Investing: The Art Of War

The Efficient Market Hypothesis (the basis for a lot of thinking about economics in general, and investing in particular) is built on a number of assumptions — one of which is that those participating in the market are rational, and make decisions based on an objective assessment of risk and reward. A growing number of investors question this assumption, and make a convincing case that there are times when the market and its participants are anything but rational.

Those who believe that the market isn’t as efficient as it’s made out to be, argue:

1. Emotion and irrational thinking can cloud your judgment as an investor,

2. These same forces can distort the market as a whole, and

3. You can avoid, or even profit from, the common mistakes of others.

Know Thy Enemy, Know Thyself

A slim text from ancient China called The Art of War has been used in military academies for decades. But when Michael Douglas’s character Gordon Gekko quoted the book in the movie Wall Street (“every battle is won before it is ever fought”), sales of the book soared. Suddenly political strategists and business gurus were quoting a Chinese general who walked the earth 2,600 years ago.

Investing is its own kind of war, and there is an art to that war. Investors would do well to pay close attention to another quote from the book: “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

Our first instinct is to think of any war as a battle against an outside opponent. And, in the case of investing, a battle against other investors, the market, the odds, conventional wisdom. But it is first a battle against ourselves. Or, to put it another way, a challenge to understand ourselves and how we react to uncertainty.

A central theme of this chapter (and something increasingly taught in the best business schools) is the brain function. The past few decades have seen huge leaps in neurological research. Particularly interesting, for our purposes, is research into how financial matters (thinking about money, worrying about money) affect the brain. By understanding our reactions to certain events and circumstances, we can avoid the same pitfalls that we and others have made in the past and will be tempted to make in the future.

“Animal Spirits”

Although human beings have been around for about 200,000 years, it wasn’t until about 11,000 years ago that our ancestors began making the transition from hunter-gatherers to what we now call civilization. And, while the environment we have built for ourselves has rapidly progressed since then, especially in the last few centuries, the human brain has evolved at a glacial pace. Our brains today aren’t much different from when we were hunting bears, fighting lions, and gathering crops.

We like to think of ourselves as beings of reason and logic, but our decisions are driven largely by instinct. How we behave in the world of finance and investing is no exception. John Maynard Keynes, a famed early 20th century economist who was well aware of this phenomenon wrote about what he called “animal spirits” — the “spontaneous optimism” driving markets and economies in good times. His observations anticipated contemporary research into how our everyday financial decisions are distorted by cognitive bias, overconfidence, and emotion.

Benjamin Graham wrote The Intelligent Investor years before anyone spoke about “behavioral economics”, but his investing philosophy was shaped by the tough first-hand lessons of the 1929 Crash and the Great Depression. He watched (and, like most people, lost money) while the market briefly rallied; crashed again in 1930; rallied again; and crashed once more in 1937. To drive home the human element inherent in investing, he wrote of the market not as a distant impersonal force but as an imaginary character he called Mr. Market — one subject to frequent mood swings, sometimes acting logically but, just as often, irrationally.

Slow and Fast Thinking

Behavioral economics is sometimes oversimplified as exposing the emotional underbelly of the so-called rational market. But it’s not as simple as pitting emotion and reason against one another. The truth is more complicated, and more interesting.

A leader in the field is Daniel Kahneman, a psychologist by training who found that his research into decision-making had a special relevance to economics and the stock market, and who would eventually go on to win a Nobel Prize in Economics. In his book Thinking, Fast and Slow, he identified two styles or modes of thinking. The first works quickly and intuitively, relies heavily on association, and is easily swayed by emotion. The second is deliberate, methodical, and logical — but also very slow. Neither is better, and we need both of them. Every day, every hour, we process huge amounts of information, and make hundreds of decisions, both large and small. We don’t have time to work through it all slowly and carefully, which is where our intuitive, instinctual thinking comes in to play. Intuitive thinking has emerged as an evolutionary necessity, and it’s spot on a good deal of the time.

But, because it relies on taking shortcuts, it’s also vulnerable to what scientists call cognitive bias — ways in which those same shortcuts lead us to flawed conclusions. Experts have detailed as many as 58 different varieties of cognitive bias that can lead to poor business decisions. Many stem from the “narrative fallacy” — the tendency of the brain to create coherent stories based on random facts, and to see cause and effect where there is none.

