Michael J. Mauboussin: On Avoiding Investor Pitfalls
Excerpted Introduction (Via Expectations Investing)
We can analyze investor behavior either at a collective or an individual level. Collective behavior deals with the potentially irrational actions of groups, and is typically associated with “excessive” market swings.3 Evidence includes investor herding and price bubbles. Herding is when a large group of investors make the same choice based on the observations of others, independent of their own knowledge.4 This massive social imitation can occasionally lead to inefficiencies—i.e., discernable gaps between value and price. A price bubble, often the result of herding, is the part of an asset price movement that can’t be explained by fundamentals.5
These collective behavior phenomena are interesting to the extent that they create profitable expectations opportunities for individual stocks. But taking advantage of collective irrationality, either for a specific stock or for the market as a whole, is difficult. Since most humans have a strong urge to be part of the crowd, acting independently is a tough assignment. Furthermore, the crowd is often right. So being a contrarian for its own sake is an unlikely path to investment success.
Additional Excerpts (Via Expectations Investing)
Five Pitfalls to Avoid
1. Overconfidence—acting as if you are smarter than you are.
2. Anchoring and adjustment—being affected by what data are presented.
3. Improper framing—being affected by how data are presented.
4. Irrational escalation of a commitment—compounding past errors.
5. Confirmation trap—justifying a point of view.
1. How do you avoid overconfidence?
· Try not to overestimate your abilities. Know thyself.
· Allow for a “margin of safety.”
2. How do you avoid anchoring and adjustment?
· Realize that past events or prices are signposts, not answers.
· View the decision from various perspectives.
3. How do you avoid improper framing?
· Remind yourself of your long-term, fundamental objectives.
· Try to reframe the issue in different ways.
4. How do you avoid irrational escalation of a commitment?
· Consider only future costs and benefits.
· Consider the perspectives of those not involved with the initial decision—they
tend to be dispassionate.
5. How do you avoid the confirmation trap?
· Play devil’s advocate at all times.
· Be honest and objective.