Intro
Disclaimer: Your writer (CHAN Yong) recently joined Star Magnolia and prior to that was navigating the world of capital allocation while investing for his family. While views and investment-related examples expressed in this article are in sync with Star Magnolia Capital’s investment philosophy, they are wholly from your writer’s personal investment journey and should not be taken as investment advice.
Thinking back, some of my worst mistakes in my personal investment journey (and in life, too) typically involved being overwhelmed by psychological or emotional factors at some point. As I devoured books on famous investors, I interestingly found that several of these bright minds had also spent quite a bit of time discussing the role of emotional discipline, temperament, and the whole spiel about 'knowing yourself.' Investing seemed like an art form that wasn't purely about who had the greater intellectual horsepower but about the awareness of one's psychology. More specifically, defending against mental biases.
As the discussion around mental biases gains popularity, it's no surprise that more people are getting acquainted with concepts like loss aversion that help explain irrational human behavior. While these ideas are compelling and relatable, applying them to everyday tasks can be impractical. Who has the time and energy to consult a checklist of these mental biases when buying a refrigerator or a standing desk?
However, it's worth considering reserving this mental discipline for more significant tasks, ones that will have long-lasting effects on your life. These decisions often revolve around education, insurance, and, especially, financial investments. Charlie Munger suggests a simple yet effective approach: using checklists, similar to how pilots train in aircraft simulations, to continually practice skills we can't afford to lose. As allocators, I would argue that being adept at navigating one’s own mental biases is a matter of financial and professional life or death.
Munger’s influential essay on “The Psychology of Human Misjudgment” is a perfect place to start as he distills decades' worth of experience into a list of 25 psychological tendencies that he thinks everyone should incorporate into their vocabulary. Even though Munger wrote that essay with the broader aim of helping us get through life making fewer dumb mistakes, it is not difficult to extend similar principles to our investment decision-making.
The list below is a condensed version of Munger's original list, tailored to various investment-related contexts. The goal here isn't to convince you to follow this checklist verbatim but rather to raise awareness of psychological biases that might lead to suboptimal investment decisions. Even if you're already familiar with these concepts, I hope that my examples and experiences will help you discover new ways to apply them in your role as an allocator
(*) Charlie Munger’s essay “The Psychology of Human Misjudgement” is found in Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger (2005)*
Body
This list of psychological biases can be a useful foundation for creating your own checklist for making investment decisions. It's important to note that there is some overlap among these ideas. Nevertheless, organizing them in this manner remains beneficial, as particular psychological biases may become more apparent and recognisable in specific investment situations.
1. Liking / Disliking Tendency
We typically ignore faults of and comply with the wishes of people whom we like. We sometimes also favour people or products merely associated with the object of our affection (e.g. political affiliation, role models, education background). Consequently, we have to be even more wary of being too trusting of people who have highly similar and aligned views. On the flipside, we might dislike people or products associated with our object of dislike. In this case, we might deliberately be blind to virtues of a particular person or even distort facts to facilitate further dislike
Such biases may be further compounded when the counterparty does us a favour which might influence us to feel compelled to reciprocate. Feelings of reciprocation that arise from instances like a fund manager being lenient on certain investment terms may cause us to have an overly favourable impression of a manager or compel us to be more lenient in our decision making process
While leading a previous investment in a Chinese manager, my Principal was quick to be enamoured by how the firm was currently focusing on the same country where he made most of his wealth and even how practically the entire firm, both the investment and operations side of things were run by professionals of Asian descent despite being based in the US. Furthermore, investor relations went out of his way to converse in Mandarin with my Principal. Even though the counterparty didn’t speak perfect mandarin, this Principal was someone who strictly requires Mandarin to be spoken at home, and as expected he was thoroughly appreciative of the counterparty’s efforts. Needless to say, this smoothed the investment process. The cherry on top was how the manager was also willing to be flexible with our funding horizon out of goodwill, which led us to feel that the counterparty was doing us a favour considering that the fund’s terms were portrayed relatively strictly from the outset
Overall, be careful of being too trusting of people who have highly similar or aligned views with you.
2. Anchoring Bias
The mind does not immediately think in terms of absolute scientific units but in terms of contrast and relative evaluation Needless to say, this tendency can lead to significant errors in thinking and decision-making. On a trivial level, it can result in us making purchases that we later regret, such as buying an expensive leather dashboard simply because it seems low-priced in comparison to a more expensive car. On a more significant level, it can lead to life-altering decisions, such as marrying someone considered suitable only in contrast to terrible parents or making suboptimal choices in successive relationships.
Perhaps on a more relatable note, we see this tendency being exploited in sales and marketing, where sellers create artificial high prices to make their regular prices seem like significant discounts, often influencing purchasing decisions. In a more extreme example, we might ignore small steps toward disaster - because each step presents a small contrast from our present position.