Behavioral economics is a fascinating area, and although we’ll touch on some of these biases as we go along, we can’t go into it in depth. Former trader and award winning author Nicholas Nissim Taleb’s book Fooled By Randomness is another important contribution to the field. But the bottom line, as Daniel Kahneman puts it, is this: “Learn to recognize situations in which mistakes are likely and try hard to avoid significant mistakes when the stakes are high.” We are most prone to mistakes in situations marked by a high degree of uncertainty. And, as you’re hopefully well aware by now, the stock market is chockfull of uncertainty.

Danger at the Top…

Our most important investment decisions will likely take place at the extremes of the stock market: when the market is riding high or when prices are sliding and panic starts to set in. These are precisely the moments when emotion and cognitive bias are liable to get the best of us. At these times, try to remember Sun Tzu’s motto, “Know thy enemy, know thyself.”

Our portfolios can go on an upswing for any number of reasons. Sometimes, we’re just riding the rising tide of the market as a whole. At other times, sheer luck plays a role. While there are always cases of portfolio managers outperforming the market each year, sustaining that performance over several years is another thing altogether. But, when our portfolio is doing well, we tell ourselves that we’re on a hot streak (what psychologists call the “Gambler’s Fallacy”), or we overestimate our own skill in picking investments — even though, more often than not, skill has little to do with it.

In a word, we become overconfident. Even seasoned businessmen and investors aren’t immune. Former General Electric CEO Jack Welch admitted he bought the brokerage firm Kidder Peabody (even though he knew “diddly” about it) because a run of successes had left him feeling lucky. And, in a phenomenon known as “chasing performance,” professional fund managers are often guilty of trying to ride the wave of a hot market by acquiring assets whose recent performance makes them appealing and popular — even when a more sober examination might reveal them to be overvalued. Chasing performance is sometimes a symptom of overconfidence and sometimes its opposite: doubt and insecurity. A fear of missing out can lead you to make a trendy investment without the necessary due diligence, or to jump on the bandwagon of a rising stock whose hot streak is bound to come to an end, probably sooner than later.

Additionally, overheated stock markets quite literally overheat our brain. In a study published in the journal Neuron, researchers using magnetic resonance imaging (or MRI) found that sudden financial gains stimulate the brain in ways similar to “euphoria-inducing” drugs like cocaine, and that these brain patterns also resemble those experienced during sexual arousal. Moreover, even the anticipation of such gains was enough to fire up the brain’s pleasure center.

… And at the Bottom

While greed leads investors to be overconfident (and thus over-purchase) during a rising or “bull” market, fear can paralyze those same investors during a falling or “bear” market. Interestingly, the brain reacts even more strongly to loss than to gain: the pain of a $100 loss is equal to the pleasure of a $200 gain. Kahneman calls this “loss aversion,” and it leads investors to be overly cautious during down markets.

The fear that grips many investors during a down market not only prevents them from taking advantage of bargain prices — it also leads them to hold on too long to a bad investment (which is different from riding out a dip in an otherwise solid investment). If an investment is radically underperforming its benchmark and similar investments, it might be wise to cut your losses and sell (and benefit from the tax write-off). But a common behavior is to rationalize holding onto a losing proposition because of the money and time we’ve already invested (the so-called “sunken-cost fallacy”), and because it hurts to admit a mistake.

Compound Psychology: Bubbles and Panics

When the market is calm, irrational decisions by individual investors might very well offset one another. In other cases, the effect of those decisions can add up in a cumulative way. And in more extreme cases, those decisions become mutually reinforcing. As Meir Statman puts it, “Sometimes our behaviors collectively compound rather than merely sum.” The result is a kind of herd mentality, producing bubbles on the upside and panics on the downside.

In a 1996 speech, then Federal Reserve Chairman Alan Greenspan used the term “irrational exuberance” to describe the collective optimism of the dot-com boom driving the stock market upward. Sure enough, that boom turned into a bubble and eventually burst. Several years later, Nobel Prize-winning economist Robert Shiller wrote a book of the same name about the forces of unreason in the market. In the book’s second edition, published in 2005, he openly worried about the bubble in the housing market — and two years later his worries were realized in the sub-prime mortgage crisis.

Bubbles inevitably burst, often producing panics in their wake. “Herds inflate bubbles, pumping stock prices far above their values,” Statman wrote, “and herds deflate bubbles faster than they have inflated them.” The net effect, is that individual investors commit more money to the markets as it rises and less as it falls, which is exactly the opposite of what investors should be doing. In other words, despite the well-worn adage to “Buy low, and sell high”… all too often, investors do just the opposite.

