Fighting confirmation bias

As humans, we all prefer hearing things we already more or less agree with... depending on your politics, you'll probably intuitively prefer to listen to left-wing, right-wing, or "sensible center" speakers, for example. In addition (the actual "confirmation bias") if we hear some things confirming our previous beliefs, and some contradicting them, we're more impressed and likelier to retain the agreeing (and thereby agreeable!) ones.

As an investor, that's not the attitude that's going to prove most helpful to you (unless you're so psychologically fragile that you desperately need confirmation... but then, maybe you shouldn't be an investor in the first place!-). If you've already decided to invest in XYZ (and even more if you are already invested in it, since the "endowment effect" makes you value more what you already own), hearing one more good pitch about why XYZ is a great investment isn't going to help your decision-making that much. The most helpful thing would be hearing a pitch against XYZ: maybe the author makes some points you hadn't thought about, points out some iffiness in the financial statements that you might have overlooked and can prompt you to re-check them in a focused way, and the like.

Hearing your beloved XYZ praised to the heavens reinforces your self-worth and makes you feel happier and more self-assured, but in general it doesn't help your investment strategies and tactics anywhere as much as the painful task of hearing XYZ dragged to the floor and trampled upon. So, fight your confirmation bias! If you have limited amounts of time and attention (and, who doesn't?!), they're better invested in trying to puncture your tentative investment thesis than in looking for psychologically-satisfying confirmation that, yes!, you are a genius (as you always suspected, after all) for thinking of putting some money into XYZ in the first place.

This goes for strategies (how do I generally regulate my investment choices and timing) as well as for tactics (what do I buy, when do I sell, &c). Me, I'm essentially a "value investor" at heart, focused on fundamentals and on getting bargains that Mr Market is currently down upon -- so, I owe it to my portfolio to research and ponder the contrary theses of momentum investing and other technicals and market-timing oriented approaches, as well as the "pure growth" enthusiasts for which "price is no object", differentiation is "diworsification", and so on. Whether such study will turn my whole strategy and character on their heads is iffy, but if I set myself to the task with a critical and dutiful attitude, it can at least give me ways to correct some excessive enthusiasm for a "too pure" approach.

And, what do you know, it has -- just like pondering Graham's ideas about balanced allocation turned me away my initial enthusiasm for an "all stocks, all the time" Peter Lynch-ish approach (so I now stick with a no-worse-than-25/75-allocation rule), so did sufficient focus on Lynch, Motley Fool, &c, convince me to "pepper" my mostly-defensive stocks portfolio with 1/4 to 1/3 of carefully selected "growth" bets, for example (more of that anon...).

I still have to grok the charm of the technicals, though... and, I decided Investors' Business Daily is not worth the bother (I loathe their politics, but then I don't like the WSJ's ones any more... but, the latter I read, as the politics is easily skippable and what I get from what's left is not technoblabbering on stocks -- it's information, facts, pointers and opinions about businesses, a much better value for my money and time!-). I'm still at it (starting with the "Dow Theory", which, whether it works or not;-), at least makes more sense to me than most other chartisms... maybe only because it's been around for over a century!-).

If you're a technical/momentum &c trader by instinct, let me suggest you similarly owe it to yourself and your portfolio to get good, continuing exposure to "the other side(s)" -- value investing, mostly. Start with Graham...!-)

Investing vs Gambling

In current, unfortunate parlance, anybody who buys stocks or other securities is often called "an investor" (and the term easily spreads to such purchases as fine arts, ancient rare wines, gold coins, pure-breed horses...!). Back when Benjamin Graham was getting started, about a century ago, just about anybody operating in the stock market was often called "a speculator" -- indeed, the title of Samuel Armstrong Nelson's excellent 1903 book about stock investing was... "The ABC of Stock Speculation"!

Neither terminological confusion -- the traditional one, where stocks are inherently "speculation", and the modern one, where just about anything is "investment" -- is helpful. Much better, IMHO, to think of "investment" as being focused mostly on the patient, business-owner-like attitude I've been sketching in recent posts (summarizing part of Graham's great "Intelligent Investor" book), "speculation" as most of what is called "investment" today;-), and "gambling" for quite a bit of it.

In these terms, Graham has priceless advice...:

Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion - the smaller the better - of your capital in a separate fund for this purpose. Never add more money to this account just because the market has gone up and profits are rolling in. (That's the time to think of taking money out of your speculative fund). Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.

This has been precious practical advice to me, and I think it may be to you unless you're the exceptional kind of person who's really totally and utterly indifferent to the lure of gambling and "the madness of crowds" under all circumstances.

I'm not quite that good and wise (yet;-), so, had I tried to practice the ascetic optimum of "no gambling at all", I might well have succumbed to the excitement of some of the many small and large bubbles that the markets (plural, considering the international nature of investing, the many kinds of securities, commodities, futures, &c) typically are showing to some prominence or other at most times, and compromised my main investment funds and operations.

