Here is a good artical to go with your post:
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 John's 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 one's 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 company's 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 couldn't stand it anymore and just
sold out for a huge loss. I knew I shouldn't be selling, but I just
couldn't 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 one's real
or emotional losses and integrating that knowledge into one's 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. EOM |
