely into that trap. The shares could've been sold at any time, after all, they didn't go from hero to zero in one night while I slept -- I was asleep in other ways, and had ample opportunity to cut my losses.
One to save us
Fortunately, it's possible to train ourselves to think in a way that helps us avoid falling into the mind traps created by expectations, assumptions, short cuts and fuzzy logic. A chap called Edward de Bono developed a powerful technique called lateral thinking, where people try to solve problems by 'thinking outside the box.'
Lateral thinking isn't a fail-safe way of making correct decisions, but it does help to expand our range of options and has helped to popularise the term 'brainstorming'. Had I used it in 2007, my money could still be in the bank, or be invested in a new house... or even be multiplied by shorting cyclicals!
I'm hoping that lateral thinking and awareness of these mind traps will make me less of an enemy and more of a friend to my portfolio in future!
Source: http://www.fool.co.uk/news/investing/2011/12/08/your-portfolios-worst-enemy.aspx
