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Regardless of what we would like to believe, we rarely are the rational/ efficient/ objective investors assumed by most theories. In fact, the list of 'simplifying' assumptions about our behavior in standard economic models is so stultifying, it makes me wonder which species the author's writing about.

In reality, our investing chatter is full of emotionally charged terms like 'bull run', 'bear rout', 'hot tip', 'pump and dump', etc. Because they portray our in-market behavior so much better than that stuffed shirt 'homo economicus'.

The relatively new field of Behavioral Finance goes a long way toward recognizing our real-life behavior, thus helping us better understand how we really behave as investors.

Here are just a few of the key findings:
Overconfidence
- We overestimate our knowledge of an investment, underestimate its risks, and exaggerate our ability to control its outcomes.
- Not realizing that we don't know enough, we take bad bets.
- Overconfidence drives excessive trading frequency

“It's not what a man don't know that makes him a fool, but what he does know that ain't so.”

Boys Will be Boys: Gender, Overconfidence, and Common Stock Investment by Brad M. Barber and Terrance Odean
http://www.mitpressjournals.org/doi/abs/10.1162/003355301556...

Endowment effect
- We value things we own more than those we don't.
- We hang on to inherited assets regardless of their fit in our investment profiles
- a.k.a. 'status quo bias': we demand more to give up something than we're prepared to pay for it

Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias, by Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler
http://www.jstor.org/pss/1942711

Prospect theory

- We are less willing to gamble with profits than with losses
- We sell quickly when we're winning, but avoid selling if we're losing

Prospect Theory: An Analysis of Decision under Risk, by Daniel Kahneman and Amos Tversky
http://www.jstor.org/pss/1914185

If you're not into slogging through original papers, probably the easiest book to read on the subject is “Why smart people make big money mistakes... and how to correct them” by Gary Belsky and Thomas Gilovich
http://www.amazon.com/Smart-People-Money-Mistakes-Correct/dp...
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Hi Cog,

If you are comfortable to share, I would love to know how you invested/allocated over the last 2 years. I see from your profile that your portfolio is limited to 3 companies (Good ones though), all of which pay a good and rising dividend. Other than MCO, JNJ and PG did not suffer severe losses. MCO has recovered a great deal. They probably gave you excellent buying opportunities during the last few months.

Thanks,

Anurag
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Hi Anurag, the last year or so woke me up to the fact that my new #1 counterparty is a Washington that is wilfully destroying foreign capital in its desperation to avoid right sizing its debt besotted economy. It's making a mockery of the very free market capitalism that helped make it the financial capital of the world.

As Rogers wrote in “Investment Biker”, if devaluation actually helped reduce indebtedness and improve the economy, Italy wouldn't have been in serial political and economic disarray with high debt, inflation, taxes, unemployment, corruption, etc. The last two US administrations have avoided biting the bullet. Who do you think is going to take it for them?

Hence, I've been redeploying my US funds into non-US markets, mostly Asia. As for PG/ JNJ/ MCO, those are probably the best examples of what I consider my very small circle of competence – Cash Kings. If I own one, I try to understand its ins and outs, hence the 'few good men'.

Reframing that in the context of this thread, that makes me a good example of all three behavioral challenges highlighted. Given the effort I make to understand my holdings, I'm probably over confident about them, thus exposing myself to being blindsided by the 'unk unks'. I definitely value them much more than arguably comparable options, and tend to tolerate losses well past my risk profile. Which circles back to over confidence, incidentally.

How about you? Have you had a chance to think through your investing behavior in any of those terms? How would you try to address them?
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How about you? Have you had a chance to think through your investing behavior in any of those terms? How would you try to address them?

I'm not Anurag, but i am definitely questioning my emotions, the aggregate investor's emotions, and how to address them.

They say, "Be greedy when others are fearful." Well, I'm a bit fearful. Does that mean it is a good time to buy? I don't think the market is fearful enough, but i think it will be soon enough. Does that mean i should wait? Some might say, just ignore your emotions and everyone elses', and focus on the fundamentals. Well what are the fundamentals? That is easier said than done for even the most astute investor right now. There is the widest divergence b/t inflation/defaltion opinion ever. The marco environment is very questionable going forward, especially regarding interest rates and corporate earnings. Individual company analysis is very difficult given a non-normalized earnings period and questionable forward looking prospects, with unknown futute corporate refinancing rates, if refinancing is even going to be possible at all for many firms in the next year or two.

There does seem a large potential for another classic double dip.
Another big panic is definitely possible, with a seemingly perfect storm scenario. I think the markets were pricing in a normalizing housing market (housing recovery was all the talk a month or two ago), and it appears that may not happen until as early as next year.