Perhaps the most pervasive form of such a bias is when an investment manager presents a benchmark highlighting how the fund has clearly outperformed an index over a period of time. However, this benchmark may not be entirely suitable to begin with, especially if there isn’t a readily available index for the type of investment the fund is making. By anchoring your expectations to a clearly “underperforming” index (which may not even be investible), you might be biased to think that the manager is really capable.
You could even make the case that indexing or benchmarking was a technique developed in recent history when it became easier to calculate widely accepted benchmarks, even at more granular levels such as sector benchmarks. This stuff simply didn’t exist 40-50 years ago and we still have an older generation using Dow Jones as a benchmark of the US stocks.
Consequently, you might have to put in the extra mental effort to snap yourself out of thinking that the presented index is your opportunity cost of investment. Be wary of being distracted from considering other investable or accessible opportunities, including adding to existing holdings or managers within your portfolio. For major decisions such as allocating capital that may have irreversible consequences, it is paramount to just take a step back and ask ourselves - do the comparisons that go on in our heads make sense?
3. Doubt-Avoidance Tendency
Man’s brain is wired to quickly remove doubt by reaching a decision, which is a useful evolutionary trait in life-threatening scenarios. This tendency can be traced back to the evolutionary history of humans and our ancestors, where swift decision-making was crucial for survival, especially when facing threats from predators. An unthreatened man on the other hand, who is thinking of nothing in particular, is in a state where his mind not prompted to remove doubt through rushing to some decision. Even though life-threatening predators are out of the picture, we can still, according to Munger, fall prey to this doubt-avoidance tendency in moments of stress and puzzlement.
In the past while I looked hedge funds or pod shops that used complex short-term oriented trading strategies to generate impressive risk-adjusted returns, I found myself being more accepting of the level of opaqueness and complexity of some of these strategies. I was simply convinced that I would never understand the black-box-like strategies that these managers were employing. To make make matters worse, I was informed by the placement agent that allocations for this manager were overall limited in size and were historically filled up within 30 minutes on the actual order submission day.
Puzzled at the opaque-but-impressive returns and stressed out by the overwhelming fear of losing the opportunity to invest, I remember being so compelled to make a commitment at the earliest opportunity
While an encyclopaedic knowledge would have most certainly enabled me to ask better questions and gain better understanding of the investment opportunity, one should generally be wary to pull any trigger on an investment commitment when the time pressure is on. Without understanding, it is hard to develop investment conviction - and without investment conviction, one will likely succumb to panic or emotion-driven decisions post-investment when things don’t go as expected.
4. Status Quo Tendency
Why is it that preventing bad habits is generally easier than changing them? More generally, what is behind our brain's reluctance to change established habits, beliefs, and conclusions?
One theory is that this tendency might have been an evolutionary product to facilitate quicker decisions when speed was essential for survival and also aid cooperation within social groups as consistent responses were easier to coordinate. Other areas where we can see this ‘stickiness’ to the status quo include one’s prior conclusions, human loyalties, identity or even accepted role in society. Such biases that arise from staying comfortably within a status quo is exacerbated with social proof or surrounding ourselves with people who agree with us. This tendency can lead to errors in cognition, where we might cling on to our initial conclusions despite evidence to the contrary.
For the most part of my investor journey I had always worshipped Value-investing of the Buffett & Munger persuasion and studied their approach and managers who followed their school of thought closely. Consequently, I became quite narrow-minded when it came to recognising the merits of other star managers operating in different realms like venture capital, hedge funds, and buyouts.
I struggled to acknowledge that there were alternative methods or processes to achieve substantial absolute returns over extended periods. In hindsight, the habitual way of looking at everything through the Buffett/Munger lens was akin to the proverbial frog in a well (井底之蛙). Worst still, I was surrounding myself with ardent followers of this camp, essentially creating an echo chamber for myself and this investment philosophy.
5. Loss Aversion
Behavioural economists have popularised the concept of ‘Loss Aversion’ where Man normally reacts with irrational intensity to even a small loss or the prospect of a foregone opportunity. In other words, individuals appear to be psychologically wired to be more averse to losing something they already possess than they are motivated by acquiring something new.
This cognitive bias has significant implications for decision-making, as it can lead to risk-averse behavior and a reluctance to take actions that might result in losses, even when those actions may be logically beneficial in the long run. This tendency can be observed in scenarios in gambling and auctions where people pour in more resources in a desperate attempt to recover the existing loss or the perceived loss of an opportunity respectively.
Needless to say, such circumstances are widely prevalent in investing too. I’ve succumbed to this tendency in various ways in my investor journey. From committing to invest in a fund due to time pressure but more fundamentally out of fear of a missed opportunity (example in Doubt-Avoidance Tendency), to holding onto losing stocks, and even selling winners too soon. The common thread I faced in each scenario was a type of irrationality that accompanied an overwhelming sense of emotion to act without a desire to reasses any facts.
