Have you heard of Ina the bear? Held in captivity in a cage for many years, and later released into a wild sanctuary, she kept pacing around a circular path like in a cage even when free! Sanctaury staff later placed a stone in her path to block this pattern of circling in an ‘imaginary cage’ and this finally did the trick.

What does this have to do with investing? In bl.portfolio edition dated April 7, 2024, in our tribute to the late psychologist Daniel Kahneman (“Daniel Kahneman and the mirror he held to our investing illusions” ), we had touched upon the two systems in our brain that govern our decision making – System 1 (fast, subconscious, biased) and System 2 (slow, analytical and objective).

The problem in decision-making arises when we apply System 1 to areas in which System 2 needs to be applied, stock picking and investing being one such prime example. Quick, less-thought-out and biased decisions are the bane of investing.

Like Ina the bear, which was influenced by its past, our decision making too is influenced by many explicable and inexplicable factors – genetics, childhood experiences, our individual financial status while growing up, etc. Conclusions and biased interpretations immediately pop up when we see a stock price movement, news on a stock, profits/losses, and the like.However, unlike Ina, others will not place a stone in our decision-making path to break past patterns. We will have to place the stone ourselves to block the path of poor decision making, and consciously develop a System 2 approach to stock picking. Here are some steps you can apply.

Maintain an investing journal

In his book, Thinking, Fast and Slow, which we referred to in our previous article, Kahneman posited a fundamental puzzle that bothered him when it comes to stock markets — ‘Billions of shares are traded every day, with many people buying each stock and others selling it to them. Most of them have the same information, they exchange the stocks because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop.’

His puzzle was, why buyers and sellers alike think that current price is wrong. He termed this the ‘illusion of skill.’ When we buy stocks, there tends to be a high degree of confidence in our decision, else we would not buy, would we? But does it always pan out that way? Guess not, for most of us.

So one way to reduce the influence of the ‘illusion of skill’ in our investing or trading decisions is to write a short thesis on why we are buying or selling a stock — every time, in a disciplined manner, without exception.

For example, if you are buying a stock, make a note of these things in the following order:

1) What is your time horizon? Be crystal clear on this. It is fashionable for short-term investors to claim they are long-term investors, when they face losses. That is trying to fool ourselves. This way, you can remind your self, in case the stock falls hard after you buy, that it should not matter if you invested with a long-term horizon as long as the fundamentals have not changed.

2) Three reasons why you think it is a good stock to buy

3) What are the risks? Are you ready to accept them?

4) How is market viewing this stock? Are you smarter than the market when it comes to this stock?

5) Pledge to accept the consequences of your decision, don’t brood over it if it does not work.

Modify, improvise on this the way you deem fit. At a fundamental level, following the above process comes with two distinct advantages. One, it slows your decision making, giving a chance for System 2 in you to take control and avoid rash decisions. Two, repeated following of this will definitely create a positive feedback loop through the course of your investing journey.

On a periodic basis, say, every quarter/half yearly or annually, you can assess how your decision to buy or sell a stock has fared. A journal helps you recollect better the context in which you made your decision and the rationale behind it. Depending on how the stock has fared, you can assess whether your decision was right or wrong and keep improving the process accordingly.

Importantly, while analysing your decisions periodically and building the feedback loop, you must assess whether luck played a factor in your decision being right – like you bought a stock in anticipation of some thing happening, but some other factor resulted in the stock going up. Similarly, if your process was good, but a totally unanticipated event played spoilsport, then there is no need for you to change your process.

Test your System 2 against your System 1

In earlier articles, we have highlighted how basing investing decisions by giving high weightage to a single metric is like holding onto one end of a rope without checking whether the other end is tied strongly or neatly, or whether it is tied at all

High-ROE stocks may not fetch you good returns if they already trade at an expensive Price/Book, low PE stocks may continue to underperform or destroy your wealth if there is no growth or there is balance sheet/leverage problem, high-growth stocks may underwhelm if growth is unprofitable or cash flows are poor, etc.

Base rate fallacy refers to a cognitive bias where we tend to ignore statistical and other data points in favour of only new or recent information we have been exposed to. Often we get anchored to one core aspect of a stock — the stock is cheap, or has high growth, or the company has built this great product. Many a time it is just a jazzy macro story. For instance, during the period 2007 to 2014, a common theme was that India will require trillions of dollars of investments in infrastructure, precisely a time when infra stocks turned out to be wealth destroyers.

