OT
Thought this was a nice article
http://OTC Journal/
Avoiding Psychological Mistakes in Micro-cap Investing
By Dr. Richard Geist Ph.D. (View Bio)
Last month we discussed several psychological aspects of successful
micro-cap investing. Even more important than knowing how to succeed,
however, is knowing how to avoid the common mental errors that often
plague micro-cap investors. Far more money is made by avoiding mistakes than seeking out new and different ways of succeeding.
Under-performance as a Way of Life
Charles Ellis studied money manger performance records between 1970 and 1990 and found that 75% of money mangers under-performed the S & P 500 [source: Ellis, Charles (1993), Investment Policy. Business One, Irwin]. During the 1990s studies have indicated that this under-performance has continued to increase. More informal studies suggest that large numbers
of individual investors lose money in the market even when investing in highly successful mutual funds.
The obvious question inherent in these studies is why do so many
intelligent, competent, creative investors and money mangers fail to
outperform the market? The usual answers, from an individual investor
perspective, include: selling to early or holding on too long; lacking a consistent approach to the market, taking too much risk or not enough risk, listening to rumors, believing too many gurus, buying at the wrong price, etc.
What almost every experienced investor will admit, however, is that
endemic to these mistakes are deeper psychological forces that seem to
underlie most of the costly judgements of both Wall Street and Main
Street. In fact even Ellis, in offering advice to investors at the end
of his eloquent 1993 book, Investment Policy, suggests that we
"Concentrate [our] studies on human psychology (not on the numbers and
the financials) because most of the blunders we make are emotional, not computational errors."
Real Life Example: Express Scripts
John had a comprehensive fundamental grasp of Express Scripts (ESRX), a pharmaceutical management company whose stock had climbed steadily from its $13 IPO price to $30 per share. A profit taking correction ensued and the downside volatility left John anxious and injured. "I should have sold at $30; I knew it; my broker should have told me to sell" was the familiar lament. By the time the stock price retreated to $20, John was on the phone with his broker every hour to check the volume and price. He also heard several rumors that the company would fail to meet its earnings projections. At $19.50, he anxiously sold out. Several weeks later, as the stock price returned to $29, John could not understand how he had overlooked his knowledge of the business fundamentals of ESRX; "they would have clearly told me not to sell." (ESRX went on to appreciate to well over $100 per share).
Anxiety: cognitive fragmentation
John's experience illustrates one of the most important causes of
investor mistakes--anxiety. Most investors take for granted that over
the long run stocks will help us make money and hedge against inflation; after all, stocks have historically gone up 2/3 of the time. This complacent dependence on the market is deceptively unconscious. To obtain some perspective, think of the more dramatic complacency we feel about our dependency on oxygen. We don't scurry around worrying that there will not be enough oxygen for our next breath; rather we assume its existence and subjectively feel as though we are quite independent of our surround. Only when there is a dearth of oxygen do we experience sudden anxiety as our normally complacent state is severely threatened. The equivalent of oxygen depletion in the market is downside volatility. Any sudden market turmoil destroys our normally complacent market expectations and creates anxiety.
A common reaction to this anxiety is cognitive fragmentation--a lessened cohesiveness of our rational thought processes so that one is unable to think clearly and "holistically." One investor described it as analogous to a ball of mercury being dropped. What he meant by this is that fragmentation causes us to experience the world in bits and pieces, and one incomplete piece of information is frequently substituted for the whole picture. As in John¹s choosing to sell Express Scripts, what appears to be a rational decision often turns out to be flawed because it is based on the elevation of one isolated variable such as stock price to unrealistic proportions. Only after the anxiety is alleviated does one return to thinking about the whole picture of one¹s company, accompanied by the regret of selling.
Anxiety: cognitive regression
Another important consequence of anxiety is what psychologists call
cognitive regression--a retreat to an earlier mode of thinking where
words and thoughts are connected by emotions rather than logic. If, for example, you were asked to say the first word that came into your head when I say the word "mother," your association would probably not
include the dictionary definition of mother. That's because mother is an emotionally loaded word. When we experience anxiety, we retreat from thinking in our usual logical, rational, ordered way to thinking in a manner that is more magical, dream like, and emotional. In this
regressed state we are much more susceptible to rumors, tips, and
gossip; thus John was much more likely to believe the rumors about an
ESRX earnings shortfall. (As an aside, this is why short sellers can
take advantage of chat boards by creating enough anxiety to facilitate
investors becoming susceptible to believing negative rumors about a
company‹but more about that in another column).
The Disruption of Self-Esteem
When we select individual stocks for our portfolio, we are holding up
our skills and judgement for proud confirmation and validation. When we achieve investment success, we experience a pride and normal grandiosity about our decisions. When we encounter failure, most of us experience a sense of humiliation--the experience of having our mistakes exposed to public or private scrutiny. This is one reason that many Wall Street analysts would rather fail by recommending stocks that everyone else recommends than pick out of favor stocks and lose.
