Rule Breaker Portfolio


The Psychology of Investing, III

By David Gardner (MotleyFool)

ALEXANDRIA, VA (June 2, 1999) -- After a topsy-turvy market day, the Rule Breaker Portfolio finished about even, up 0.25% for the day. We were variously down by as much as 6% and up by as much as 2%, driven largely by extreme volatility in our holding of The broad market averages ended up modestly today, as well.

Before I get into the meat of tonight's recap, I want to point out our contest to:

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OK, prior to tonight's report, I have flipped a coin seven times. And below I have listed three heads-and-tails sequences, one of which is the exact sequence I flipped (the other two are duds):

  1. H-H-H-H-T-T-T
  2. T-H-H-T-H-T-T
  3. T-T-T-T-T-T-T

Let's make a hypothetical bet. You get $30 if you guess the sequence I flipped, and I get $15 if you don't. On which would you bet?

Thus begins our third installment in the ongoing occasional series, "Psychology of Investing."

As you'll recall, we are looking at cognitive illusions, inspired by (among others) the book Inevitable Illusions: How Mistakes of Reason Rule Our Minds by Massimo Piattelli-Palmarini. It begins:

"In simple and basic fashion, this book proposes to set out the recent scientific discovery of an unconscious. Not the unconscious or subconscious explored by psychoanalysis, but one that always and unbeknownst to us involves the cognitive: that is, the world of reason, or judgment, of the choices to be made among different opportunities, of the difference between what we consider probable and what we consider unlikely."

The premise is that the human brain takes certain basic shortcuts, makes certain mistakes in reason -- all brains in all cultures at all times. These are essentially the cognitive version of optical illusions; our reason is tricked.

By recognizing these and becoming self-conscious about them, we may in various instances overcome them.

Self-scrutiny, questioning one's own instinctive thinking, can be of enormous benefit to investors. We in Rule Breakerdom actively do this as much as we can, and we value the ability of so many of you, our readers, to help us do this.

The previous two installments dealt with framing and anchoring, two fallacies, two "mental tunnels" that we go down consistently, losing track of objective reality. You can read about framing here, and anchoring here, via our Breaker archives. I'll follow up only with an excellent example of framing brought to us by 2DoubtFool, who told this joke:

"A guy, addicted to smoking, went to a monk and asked whether he could smoke while thinking about God. The monk gave him a cold look and vehemently rejected the idea. Our guy said sorry and wandered further in that area. In a corner under a tree he saw a guy sitting around and smoking while he appeared to be praying to God as well! Curious and a bit disappointed, he went to the guy and inquired of him about this. 'How come you are smoking while praying? That monk did not like the suggestion when I asked his permission!'

"The reply was: 'Well, I told him that I am a chain smoker, and asked whether it is okay to think about God while smoking.'"

That is framing, succinctly put!

Now let's return to our bet about the coins. On which would you bet?

If you weren't fooled (small f!), you realized that in fact there is no single choice that is better than any other. Each time you flip a coin, the chances are even that it will turn up heads or tails. Thus, the probability of:

  1. T-T-T-T-T-T-T

is just the same as

  1. T-H-H-T-H-T-T


  1. H-H-H-H-T-T-T

Given that you win $30 when you win and lose $15 when you lose, you will merely break even over time, repeatedly making this bet.

(However, if I wanted to take your money, I would play a shell game with new bettors each time by putting the metaphorical white bean under shell "C.")

Now, experiments cited by Piattelli-Palmarini (from whose book this example is adduced) show a very strong preference among respondents for that second sequence above (T-H-H-T-H-T-T). In fact, the order of preference is (b), (a), then (c).

Why are most people tricked by this? What is the cognitive illusion that underlies this misjudgement?

In the author's terms, it is the fallacy of typicality. Put in my own words, "Plausibility does not equal probability." But our brains (mine included!) frequently and instantaneously leap to the assumption that whatever looks the most plausible (or "typical") is therefore the most probable. We must cerebrally back away from this, check ourselves.

Again, the coins example above makes it perfectly clear that large numbers of people make this error. Our job then is simply to understand why so that we may avoid the same mistake ourselves.

What's really at play here is stereotyping. The act of equating plausibility with probability is exactly what we do when we stereotype things. Our minds say, "Oh, that person is a [insert any subset here] so of course she is [insert adjective here]." We may not explicitly state this; it may lurk in our subconscious. But we rarely recognize that "tails-tails-tails-tails" (as I shall call it) is as equally probable as the more "plausible" or "typical" expectation, "heads-tails-heads-tails."

Turning our focus toward our own pet subject, business and investing, do you find any of your own applications of the typicality fallacy? I'd love for you to contribute your ideas to our Rule Breaker message board discussion. I'll kick it off here by providing a few of my own.

I think one of the great conventional mistakes -- Wisdom, as we call it here at The Motley Fool -- of our investment era right now is "Internet stocks are overvalued." As I have argued repeatedly here and elsewhere, there really is no such thing as an Internet stock. It's a hazy and lazy stereotype that causes us to lump together disparate items, companies with totally different business models. When you hear some broker on CNBC refer to "the dot-coms," you are watching someone propagate a cognitive illusion that will most likely be accepted by thousands of others who are themselves under the spell of that same cognitive illusion.

