15 Lessons in 2018


Circle of Competence, Decision Making, Expected Value, Filter, Investment Process, Opportunity Cost, Portfolio, Probability, Psychology, Risk / Wednesday, January 2nd, 2019

1. Experience may not be a good teacher

Most elderly who died in Hurricane Katrina dies not because of their health, but because of confidence and denial. They have survived several hurricanes over their lifetime, so they believe Hurricane Katrina is no exception. Experience can create a close attitude that prevents us from seeing things with a fresh pair of eyes when the underlying circumstances have changed. Hence it is critical to stay within your circle of competence. Have a good dose of humility by appreciating how much you don’t know. Always be skeptical about your own belief and beware of confirmation bias.

2. What to buy is overrated

We value action over inaction. We don’t like to look stupid for missing out on an opportunity as a result of doing nothing. We also believe more actions (actively buying and selling) increase return. But don’t confuse movement with progress. Far more money has been lost buying into bad ideas than missing out on great opportunities. Avoiding losses is paramount to the preservation of capital, which is the precondition to compound return. Know what not to buy is more important than know what to buy. This is where you need better filters.

3. Better filters, not more information

We don’t need more information, we need a better way to think, to have better filters. Filters separate the wheat from the chaff by isolating the signal from the noise so we can focus on those 1 or 2 variables that determine 80% of the outcome. My favorite filter is to ask yourself: Will this matter 20 years from now?

4. Leave your ego outside the market

In the market, it is not about being right or wrong or defeat, it is about making decision. We often become reluctant to sell a losing position because we equate it as failure and incompetence. We personalize the market and let ego creeps into our decision-making process. And the easiest way to personalize the market is to have an opinion about everything. You become interested in defending your own opinion instead of making the right decision. You confused net-worth with self-worth. So always ask ‘What if I’m wrong?’

5. ‘‘I don’t know’

No one likes to say ‘I don’t know’. It is a conversation killer. It makes one look stupid. But here are the benefits: You avoid personalizing the market because you don’t have an opinion on everything; it create open-mindedness—a chance to listen to the other side of a story; decision quality goes up because you don’t buy into bad ideas; it cultivate intellectual humility and willingness to learn; and you’ll treat your investment ideas as hypotheses that need to be tested instead of a trophy to be cherished.

6. Opportunity cost, not sunk cost

When making decisions, think in opportunity cost—the future cost of not taking an action, instead of focusing on sunk cost—what had been invested. Don’t let past decisions affect current decisions. One way to prevent sunk cost fallacy is to avoid loss aversion. We find it hard to sell a losing position because of loss aversion. We also become more risk-seeking hoping the share price will bounce so we can sell at a profit. Sunk cost fallacy also explains why we get into bad ideas after investing a considerable time researching it. Consider all the decisions you’re making as independent of the past.

7. The risk is on the characteristics of a man

Risk is not whether your money is on the sideline or in the market. but how you approach the market. If you enter the market looking for excitement, then you are gambling. You can still lose money sitting on the sideline just as you can exhibit crowd mentality sitting alone. If you are highly suggestible and always seek out opinions, ready act on emotion and impulse, then the risk is on you.

8. Have a plan

Most investors don’t know what they want to be. When the price is going up, they’re a trader “$9 soon, $10 target price!”; when the price comes down, they become an investor “Buy at the dip, I’m in for the long haul anyway.” Having a plan prevents you from changing your story to suit the market condition. Most investors lost money not because of a bear market, but because of changing the  story to rationalize bad decisions. Before entering a position, have an exit plan. Consider as many what-ifs scenarios as possible and what you will do when they happen. The question ‘should I hold or sell now?’ should be asked before you enter the market, not after the price has fallen.

9. Following the market opens the Pandora’s box of psychological misjudgment

Market news is sensationalism. Kind of like refined carbs that keeps you satiated but has little nutritional value. What is so bad about following the market? You’ll suffer outcome bias; misjudge risk and probability; promote short-termism; loss aversion; availability bias; illusion of knowledge; FOMO; crowd mentality; it is a cocktail of fallibility that lead to overconfidence behavior and excess risk-taking.  

10. Think in expected value

Expected value is the probable payoff of all possible outcomes. It tells you what is the payoff if you do the same thing over many times. Expressing beliefs probabilistically is not about trying to be precise. But to make it clear what those beliefs entail. Thinking in expected value prevents you from outcome bias and satisficing. You’ll consider alternative outcomes and focus on the magnitude of things rather than its frequency. What matters is not whether a stock is going to keep going up or down, it is what expected value is telling you. Betting on a rising stock that has negative payoff is like going to the casino, you might win a bit here and there, but do it long enough, you’ll go broke.

11. Nothing sedates risk as good as a bullish thesis and a rising share price

There is a fine line between the price as a source of information and as a source of influence. Checking the price every day irreversibly turn it into influence. And nothing lights up the prefrontal cortex (part of the brain responsible for risk-taking) as good as a rosy future prospect and a rising share price. You start using the price to do valuation and confirmation bias creeps into your decision-making process. Always be careful when you start thinking nothing can go wrong.

12. Value business you understand, not understand the business you’re valuing

Sequence matters. We tend to assume that we understand the business if we can ascribe value to the stock. But it is often the opposite: we started off with a set of presumption that the business is good (or bad) based on historical share price trend, earning track record etc and find supporting evidence (selection bias) to match it with our own beliefs. Always challenge your own thinking and stay within your circle of competence.

13. Don’t worry about a market crash

Why are we afraid of mass casualties (dread risks) from plane crashes, terrorist attack to market meltdown? Because they are outside of our control. The scale of destruction is huge and potential suffering is immeasurable. This is why media love selling these stories because it triggers our fear button. But the reality is this: you have a higher chance of losing money in everyday speculation than in a market crash. If you see something that is always on the news i.e market crisis then you shouldn’t worry about it. It is those things that don’t appear in the news that you should worry about. Because they happen so often that it isn’t worth mentioning!

14. Compare effectively and avoid narrow framing

When making investment decisions, compare it with the whole portfolio. The rule of thumb is this: The weakest investment idea in your portfolio is the benchmark for evaluating new ideas. A new idea is only a buy if it beats the portfolio’s least attractive idea in expected return. You shouldn’t buy a stock just because it is undervalued. It makes little sense to own an undervalued stock if it is your 50th best idea (ranked by expected return) when there are another 49 ideas that can deliver a better return. Keep your hurdle rate high.

15. Focus on things you can control

It is easy to get lost within all the market noise trying to control the uncontrollable. 80% of our time is spent on things we’ve little control such as checking the share price, obsessing over the outcome, or what others are saying and 20% on what should be the bulk of our time from refining decision process, meta-thinking, and review mistakes etc. If you can flip that around, you’ll have more focus, achieve a better return, and live a happier life.

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