We all wish to have Mr. Market validate a healthy sense of self-esteem
and well being by confirming our investment judgements and skills. When the normal four-year-old jumps off the couch and says, "look at me I can fly" he is holding up his self for an adult's appreciation of his unique growth and development. When an adult attempts to "beat the market" he or she is engaged in the adult equivalent of exhibiting one's investing prowess. When the market goes against us, we frequently respond as if our personhood has been insulted. One major reaction to this injury underlies investor mistakes: the rageful blaming of others. Like the wicked witch in Snow White who turns to her mirror and asks: "Mirror, mirror on the wall who's the fairest of them all?" The investor whose market mirror fails to confirm his self-esteem often smashes it into fragments. Rage in these situations serves to revitalize a crumbling sense of power and efficacy.
Unfortunately the anger is usually directed at brokers, analysts,
company management, and friends. Thus one is likely to angrily sell a
stock because we felt that management let us down by not revealing some glitch in the company¹s progress. In its extreme form these rage
reactions to feeling personally injured frequently lead to frivolous
shareholder lawsuits, for accompanying this rage is a sense of revenge-- a need to get even. In the market, getting even means immediately making up for the loss. But such actions distort our capacity to discern the world from multiple perspectives; our only goal becomes getting even. In this vengeful state, the choice of the next investment will almost always lack the careful consideration of the first.
Investing in the context of Loss
Loss may seem like a strange emotion to consider in the context of
financial decision making, but volatility in the market tends to evoke
and then telescope past losses into the current situation. All human
beings experience both real loss of valued people and emotional losses.
If one has not resolved former real or emotional losses, there is a
tendency to blindly eliminate losing situations in the face of downside volatility. This is one reason many analysts down grade stocks after they have already tanked and why investors often sell at the bottom. They experience an almost panic like psychological urge to divest themselves of the psychological and paper position of loss without first understanding whether the fundamentals warrant such actions. Such mistakes frequently occur on anniversaries of former losses.
Common to those who have not resolved emotional or real losses is a
panic like feeling when a fundamentally sound stock begins a sharp
retreat. As John commented when ESRX was in a free fall, "I saw the
stock going down and down and down some more. All I could think of was
that I was losing everything. It brought back all the losses in my life. It got to the point where I couldn¹t stand it anymore and just sold out for a huge loss. I knew I shouldn¹t be selling, but I just couldn¹t
stand living with that feeling of loss. The monetary loss was awful, but it was such a relief to not think about losing that for a moment it almost made it (selling) worth it." Reflecting on one¹s real or
emotional losses and integrating that knowledge into one¹s investing
style not only alleviates much unnecessary panic; it also prevents
significant denial of loss when the market is volatile on the upside.
Avoiding important investment decisions on the anniversary of losses
also helps to avoid irrational mistakes.
Grandiosity
Dealing with success in the market is much more pleasurable than dealing with loss. But success still puts the investor at risk for erroneous judgement. The difficulties are often ignored until success turns to failure and we realize that a healthy profit was lost because our grandiose excitement went spinning out of control. Like Icarus who, with his newly found wax sings, ignored warnings not to fly too close to the sun and soon found himself falling quickly into the sea, the stock market frequently stimulates our grandiose fantasies, those akin to the flying fantasies of many children. Such normal grandiosity is often mistaken for greed, its pathological counterpart. But grandiosity is a powerful motivating force in all human life, and a particularly potent force to be reckoned with in the stock market. One of the biggest psychological risks in investing is being brilliantly right. It leads to overstaying positions and giving back a significant portion of one's gains so that excess returns regress to average returns. Institutions have contributed to this phenomenon by setting up a culture that rewards stars for being brilliantly right. Most of these rock star managers, however, like grandiose individual investors, usually have a dramatic fall from grace as they reach the height of their achievements.
Know your vulnerabilities
Every individual tends to develop patterns of mistakes. The more aware
you are of these patterns, and the more you study rather than dismiss
and deny your "mistakes," the fewer you will make.
1.Before making any decisions, check your anxiety level. Each person
experiences anxiety in different situations and through idiosyncratic
symptoms. Get to know your symptoms and try not to buy or sell stock if you feel anxious.
2.If you begin to make decisions based on only one or two variables,
stop and reconsider the decision making process.
3.When you feel anxious, realize you will be vulnerable to tips and
rumors. Avoid getting caught up in either negative or positive stories.
4.If you feel overly confident about your investing, be especially
careful with your subsequent investment choices.
5.Don't make investment decisions around the anniversary of an emotional
or real loss, even if it was ten years ago.
6.Try not to let your self-esteem be dependent on market success or
failure.
If you can avoid these common mistakes, your micro-cap success should
improve dramatically.
Regards
Norden |
