Perception vs Reality: When a good story trumps rationality
Colins St Asset Management
Despite our best efforts, human nature dictates that in life and in investing we often find ourselves making irrational decisions. That's not to say that those decisions aren't reasonable, but instead that most people prefer to act 'reasonably' rather than rationally.
In the early 1900's a doctor by the name of Julius Wagner-Lauregg began testing the premise that a fever as treatment for certain ailments could dramatically reduce mortality. He tested his theory on patients with neurosyphilis and discovered that his patients (with an induced fever) had twice the survival rate of patients left untreated.
Dr Wagner-Lauregg went on to win a Nobel Prize in 1927 for his discovery before Penicillin was discovered and made his treatments redundant.
Nonetheless, his research clearly identified the healing properties of a fever, and its usefulness in treating illness. Yet, despite his discovery, and despite the fact that modern medicine recognises the fever's role in the healing process, I know very few people who wouldn't immediately offer their sick child Panadol at the earliest signs of an increased temperature.
The challenge is that what we know and how we feel are in direct conflict. We may recognise the benefits of the fever, but at the same time, we can't stand the thought of our child suffering. The same is often the case in investments. Even for those not speculating, for those who know the underlying value of a business, it's no easy feat to watch the value of one's holdings fall (considerably) and not feel the pull of the emotional pain of that loss.
The Cost of Loss:
Most parents and investors act reasonably in their avoidance of pain and suffering. Reasonably, but not rationally. Rational investment decision making requires one to look past how they feel about an idea, and instead focus on the numbers.
However, that is a concept far simpler in principle than in practice. You see, psychological studies have often found that the pain felt from an investment loss is considerably greater than the joy felt by a gain. In fact, that loss:gain coefficient is thought to be as high as 2.5x.
Take a moment for yourself as you read this now to consider what your own loss:gain coefficient might be.
Consider a coin toss scenario (a 50/50 toss).
Now consider a meaningful stake; a potential loss of $250,000 (for some that might be $200, or $2million).
How much would you need to be offered to win in order to risk losing that $250,000?
The psychology is very interesting, and within that psychology lies the vast majority of our opportunities as fund managers. Our role is quite simple: recognise those emotional drivers that push investors into irrational decision making, and when the difference between the reasonable and the rational is wide enough, to take advantage.
Keeping Things Simple:
Even in the face of identifying emotional behaviours in the market it's not enough. At the risk of stretching an analogy, there are plenty of tasty looking fruit on the tree, and common thinking seems to be that investors should focus first on those lowest hanging fruit.
We take a different approach. We don't want to pick fruit at all. Why stretch and stress when there are wonderful ideas already lying on the floor. I'd rather pick up a watermelon (investment idea) off the floor than stretch to pick an apple any day of the week.
And there are plenty of 'watermelon' ideas available to those looking for them. They aren't necessarily as exciting as the more complex highly prospective ideas, but they are simple, they are profitable, and there is far less chance of falling off a ladder (getting oneself into financial trouble) if you aren't climbing one.
"The fewer the steps between an idea and its success the better."
That may seem anecdotally obvious, but the numbers describe a very compelling story. Imagine for a moment that we were investing geniuses. So good are we at investing that we could accurately predict outcomes at a rate of 70%. Now by most accounts, a 70% accuracy rating in investing terms would generate extraordinary outcomes. Simply by predicting earnings outcomes would mean that we are right 7 out of 10 times, and no doubt our results would be great. But what if, on top of having to accurately predict earnings, we also needed to predict market growth rates, or margins, or the outcome of a strategy adjustment?
Well, if we need to predict two factors accurately to generate a positive investment outcome, our strike rate falls from 70% to (70%x70%) 49%! If we are required to accurately predict three factors to generate a positive outcome, that rate falls all the way down to 34%.
The more decisions we need to get right, the lower our strike rate. And from what started off as an enviable and impressive 70% very rapidly deteriorates to getting things wrong more often than getting them right.
It's not just unnecessary to invest in complex ideas, it's hubris to think that we as investors have the capacity to know the full impact of each variation and how it may play out in markets. Recognising the importance of keeping things simple truly is the ultimate indication of investing sophistication.