Staying Smart in an Often Irrational Market

Right now you’re probably wondering: If the market is so unpredictable, so subject to the influence of emotion, irrationality and herd behavior, how can I ever hope to succeed? All of the above is indeed sobering, and it is meant to be — like a cold, bracing splash of water to the face. But it shouldn’t paralyze you or discourage you from participating in the market, and even taking some calculated chances. You just have to be smart about it.

And being smart means, first and foremost, understanding the pitfalls that so many individual investors and even professionals fall for, and doing your best to avoid them. If you follow a set of guiding principles, you can minimize your mistakes, make more good choices than bad ones, and maybe even profit from the mistakes of others:

1) Be A Healthy Skeptic.

This is such an important point. In his book The Most Important Thing, Howard Marks stresses the importance of contrarian, “second level” thinking. This mean not going against the crowd just for the sake of it but looking critically at what seems to be the consensus point of view. You will outperform the market, he claims, only by being successful at “non-consensus” strategies[J2] .

A big part of being a healthy skeptic is being selective, and a bit suspicious about the media you consume. A good deal of media coverage of the financial markets appeals to the twin demons of emotional investing: greed and fear. Learn to identify and stay away from market reporting characterized by these two extremes.

2) Don’t Trust Forecasters.

An essential part of skepticism is a distrust of forecasters who almost invariably pander to our emotional response to the market. They tend to be either unbridled optimists, promising rich returns for modest risks, or doom-and-gloom pessimists. Whether they’re peddling hope or fear, stay away from them. As the famous economist John Kenneth Galbraith said: “We have two classes of forecasters: Those who don’t know — and those who don’t know they don’t know.”

Although some people credit him with predicting the collapse of the sub-prime market in 2007, Nassim Nicholas Taleb (author of Fooled By Randomness, The Black Swan, and Antifragile) isn’t a fan of making predictions. Instead, he argues for what he calls “non-predictive decision-making” — a stance that is very similar to Meir Statman’s advice to prepare rather than predict.

3) Know What You Don’t Know.

We began this chapter with Sun Tzu’s motto, “Know thy enemy, know thyself.” We return to it now because one of the most important kinds of skepticism is the one that is turned inward: at one’s own pre-conceptions and cognitive biases. A central insight of behavioral economics is our tendency to see cause and effect where there is none, to think we know more than we know. Guarding against this is crucial.

Even George Soros, one of the world’s great investors, with a cumulative rate-of-return that rivals that of Warren Buffett admits he is “overwhelmed,” by the persistent reality of uncertainty. “I’m constantly on watch, being aware of my own misconceptions, being aware that I’m acting on misconceptions and constantly looking to correct them.”

4) Avoid Impulsive Decisions.

Often, the most important decisions an investor makes occur when the market is at an extreme: in the grip of an optimistic bubble or a pessimistic panic. It is at those extremes when an investor is mostly likely to make a rash decision driven by emotion or cognitive bias.

Our vulnerability to impulse decisions can be gauged in part by how frequently we buy and sell investments. Overtrading is a common pitfall for both the individual, and the professional investor. The more we turn over our portfolio, the more we expose ourselves to errors of judgment. One researcher, Terry Odeon, found thatthe most active traders generally had the poorest results — and, interestingly, that men were more prone to such overtrading than women.

5) Stick To Process.

This might be the most important rule of the bunch. A clearly defined process, governed by simple but flexible rules and principles, is the best way to guard against impulsive decisions. Figure out your short-term, mid-term, and long-term goals– determine a set of sound principles for meeting those goals, and then stick with them. That doesn’t mean you don’t adapt and occasionally reconsider your strategy or realign your portfolio. (We’ll discussing portfolio rebalancing in the final chapter.) But it does mean you err on the side of buy-and-hold and stay away from overtrading — from constantly tinkering with your portfolio and trying to “time” the market just right.

For example: You might build an investment strategy around a core of index funds or ETFs that you think are strategic yet reasonably diversified. And, instead of trying to “play” the market and be smarter than you really are, you set up a schedule of automatic investments into those funds. You trust that a well-conceived system, over time, will be smarter than your day-to-day self.

Because in the end, as Ben Graham wrote decades ago, “investing isn’t about beating others at their game. It’s about controlling yourself at your game.”

…Part of this piece originally appeared in my investment book “The Millennial advantage: How Millennials Can (And Must) Be The Next Great Generation Of Investors….