A more recent example is the digital transformation buzz, a macro theme that got hyped beyond realities, resulting in wealth destruction in IT services stocks since January 2022. But when investment themes are sold with verbose prose, even though the math is not clear, we can be influenced to invest . Worse, sometimes it is even silly and illogical perceptions that stocks that trade in single digits or double digits can perform better!

How can we overcome biases that influence us in such cases? A disaggregated approach to picking stocks helps. Choosing stocks based on our anchoring to a single metric represents a System 1 approach that is unlikely to succeed in the long term. To the contrary, under a disaggregated approach, a stock/company is broken down into different components — valuation, growth, balance sheet strength, corporate governance, etc, and each aspect is measured independently to check whether one component that is favourable is veiling other negatives. However, if the stock is faring well in all these aspects, then it’s a case of an opportunity the market is missing.

Following this approach will also guide you to pick the best stock in terms of risk-reward in an industry. For example, even in the homogenous IT services sector — with stocks such as TCS, Infosys, Wipro, HCLTech, Tech Mahindra, et al — each stock can be justified as an investment based on a single metric: Wipro is cheaper, TCS has industry-leading margins and best execution track record, Infosys is cheaper than TCS but has potential to bridge the execution gap, etc.

Which one to pick? Try to get holistic perspective using a disaggregated approach to see how stocks fare when you add up the parts, before investing. Of course, there will be times when no stock will be worth the risk, in which case you should avoid the industry.

In following this approach, it is important to identify the fundamental factors that drive outperformance in stocks over the long term. This may vary according to industries, but a few common factors are valuation, growth prospects, current business trends, management quality, balance sheet strength, etc.

Treat your current portfolio as fresh capital

None of us like losses. The fallout of this nature in us is a tendency to sell the winners in our portfolio and hold on to the losers (to avoid booking losses). But a key thing we miss while succumbing to our biases is –profit or loss is a subjective experience and has zero bearing on how the stock actually performs in future. The same stock, at a point in time, will be highly profitable in one person’s demat account and at a huge loss in another demat account.

So is there any logic to selling winners and holding on to losers? No, but the tendency to be influenced by this is called the ‘Disposition Effect.’ Further the ‘sunk-cost fallacy’ where we tend to average our losers by ploughing in more money, when there are much better investments out there, complicates this further.

Kahneman terms this a costly bias, since a ‘rational decision maker is interested only in the future consequences of current investments.

How can we deal with these biases? Dan Ariely, professor at Duke University who has done extensive research in behavioural economics, recommends treating your total portfolio as fresh capital whenever you want to make important investing decisions. Every time you are looking to sell your winning stocks or allocate fresh capital to bringing down average price of stocks at a loss, try to ignore the P&L of each stock. Factoring current information available, what are the best ways in which your wealth can be invested to ensure an optimal performance in the long term? Based on this approach, which stocks will you sell? Will you average your losers or will you allocate money to buy another new interesting stock?

This reflects a forward-looking approach to investing without being weighed down by past investing decisions (good or bad). The objective here is to progress versus the ‘previous day’. Not try to make up for losses made in recent months or years.

It is important to note here that, averaging loss making stocks is not all bad, if the market is mispricing it. This is one area where maintaining a journal and seeing how your original thesis fared can help. It will make you ascertain whether you mispriced the stock or market is mispricing it.

Test your System 2 against your System 1

The late Jesse Livermore was a legendary trader. More than 80 years after his death, he is still considered one of the greatest day traders and speculators, and his rule book for trading is widely popular and followed. At his peak, he was one of the wealthiest Americans, the wealth having been earned from his successful trading activities.

But by the time he died by committing suicide in 1940, he had not only lost his wealth, but had heavy liabilities as well. The reason being that his trades had gone wrong. Truly ironical that while he had one of the best rule books for trading or investing, he could not adhere to it all the time. Nothing can highlight better the difference between skill and ability to harness this skill as the life of Jesse Livermore.

Cognitive biases will continue to influence us to break our investing rule books. While the intensity may vary according to each individual’s core nature and circumstances, typically nobody is spared of this.

Hence, while at one end we should implement the disciplined approach of maintaining an investing journal and using a disaggregated approach to pick stocks, another step we can take is maintain two broking accounts. Allocate most of your capital to following the disciplined approach. Allocate a smaller portion to another broking account where you trade and invest without resisting your biases. Over a period of time, say, a year or two, see which portfolio is performing better and also, more importantly, which portfolio allowed you to sleep well at night.

Lessons from this approach can strengthen your rational side to keep your irrational side at bay when it comes to investing.