Mind over matter An investors guide to remaining sane in an insane world Elio D Amato Chief Executive Officer Lincoln Indicators Pty Ltd
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Psychology of investing I used to think that the brain was the most wonderful organ in my body. Then I realised who was telling me this. Emo Phillips
Behavioural finance Common economic theory proposes that individuals make rational decisions in their best interests This often does not occur Behavioural economics (or finance) is an effort to integrate traditional economic theory with human psychology to understand why things happen as they do Understanding our emotional flaws allows for better rational decision making
Behavioural finance THIS IS A VALID FIELD OF ACADEMIC STUDY! Drs. Daniel Kahneman and Amos Tversky wrote about: Cognitive psychology to explain various divergences of economic decision making from neoclassical theory Prospect theory: An Analysis of Decision Under Risk (1979) Both awarded the 2002 Nobel prize in economics
Behavioural finance Key concepts of behavioural finance Anchoring Framing Over-confidence Confirmation Bias Game theory and crowd behaviour Over-reaction Let s go through each of these and see how sane you are.
Anchoring Anchoring: tendency to rely too heavily on one trait or piece of information when making decisions. Assessing the merits of an existing investment based on entry price I purchased NCM at $40, it s now $15. I am holding to recover my loss. I purchased CSL at $20, it pays $1.40 dividend so I am holding the stock for the high yield!
Avoiding mistakes How to avoid Anchoring Don t look in the rear view mirror Remind yourself you have a decision to make TODAY, not yesterday Engage in critical thinking and be prepared to test the validity of your idea Decisions should be based on your current objectives To reach a port, we must sail - sail, not tie at anchor Franklin D Roosevelt
Framing Framing: tendency to bias decision depending on how the problem is presented. Positive framing biases decisions towards risk taking.
Avoiding mistakes How to avoid Framing Try re-framing the problem and see if that changes your decision Don t be blinded by potential Understand that all investing carries some risk Identify the level of risk you are willing to take on It is a risk / reward decision you have to make The optimist sees the donut, the pessimist sees the hole. Oscar Wilde
Over confidence Overconfidence: causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events.
Avoiding mistakes How to avoid over confidence Be 100% honest with yourself Set realistic goals, not optimistic fantasy Don t dive in head first before you have done the work Learn lessons from your mistakes I am not overconfident. Romano Prodi
Confirmation bias Confirmation Bias: tendency to search for, or interpret information in a way that confirms one's preconceptions
Avoiding mistakes How to avoid confirmation bias Be systematic, structured and disciplined in your investment approach Have a structured plan that identifies your entry and exit criteria Have a healthy dose of scepticism about your research Take note of when your rationale changes The human understanding when it has once adopted an opinion draws all things else to support and agree with it. Francis Bacon
Crowd (Herd) behaviour Crowd (herd) behaviour: the tendency for individuals to mimic the actions (rational or irrational) of a larger group.
Crowd (Herd) behaviour Game theory is often attributed to crowd behaviour in that equilibrium in social systems can be: Unstable: small changes lead to large shifts in the equilibrium Sub-optimal: smart people, acting independently, can produce a dumb result John Nash Jr 1994 Nobel laureate Economics
Avoiding mistakes How to avoid crowd behaviour Understand volatility is inherent in the market. This creates OPPORTUNITY! Use the facts as your guide Apply a defined investment strategy that blocks out emotions Have a structured framework for making informed decisions Invest for the long term The herd instinct among forecasters makes sheep look like independent thinkers Edgar Fiedler
Overreaction Overreaction behaviour: the tendency participants in the stock market predictably overreact to new information, creating a larger than appropriate effect on a security's price
Avoiding mistakes How to avoid overreaction Block out the noise Don t use short term news as an investment decision point Retain a sense of perspective Remember, overreactions can help you I'm still astounded by some people's reaction to things I consider quite normal. Jean Paul Gaultier
Other biases Gambler s fallacy The belief that the onset of a certain random event is less likely to happen following an event or a series of events. Mental accounting Individuals sometimes make decisions which partition money which causes them to neglect their current holistic financial situation.
Behavioural finance How investing sane are you? Anchoring Framing Over-confidence Confirmation Bias Game theory and crowd behaviour Over-reaction 6: You need to take a bex and have a good lie down in a dark room and seek professional help 5-4: Investing will continue to be stressful and you will make mistakes unless you change your thinking 3-2: You are on the path to mastering the emotions around investing. Well done! 1: Your mental strength puts you in the upper echelon amongst your peer investors. 0: You are the investing equivalent of the Dalai Lama. Enlightenment awaits you.
Behavioural finance Lincoln s view: As investors we should not deny that various bias exist. Rather we should come to understand them and how we can benefit from them We simply attempt to be greedy when others are fearful, and fearful when others are greedy Warren Buffett
Behavioural finance What you need to accept 1. Investors think and act differently to maximise their personal utility Therefore understand intimately your personal objectives to know what action best suits you 2. Investors should take total and sole responsibility for their investment decisions Once you know your objectives, decide on how much risk you are willing to take to achieve it
Behavioural finance 3. Investors think in probabilities and are comfortable with that While we might like to get it right 100% of the time the facts are we can t. So invest in a way that optimises the probability of success 4. The simpler the system, the better What s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. Warren Buffett
Behavioural finance In summary Investor behaviour can influence the market but this is a positive thing for a rational investor Let the facts be your guide Make sure you have a structured investment approach Always have your noise filter switched on Don t be stubborn! It s ok to be wrong sometimes Hindsight is not your problem it s failing to learn from mistakes that is Focus on identifying the best of the best!
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