While emotional awareness and mindfulness are desirable qualities to combat this tendency, a more practical but boring approach might involve forcing yourself to go through a short checklist-like exercise to give yourself a chance to at least practice some form of reasoning before being compelled to make that snap judgement. Many prominent investors have also warned that the market will eventually ‘test you’ and this is where I’ve learnt, through unfortunate experience, that a lack of understanding or conviction about a particular investment will mercilessly amplify the psychological tendency of loss aversion.
6. Over-focusing on what is available
This is a cognitive bias that underscores how the human mind tends to prioritize information and decisions based on what is readily available or easily accessible, often overestimating the significance of this information. Taking a step back, it seems apparent that an idea or fact is not worth more (or more true) merely because it is easily available to you.
This tendency might be due to the brain's limited capacity and its overall reliance on what it can remember or what is readily recognized. One may use this tendency to his advantage to persuade someone else to reach the correct conclusion or enhancing one’s own memory by attaching vivid image associations.
During the due diligence process, a common scenario where this bias can affect allocators is when we are first granted access to a data room. Without a well-defined checklist outlining our requirements from the manager, we might fall into the trap of framing our questions purely based on what might be a deliberately limited set of information disclosed by the manager. For instance, a manager might present meticulously crafted case studies of their current portfolio holdings, demonstrating their expertise in these areas. However, it's essential to question how well we truly understand their knowledge about other investments in the portfolio that didn’t make it into case study materials.
Generally, to combat this bias, it might be prudent to implement procedures like checklists, searching for disconfirming evidence, and seek input from skeptical individuals with diverse perspectives. In our manager evaluation example, we might wish to prioritise asking questions about portfolio holdings or aspects of the manager’s operations that were disclosed only in brief details. I believe (cynically) that what is openly presented is likely carefully curated and polished, making it vital to be discerning about what remains unspoken or unshared.
7. Overvaluing authority
The tendency or inclination to follow leaders and authority figures might be a product of deep roots in our evolutionary history, as humans have typically self-organized into dominance hierarchies. In such hierarchies, the majority of individuals follow leaders, with only a select few assuming leadership roles. This hierarchical structure is further reinforced by cultural norms and societal structures that encourage people to follow those in positions of authority.
While this natural tendency to defer to authority figures has its merits in ensuring social cohesion and cooperation, it can also lead to significant cognitive errors. One key challenge arises when the authority figure is wrong or, even worse, has exploitative goals. However, it is useful to have the mind to recognize and call out foolish instructions or charlatans who might be maliciously misleading others.
When dealing with investment managers, particularly those specializing in niche or emerging areas, it's common to rely on their expertise to understand the compelling nature of their chosen investment domain. However, it's crucial to avoid automatically perceiving these managers as authoritative figures with deep insight, given their vested interests in the context. How do we then guard against potential charlatans?
To mitigate this, we should scrutinize the fundamental premises upon which these authoritative figures build their cases. In an investment context, we should diligently assess how a manager presents the attractiveness of the opportunity set. Even if the initial premises seem highly factual, it's imperative to question the logical connections and arguments that follow. Often, managers may attempt to make these connections appear obvious and self-explanatory, leveraging their authority to garner trust.
For example, an investment manager with a decade of experience investing in Southeast Asian startups might highlight favorable regional-level statistics such as GDP projections, high mobile penetration rates, and youthful populations as factors supporting the growth of substantial unicorns in the region. While these premises might be undeniably factual, they overlook the region's diversity, including differences in consumption habits and the challenges startups face when expanding across borders.
Another example would be how a manager might make the argument that they have an attractive opportunity set because they are specialist venture capitalists looking to make seed-stage investments in AI-enabled healthcare solutions in Latin America - a space with close to no investor competition. We should then question why this space is uncrowded to begin with. The pitch is analogous to saying that a fusion Japanese-Texan-French restaurant will succeed in a crowded downtown area because it is offering a one-of-a-kind cuisine.
By critically identifying and assessing inherent arguments when an ‘expert’ pitches an investment idea, investors can avoid falling prey to superficially convincing but ultimately flawed arguments.
Conclusion
While all of these might seem informative, I can’t stress the importance of relating the above lessons to your own experiences, investment-related or not.
In my behavioral economics classes, I explored human irrationality and mental biases. Initially, I believed I was immune to these pitfalls, failing to see where I might have fallen prey to them before. However, recognizing and admitting to our biases is crucial. Our ego can sometimes blind us, but by acknowledging our past mistakes, we truly understand and apply the lessons from these lessons.
While grasping your own behavioral biases alone won't transform you into a stellar investor, it may, at the very least, steer you away from potential disaster on your investment journey.