The retail investor is spooked, yet perhaps less likely to panic as much as they did earlier in the year. Interest rates are rising, albeit from a low level. Inflation concerns are exploding. Defaltion hawks' voices don't sound as strong anymore. I have been in the near term defaltion camp, however, with all the hands out and willing donor in the FED, they may solve the deflation problem a little to well. Oil is rising to high levels, and may crimp any attempt at a recovery. Credit cards defaulting. Mortgages defaulting. Commercial Real Estate beginning to crack, which could be potentially huge problem, bigger than residential. Consumer levered to the tilt. Municipals and states are on the verge of bankruptcy, and looking for federal aid, which means more printing presses, exacerbating other fears of more inflation from bailing everyone and everything out. I DO think government assistance is necessary in most of these cases, but not the banks. If commercial real estate cracks and CC defaults soar higher, and the banks get in trouble once again, they need to wipe out the equity and and convert debt for equity to solve the problem and not print more money to keep the equity holders alive. I think inflation is somewhat manageable given current events, however given that i think the government will be willing to bail out nearly every institution systemic or not in the near future (such as municipalities & states), I think we may hit the inflection point if we haven't already. The only real positive "green shoot" i see is that corporate spreads are tightening, and investors are biting on equity offerings in overleveraged companies. We are sailing unchartered waters.
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Now and then there is a glitch in the matrix, and one can actually find something useful in that massive propaganda machine known as CNBC. Presented below is an interview with Robert Rodriguez, CEO of First Pacific Advisors and Morningstar Fixed Income Fund Manager for 2008, which is quite impressive, not least in that CNBC allowed this segment to air at all, but because Rodriguez captures the essence of the collision course in which the economy is headed.

"People do know that we are in trouble and that we have to go down a different course. The question is which course and we have a course in this country right now of excessive debt growth and liability growth, and there is a group of people that realize this is a non-sustainable course that's dangerous to the country, the economy and to their children."

http://www.cnbc.com/id/15840232?video=1136256079&play=1
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Thanks for your thought provoking reply, as usual :-)

Since you're already quite clued in on the quantitative risks of investing - e.g. volatility, liquidity - have you considered applying the same talent to *quantifying* your emotional risks so as to give you a yardstick to go by?

For example, if you tend to be more 'overconfident' about, say, OTC stocks, then you could set up an 'OTC policy' which stipulates maximum position size both overall in OTC and in individual OTC stocks. Or you could require a significantly higher margin of safety over and above what the fundamentals dictate, regardless of the stock. Or, a significantly higher gap criterion for adding to a falling position.

Individual company analysis is very difficult given a non-normalized earnings period and questionable forward looking prospects, with unknown futute corporate refinancing rates, if refinancing is even going to be possible at all for many firms in the next year or two.

Very true. Amazing how Goldman and Citi got away with their last set of repackaged quarterly numbers. It is, however, the perfect environment for a laser focus on what the moat of the business really is, and how much of its recent success was a fair weather one - or just sheer luck!

Which cues yet another behavioral challenge - the availability/ recency bias. Incredible how Graham figured that out back then and insisted on 10 year average earnings as the basis for forecasting!

"i think the government will be willing to bail out nearly every institution systemic or not in the near future (such as municipalities & states)"

I think this government no longer has a choice in such matters. It's a runaway train - and I keep coming across people scrambling to get off and avoid being left holding the inevitable can.

Thanks for the CNBC link - was lucky to watch its concluding segment live. Rodriguez was particularly eloquent in describing it as an 'entitlement' setup where you don't even need a lame excuse to qualify for disability bailouts.

Totally O/T, but what's your take on the next round of blood letting by private equity firms and hedge funds in June?
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have you considered applying the same talent to *quantifying* your emotional risks so as to give you a yardstick to go by?

For example, if you tend to be more 'overconfident' about, say, OTC stocks, then you could set up an 'OTC policy' which stipulates maximum position size both overall in OTC and in individual OTC stocks. Or you could require a significantly higher margin of safety over and above what the fundamentals dictate, regardless of the stock. Or, a significantly higher gap criterion for adding to a falling position.


Funny you mention that. I have been trying to quantify my emotions/investments through various hedges as opposed to trying to hit a home run in one direction or another. You could say my allocations are somewhat market neutral, with a bearish tilt. I do require a much more significant margin of safety in the current environment above what normal fundamentals dictate. I have targets set for a handful of companies that i intend to add to should the market overcorrect or the individual price positions fall within range.



Totally O/T, but what's your take on the next round of blood letting by private equity firms and hedge funds in June?

Private equity and hedge funds were deluding themselves in hoping to go back to business as usual after the trauma of the last 18 months.

This is not a normal recession and there will be no V-shaped recovery. The crisis has destroyed leveraged companies. We’re going to see a catastrophic increase in the number of LBO’s (leveraged buyouts) going into default because they’re knee-deep in debt and no solution exists since they can’t refinance. Embedded leverage will be the best available. For the lucky ones, re-leveraging of old assets will be at historic maximum metrics.

Alpha hedge funds have been making their money by gambling with excessive leverage, so the knife that cuts off leverage is going to cut off their heads as well.

Couple leverage with investor skepticism of hedge fund managers given recent psychological events of Madoff, Pequot Capital (after very recent alleged insider trading allegation disclosure), and even the infamous Quant, James Simon's Renaissance Funds are getting inquiries from the SEC:

http://online.wsj.com/article_email/SB124235370437022507-lMy...

The WSJ reported that, among other things, the SEC has been recently poking around RenTec's books, maybe trying to answer the $64,000 question of how Medallion consistently outperforms RIEF and RIFF.

If anymore "SEC Inquiries" pop up from any more large prominent hedge funds, there very well could be more deleveraging to come from investor redemptions, baring no lockup period. On the positive note, most large reputable hedge funds are now flush with cash-to-relative assets due to their skepticism of the recent rally, and due to holding a natural redemption cushion for near term lock-up expirations. I've seen quite a few hedge funds holding as much as 35% cash at the moment.
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