Thanks to Graham's advice, instead, I keep no more than 1-2% of my net worth in a small, separate "mad money" account, actively play with it, often over-trade with respect to what I know I should be doing (not a defect I'm entirely free from even in my "real" investment, but, going wild with it in the "play" account saves me from doing worse in the "real" one!-), trade naked options, use margin, short some stocks or commodities, and so forth. The 1-2% level is kept by occasional rebalancing -- in my case, not on a "timed" basis, but considered every time the total worth in the "mad money" account falls much below 1%, or rises anywhere above 2% (the latter trigger helps me intrinsically "get" the "time to think of taking money out of your speculative fund" that Graham mentions in passing;-).

As an extra, practical tip -- I've recently found options house quite suitable for this purpose -- low commission rates, decent execution, decently usable platform all around especially for complex options plays. As an added bonus, they even offer a free "virtual account" where you can simulate trading, speculating and gambling without actually putting any real money at risk (at least it helps learning their platforms and trying out weird options plays, though I admit that for the actual purpose of "getting the gambling craving out of my system" I'd rather have some -- albeit small -- amount of real money at stake... just like, differently from, say, bridge, poker is really no fun when played for beans!-). Having a completely different and separate platform for the small "mad money" account as compared to the larger "serious money" ones helps me psychologically, I think, to keep them completely "disjoint" in my mind, avoiding the "mingling" that Graham's great advice warns against!

Benjamin Graham's "Mr. Market"

Chapter 8 of Graham's book "The Intelligent Investor", "The Investor and Market Fluctuations", is a core one in the work, especially since most "investors" today take a stock's price as the sum total of the information that's needed about it, and thereby are totally enslaved to the market's fluctuations (one might partly blame the EMH for that, but the germ of that specific idea was widespread well before Fama reprised Bachelier's thesis in the '60s -- see point three of six in the classic Dow Theory, first elaborated by Dow in the 19th century, "The stock market discounts all news"... and of course Dow Theory, as an early form of Technical Analysis, is totally incompatible with the fully developed EMH!).
Graham's overall philosophy has become the core of what today is called the value approach to investing -- focused first and foremost on the value of the business whose part-owner you become by buying common stock (its underlying financial situation, its business model and competence in executing it, its investments and research and preparation for the future, its competitive "moats", and so forth), only secondarily on the stock's market price.
"Only secondarily" does not mean "no attention to price at all": a "price is no object" attitude, when buying securities, is neither sensible, nor at all "intelligent" (nor "prudent"!-). Rather, as Graham puts it, the simplest form of "pricing" "is the simple effort to make sure that when you buy you do not pay too much for your stocks", which represents "an essential minimum of attention to market levels". It's also OK to focus on the other side of the equation, possibly buying a so-so business if the market price is so ridiculously low that, despite its mediocrity, the business (and therefore the stock) is a bargain anyway... but that's nowhere as important as never, ever overpaying. The market's enthusiasm for a good business, even when fully justified, often goes way overboard and prices that business's common stock so high that -- despite the business's excellence -- not even in the rosiest, most optimistic scenario could buying or holding at today's price ever be a long-term win.
At the end of the chapter, Graham's introduces "something in the nature of a parable" -- an incredibly useful metaphor, because it's so vivid that it will easily stay in your mind and help fortify your willpower against unwise reactions to the market's inevitable fluctuations.

Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you found yourself in this situation, obviously a good strategy is to mostly ignore your friendly partner's babblings, except that, when he offers to sell you an interest for a ridiculously low price, if you have cash available to invest, it's a good idea to accept the offer, and buy from him, and, vice versa, when he offers to buy you out for a ridiculously high price, it's a good idea to sell to him.
Of course, to form your own judgment on when prices are ridiculously high or low, you need a sound judgment about the business's "fair" value -- but then, as a part-owner, you would be supposed to have some sensible ideas about that, no? Your general attitude as an investor should be no different... because, as an investor in common stock, you are exactly a part-owner of a business (with an obliging partner, Mr. Market, who's always ready to buy you out or sell you more, sometimes at sensible prices and sometimes at crazy ones).
To me, this simple fable, or parable, always proves helpful and soothing in fortifying my emotions somewhat against the natural herd responses of collective fear and greed -- to, instead, "be fearful when others are greedy and greedy when others are fearful", to quote one of Warren Buffet's best-crafted soundbites.

Benjamin Graham's "The Intelligent Investor"

My "investing philosophy" begins (though it doesn't quite _end_;-) with Benjamin Graham's popularization masterpiece, The Intelligent Investor (incredibly to me, I see the paperback edition is only $8.99 on Amazon as I write!-).

Unfortunately, the author who curated this "Revised Edition", Jason Zweig, is no Ben Graham -- I appreciate much of the work he's done to bring the work up to date for 2003 (Graham's own editions went from the first one in 1949, to the fourth one in 1973), but I object to a lot of what he adds to the text (I'm particularly fuming about his unthinking and wrong-headed condemnation of covered call writing in his sidebar at the end of his commentary on Chapter 16 -- but, that's a specific technical subject for another post somewhat in the future). Fortunately, he does leave Graham's text substantially alone, only adding footnotes and commentary -- some helpful, some, not so much, but, worst case, a reader _can_ just skip them!-)

I can't summarize this masterpiece within a post, but, if 600+ pages are too much for you, get it anyway and read just one chapter -- Chapter 20, "Margin of Safety" as the Central Concept of Investment (p. 512-524 in the paperback).

