To thine own self

We have covered in the previous sections of portfolio management topics including investment framework, time horizon and position sizing. We now focus on perhaps the most important aspect of successful investing: behaviour. How can we instil discipline into our investment framework? Investor time horizon and behaviour are intrinsically linked. For instance if the market sells off aggressively on the back of a disappointing set of earnings announcements do you react or do you sit on your hands? If it’s the latter, then you may be better suited to more strategic, longer-term investing given you have the discipline to hold your nerve. A period of self-reflection is important for most investors and like life you learn a whole lot more about the nature of your character when the market is slumping than when it is making higher highs. Crucially, we must ask ourselves a simple question: is this market noise or has there been a visible shift in the factors determining our longer-term view.

I have read the famous Market Wizards book by Jack Schwager a number of times. It is a fascinating read and I always learn something new. There are five key lessons that I have take from studying these super-investors/ traders:

  1. Robust Risk Management is central to everything
  2. A healthy dose of humility and self-awareness is crucial
  3. Losses are simply the cost of doing business – just don’t make them terminal
  4. Do your homework – The markets are a wasteland for those looking for the quick $
  5. Investor Psychology distinguishes the super-trader from the average trader

Without exception, legends of the investment world including Ed Seykota, Marty Schwartz, Richard Dennis and Bruce Kovner pointed to human psychology as a major contributing factor to investment success. In this couple of paragraphs we take a closer look at some of these behavioral biases so we are better prepared to recognize them in ourselves.

Behavioural Models

There are two key questions that behaviour models need to address:

  • Why does mis-prising persist in the market?
  • How do noise-traders survive in the market?

The phrase the “price is right” is short-hand for the efficient market hypothesis. However in some Behavioural models prices do not equal fundamental values – Why? The rational traders are inhibited in some way from arbitraging away any mis-pricing caused by the noise traders.

Beliefs and Preferences

Psychological experiments tend to show that individuals make systematic mistakes. I have compiled a list of the more common examples below:

  • Investors tend to overreact to new information
  • Investors tend to extrapolate past price trends
  • Investors are also over-confident and take on excess risk
  • Individuals seem to attach too much weight to recent data
  • Individuals are susceptible also to the gamblers fallacy
  • Individuals are also susceptible to anchoring and memory biases
  • Most notably investors are susceptible to loss aversion

It is instructive to dig a little deeper into just some of these examples

Loss/ Risk Aversion – Ellsberg Paradox

Numerous experiments have shown that individuals do not follow the basic axioms of expected utility theory. The most famous experiments were conducted by Savage (1964). In short there are two boxes each containing a mixture of red and blue balls presented. You are told that box A contains 100 balls with 50 red and 50 black. Box B also contains 100 balls. We are not told how many are red and how many are black. You are told that you have the opportunity of winning $100 if you reach into one of the boxes (without looking) and choose a red ball. The facilitator has one simple question: which box would you choose? The majority will opt for A.  Lets continue. Using the same boxes, the facilitator advises that you will receive $100 if you draw out a black ball. Now which ball will you choose? Most likely it will be A again. This is fascinating and illogical. In the first round you assumed that B contained fewer red balls and more black balls. If you are rational you should opt for box B this time around. The research indicates that we favour ”Known probabilities (Box A) over Unknown probabilities (Box B)”.

The impact of Loss Aversion on lifetime utility clearly depends upon the frequency with which investors monitor their portfolios – i.e. the more often that an investor reviews their individual portfolio holdings then the more likely they are to experience negative periods.


  1. On average, about one third (32%) of the participants who were placed in this situation went along and conformed with the clearly incorrect majority on the critical trials.
  2. Over the 12 critical trials, about 75% of participants conformed at least once, and 25% of participants never conformed.
  3. In the control group, with no pressure to conform to confederates, less than 1% of participants gave the wrong answer.

Apparently, people conform for two main reasons: because they want to fit in with the group (normative influence) and because they believe the group is better informed than they are (informational influence).


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