Behavioral Edge

To err is human. Except, in investments, errors end up lot more expensive. In most cases, esp. in listed space, such errors are more often caused by emotional short-circuitry than any intellectual shortcomings. Emotional handicaps often occur because of mind’s inherent nature to magnify events that are current and immediate while short circuiting other material events that may not be current. To understand this better, we can try modeling this in a algorithmic fashion. Imagine, we have a computing algorithm that magnifies micro inputs using self-feeding feedback loop and throws magnified outputs based only on “recent”, but minor events, bypassing other rational “past” material inputs. This model would effectively mimic the emotional brain with a behavioral bias.

Investment decisions are supposed to be rational and logical. But in reality, they are anything but that. If investors are rational, then, markets which are nothing but collection of investors, by definition have to be rational. Since we know markets are irrational, we can deduce that investors suffer from significant number of delusional defects that deter them from making sound logical decisions. Though there is a separate stream of finance, called behavioral finance, covers extensively on the various types of cognitive biases, we would like to look at closely one bias that has an outsized impact on investment results.

To understand this special one more, let us look at two investment options in the below illustration and check how investors respond to this situation.

BizNotes_April18

The choice is straightforward, if investors are logical. They should go with option-1 and accumulate/add on every fall. But in practice, what many studies have found is, much of the times, investors chose option-2. What is going on here? It is interesting to note that the emotional circuitry (blind-spots) edges out the logical circuitry in all those cases. Let us examine these blind-spots little more, by looking at the list of behavioral biases that are at play in this decision making:

• Loss aversion bias, even though loss is notional.

• Fear of more downside.
• Recency bias where mind gives more weights to short-term events.
• Tendency to over-estimate one’s ability to time the trend change.

As someone wise said, how one behaves near the top and near the bottom makes all the difference between success and failure in investing. If one has the ability not to freeze into inaction at the edges, then it brings real competitive edge in this business. This means, one has to constantly hone the emotional skills to deal with the greed of making more near the top and to deal with the fear of losing more near the bottom.

Logically speaking, both should be easy because both upside and downside are notional near the edges. But emotional short-circuitry magnifies the greed and fear so as to blind the logical circuitry. Large part of success in investing comes from how one deals with these inner demons that distort the decision cycle thro’ behavioral bias. Edge in investment business comes from simple emotional skills (EQ), not from any intellectual ability to solve three dimensional complex algorithms.

“Moat in investment business comes, not so much from thinking skill, but from silencing the emotional circuitry i.e. honing emotional skills”

Current market weakness is throwing multitude of option-1 type opportunities for investors to grab. It is time to still the mind by silencing the inner demons to capitalize on the market capitulation, not to lose bearings on probable paper losses.

Happy Value Investing!!

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