As for practical tips, start with the "General Portfolio Policy" discussed in Chapter 4 -- forget "Modern Portfolio Theory" and the utter idiocy of modern theories dictating your stocks/bonds split based on your age, or when you want to retire (totally ignoring the prices and yields of stocks vs bonds at any given time -- eep!-), and, instead, follow "the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds" (investments in other than negotiable securities -- real estate, commodities, art masterpieces, etc -- are totally outside the bounds of Graham's interests, as they are of mine in this blog; as are obvious but crucial considerations such as, pay off high-interest debts before you dream of "investing" anything, keep in ready cash any money you need -- or would need in an emergency -- for at least the next six months; and so on).

Graham makes extremely convincing points to support this simple rule -- convincing enough, that they easily convinced me (before reading and pondering them, I was convinced that I should have all in bonds when stocks are in a bubble, and vice versa; now, I'll never again stray outside the 25-75 boundaries). You should read and ponder the arguments yourself, but it boils down to two key points: no matter how accurately and closely you've analyzed the markets to convince yourself that stocks or bonds are in a bubble, still (a) you could be wrong, and, if that's unthinkable, nevertheless (b) the market might stay crazy for more and more years to come (before finally coming to its senses as it always does eventually) making you really sad about your timing; softening the most extreme allocation to 25-75 instead of 0-100 will proportionately soften the consequence of either issue, though it proportionately softens the gains from being right and "on time". Avoiding or reducing overall big losses is, in the long run, more important than achieving or enhancing overall big gains, and, you know that "the markets can stay crazy longer than you can stay liquid"...!-)

Case in point: by late '96, I had convinced myself that Mr Market (in stocks) was high into one of its manic periods, so I got entirely out of stocks and into bonds -- with the S&P500, as I recall, somewhere below 800. I wasn't too bad off in diagnosing the bubble... I was just way early in so doing, as S&P500 kept rising back up all the way to peaks over 2000 four year later (!). Had I kept 25% of my securities in stocks, and rebalanced once or twice a year, I would have been substantially better off, even though the S&P500 then crashed badly again to a low of 800 or so after another couple of years. Similarly, I've been convinced for a while that the bonds market is now in a bubble... but, nevertheless, keeping 25% of my securities in bonds (and rebalancing once or twice a year) lets me benefit from the fact that the market can (and often does) keep being crazy for years after dispassionate observers have called it out as being mad!-)

As for the details of how to invest in bonds -- I really can't be bothered much with the details, except for the obvious advantages (for US citizens or residents) of US Savings Bonds, which Graham already pointed out (they're the only bonds I know that are "callable by the lender" with little penalty, so if interest rates spikes you can sell your existing ones at essentially no loss and buy new and higher-yielding ones) -- each person can get about 5 or 10 thousand dollars' worth a year, so they won't fill your quota for bonds unless your overall holdings in securities are modest, and like all tax-advantaged investments make no sense in an IRA or 401K.

If, to reach your desired total of bonds, you need more than the amount of US Savings Bonds you can hold, or you need to keep some in an IRA or 401K, then reach for the bond ETFs (Exchange Traded Funds) of your choice to get the overall mix or differentiation you desire (US vs foreign advanced countries vs emerging countries, dollar-denominated vs other currencies, government vs investment-grade corporates vs junk bonds, mix of maturities, munis if you need to hold some in a taxable account, inflation-protected ((but never those in a taxable account!))... -- those choices depend too much on your personal situation and opinions; e.g., I want more exposure to foreign currencies than the typical US investor probably does, simply because I may decide after retirement to move back to Europe again... after all, I do retain my EU passport and citizenship, in the US I'm only a permanent resident).

With these investments, as well as any other "differentiation/diversification" plays you make in ETFs, I recommend a "set and forget" policy -- look at them only every 6 months or so when you consider rebalancing your whole portfolio of securities. Churning into and out of ETFs (or, for that matter, old-style mutual funds) makes no more sense than it does for common stocks -- even if your IRA and/or taxable account are with one of the growing number of firms that let you trade commission-free with respect to ETFs underwritten by the firm itself (e.g., my accounts with Vanguard have that feature). "Fund churning" is responsible for a huge loss for the many investors who practice it: many studies show that, while mutual funds overall way underperform a S&P500 index, individual investors in funds, in turn, way underperform "mutual funds overall" by an even worse margin: simple reason, too much fund churning in chasing the high-gaining fund of yesterday (which, by mean reversion, is unlikely to be the one you care about... the high-performing one of tomorrow!-).

My philosophy and approach is quite different for stocks, than it is for funds. But, more about that, and (separately;-) more about allocation, diversification, differentiation, and wonderful little tidbits or tips from Graham's masterpiece (as well as other books), in many future posts to come.