Foolish Collective
Investment Madness - Chapter 15

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By admiraltroll
July 11, 2003

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Hi Collective,

I finally got round to summarizing the last chapter which was interrupted by my trip to the UK

Links to previous chapters

Chapter 15 � Battling Your Biases
The modern day investment environment is likened to a roller coaster with dramatic highs and lows. This emotional roller coaster has a tendency to enhance your natural psychological biases and can lead to bad investment decisions.

This chapter proposes strategies for controlling your environment and gives specific "rules of thumb" that focus on long term investing and avoiding short-term emotional decisions.

Strategy 1 � Understand Your Psychological Biases
Nofsinger uses 3 categories of psychological biases: not thinking clearly, letting emotions rule, and functioning of the brain.

The following table, reproduced from the book summarizes all of the psychological biases. Reviewing this table should help you understand your psychological biases. [see original post for table]

Strategy 2 � Know Why You Are Investing
Most people only have a vague notion of why they are investing and it is not enough to say "I want to travel when I retire" or "I want to send my kids to college". Some people think in the negative, "I don't want to be poor when I retire". These vague notions give little direction nor do they help in overcoming psychological biases. Nofsinger gives a more specific example:

A minimum $75,000 of income in retirement will allow me to take 2 international trips per year. Since I will receive $20,000 in Social security & retirement benefits I will need $55,000 per annum in investment income. Investment earnings from $800,000 should generate the desired income. I want to retire in 10 years.

Of course even this example is simplistic but having specific goals really does help

1. Focus on the long term and look at the big picture
2. Be able to monitor and measure progress
3. Be able to determine if your behavior matches your goals

Strategy 3 � Have Quantitative Investment Criteria
This allows you to avoid investing on emotion, rumor, stories and other psychological biases. Nofsingers intent is not to propose an investing strategy such as value or growth investing but suggests a few simple guidelines nonetheless. Investment criteria eg:

1. Positive earnings
2. A maximum P/E ratio (the book had 50 although suggested 20 for a value investor)
3. A minimum sales growth (the book had 15%)
4. A minimum 5 years of trading publicly.

Nofsinger is by no means recommending these criteria as the only ones. The point here is that you should decide what investment criteria suit your style of investing and stick with them. It is also important to have qualitative criteria written down. This could include type of management, competitive advantages etc. Nofsinger sites the success of the Klondike Investment Club which required a full research report and full discussion before any purchase was made. This was a qualitative requirement.

Strategy 4 � Diversify
Not necessarily in the manner proscribed by Modern Portfolio Theory in chapter 9 but at least some diversification. Investing in technology stocks alone is poor diversification.

1. Stocks: different industries & different market cap size. May be 15 stocks or a well-diversified mutual fund.
2. Own very little stock in the company that you work for. You could be laid off and lose your investments from the same event.
3. Invest in bonds too. Again a bond mutual fund if not individual bonds.

Diversification can shield you from tragic losses and is a shield against attachment and familiarity biases.

Strategy 5 � Control Your Investing Environment
If you are an alcoholic you should not go to bars with your drinking buddies. If you are on a diet don't leave a dish of candies on the table or on your desk.

Do you check your stocks everyday? Every hour? If you are you run the risk of succumbing to your psychological biases. Nofsinger suggests the following:

1. Check your stocks once a month. This will help you avoid behavioral reactions of feeling snake-bit, seeking pride and playing with the house's money.
2. Make trades once a month and on the same day each month. This will help you overcome the misconception that speed is important (you can not time the market consistently). This will help overcome overconfidence and trading on "info bombs".
3. Review your portfolio annually and compare it to your specific goals. In doing this keep in mind the biases of status quo, endowment, representativeness, and familiarity. Does each security still contribute to your goals. Also keep good notes on each security to help overcome cognitive dissonance and other memory biases.

Nofsinger suggests that if you can not bear to do these things then you are probably addicted to the gambling aspects of the market.

To overcome this Nofsinger suggests taking a small proportion of your portfolio and putting it in a separate brokerage account as your "play money" but that you should only do this with money that you do not need to reach your specific goals

Do not under any circumstances intermingle this account with you main account or divert funds from or intended for your main account

Some More Rules of Thumb

1. Avoid stocks selling for less than $5. Most scams are with "penny" stocks
2. Chat rooms and message boards are for entertainment purposes only. It is on message boards that your overconfidence is fostered, familiarity magnified, and artificial social consensus is formed (Ouch � can't be TMF & certainly not the FC!!!)
3. Before you buy or sell a stock that does not meet your criteria remember that it is unlikely that you know more than the market. If you think that you have informational advantage are you sure?
4. Have a goal to earn the market return. Most active trading is motivated by the desire to "beat the market" and everyone else. Strategies to achieve this usually involve magnifying psychological biases and result in lower returns. Strategies such as diversification can limit this.
5. Review the table in this chapter at least once per year.

Successful investing is more than knowing all about stocks. Understanding yourself is equally important. Investors who think that they are knowledgeable frequently fail because they allow their psychological biases to control their decisions


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