Switch gears. Let me provide another example of a stereotype: race. No, I'm not going to speak here about "racial stereotyping," in the traditional sense -- saying that because somebody has blue skin, that means such-and-such about that person. (A miserable history attends this form of stereotyping.) No, my example is even more fundamental than that. I find the very idea of "race" itself as unilluminating as "Internet stock."

How many races are there, do you think? Whatever number you want to come up with, I can almost certainly come up with one more by "blending" a few of yours together to identify a tighter additional subset of people who are part of this other "race." But still, the whole notion of "race" is something many of us take for granted, whether we see it referred to in a scientific study or mindlessly scan over it in a newspaper headline. The notion that we can make any useful or meaningful generalization about race is going to be regarded by future historians as a cognitive illusion of our era.

(One of the many things I like about Star Trek is its depiction of a future in which no one even thinks in terms of "race." None of the characters ever appear conscious of it.)

Back to investing. We do not speak coherently or meaningfully when we generalize about "Internet stocks" or "the dot-coms" and make a point about their businesses, their valuations, whatever. The Internet is a technology that businesses use; it is not an industry. Hey, BreakerPort holding Goodyear just opened up e-commerce on its site yesterday, so I suppose that Wise thinkers can add Goodyear to their list of "Internet stocks." Never holding much meaning in the first place, the phrase loses more meaning with each passing day.

How can escaping this example of typicality help you, as an investor? Simple. Just examine things as they are -- @Home on @Home's terms -- rather than fitting @Home into some odd-shaped box that causes you subjectively to pick out a few of its elements and miss the rest of the reality. Obvious inabilities to do this have attended anyone who threw money at any so-called new "Internet IPO," lumping that business together with all the "others." Sorry, dear Fools, but each business is distinct, and even while AOL's stock movements may correlate well with eBay's over the short term, over the long term that correlation will most probably break down. At one point, AOL's business correlated with Prodigy's. At one point, AOL stock correlated with Netscape.

A closing comment. The true Fool, while celebrating our human similarities, will nevertheless look for, respect, and recognize the amazing differences between any two people -- however demographically or culturally similar. Fools "think different." We view the world as an incredibly motley arena, and we celebrate that. We wouldn't want it any other way.

On a personal note, in my own life I frequently find myself saying something or doing something specifically to shock other people into questioning their own assumptions -- about me, or investing, or about the world in general. This is instinctive; I can't help it. Who would ever have thought that one could wear a jester cap and dispense financial advice? I expect many of you have similar stories, a similar modus operandi within the context of how you spend your days.

This is, to me, what makes each of us special, what makes us human.


-- David Gardner, June 2, 1999

06/02/99 Close
Stock  Change    Bid 
AMGN  -  3/16    61.75
AMZN  +6 5/16   112.13
AOL   -2 15/16  110.31
ATHM  -3 1/8    114.44
CAT   -  3/8     58.38
CHV   +1 9/16    92.00
DD    -2 3/16    66.00
DJT   -  1/8      5.31
EBAY  +2 5/16   168.81
GT    +  1/4     61.13
IOM   -  1/4      4.38
SBUX  +2 5/8     37.75
TDFX  -  1/8     19.38

                  Day     Month  Year   History   Annualized 
      R-BREAKER  +0.25%  -5.32%  26.70% 1171.74%   69.41%
        S&P:     +0.04%  -0.54%   5.65%  196.02%   25.23%
        NASDAQ:  +0.85%  -1.54%  10.93%  237.75%   28.70%

    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    110.31   12037.59%
   9/9/97  1320     6.58    112.13    1604.22%
  5/17/95  1960 Iomega Cor     1.28      4.38     241.69%
  12/4/98   450 @Home Corp    56.08    114.44     104.06%
  2/26/99   300 eBay         100.53    168.81      67.93%
 12/16/98   580 Amgen         42.88     61.75      44.02%
  4/30/97 -1170*Trump*         8.47      5.31      37.27%
   7/2/98   470 Starbucks     27.95     37.75      35.04%
  2/23/99   290 Goodyear T    48.72     61.13      25.47%
  2/23/99   300 Caterpilla    46.96     58.38      24.30%
  2/23/99   180 Chevron       79.17     92.00      16.21%
  2/20/98   260 DuPont        58.84     66.00      12.16%
   1/8/98   425 3Dfx          25.67     19.38     -24.52%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 242687.50  $240688.03
   9/9/97  1320  8684.60 148005.00  $139320.40
  12/4/98   450 @Home Corp 25236.13  51496.88   $26260.75
  2/26/99   300 eBay       30158.00  50643.75   $20485.75
 12/16/98   580 Amgen      24867.50  35815.00   $10947.50
  5/17/95  1960 Iomega Cor  2509.60   8575.00    $6065.40
   7/2/98   470 Starbucks  13138.63  17742.50    $4603.88
  4/30/97 -1170*Trump*     -9908.50  -6215.63    $3692.88
  2/23/99   290 Goodyear T 14127.38  17726.25    $3598.88
  2/23/99   300 Caterpilla 14089.25  17512.50    $3423.25
  2/23/99   180 Chevron    14250.50  16560.00    $2309.50
  2/20/98   260 DuPont     15299.43  17160.00    $1860.57
   1/8/98   425 3Dfx       10908.63   8234.38   -$2674.25

                              CASH   $9924.87
                             TOTAL $635868.00
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.


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