Investing is commonly seen as a field where analytical skills are paramount. However, the role of emotion is often overlooked and yet immensely influential. The reality is that emotional responses can have a significant impact on investment decisions, sometimes even overshadowing the most technical analysis. Legendary icons Buffett, Prechter, and Graham expressed:

“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”“Markets are driven by humans, and human nature is the same now as it was 500 years ago.”“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

We would like to thank James Montier for his work, ‘The Little Book of Behavioural Investing’, which has been a pivotal resource and the key inspiration behind this letter.

Empathy Gap

Human beings are not particularly skilled at predicting their own behavior in emotionally charged situations. This phenomenon, known as the empathy gap, often leads us to make impulsive decisions we later regret. This letter explores the concept of the empathy gap, its consequences, and the power of pre-commitment in mitigating its effects. We will discuss how understanding and managing our emotions can help us make better decisions, particularly in the context of investment.

The empathy gap is a cognitive bias that hampers our ability to foresee how we will act when emotions are running high. A classic example is the inability to imagine feeling hungry after a satisfying meal or overbuying groceries while shopping on an empty stomach. One striking experiment illustrates this concept: participants were asked to predict whether they would regret not having food or water when lost in the woods. The results revealed a significant difference in their responses based on when the question was asked. People’s predictions changed dramatically after they had experienced the physical strain of a workout, highlighting their inability to accurately anticipate their emotional states.

Think about March 2020 during the COVID crash. Many investors had carefully crafted investment plans, yet when the S&P 500 plunged 34% in just 23 trading days, these same investors abandoned their strategies. Why? The empathy gap made it impossible for them to accurately predict their emotional response to such extreme market conditions.

Procrastination is another manifestation of the empathy gap. It is the tendency to delay tasks even when we are fully aware of their importance. Many of us choose to complete tasks at the last possible moment, assuming we will maintain our productivity. However, this decision often leads to undue stress and subpar results.

Consider a scenario where a proofreader is tasked with reviewing a set of essays. They have three options: setting their own deadlines for each essay, submitting everything at the last minute, or adhering to predetermined deadlines. While the last-minute submission may seem tempting, research indicates that imposed deadlines are the most effective. In a study, participants assigned equally spaced deadlines achieved the best results and submitted their work with the least delay. Those who chose their own deadlines made more errors and were significantly later in completing their tasks. The worst-performing group consisted of those allowed to wait until the final deadline, who made fewer errors but were nearly three times later in submission.

To combat the pitfalls of the empathy gap and procrastination, individuals can employ the strategy of pre-commitment. This strategy involves making decisions and setting goals in a rational, calm state, unaffected by immediate emotions. One famous investor, John Templeton, provides an excellent example of this approach. He believed that “the time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” However, he recognized the challenges of buying during a market downturn when emotions were running high.

To overcome this challenge, John maintained a “wish list” of stocks he wanted to buy at specific price levels. He had standing orders with his brokers to purchase these stocks if the market experienced a significant sell-off, thus removing the emotional barrier to buying. This practice exemplifies the power of pre-commitment, as it allowed him to stick to his investment strategy even when faced with emotional turbulence in the market.

Fear

Investing in the financial markets often involves navigating emotional challenges, especially during periods of market turmoil. This section explores the impact of fear on investment decisions and the role of pre-commitment in managing these emotions effectively. Through the analysis of a simple game and real-life examples, we will delve into the psychology of investors facing market uncertainty.

Imagine a game in which you start with $20 and play 20 rounds. In each round, you have the option to invest $1, and a fair coin is flipped. If it lands heads, you gain $2.50; if it lands tails, you lose your $1. Logically, it is in your best interest to invest in every round, as the expected value is $1.25 per round, totaling an expected value of $25. However, when experimenters studied this game, they discovered that human behavior deviated from this logical choice.

Three groups of participants were involved in the study: one group with brain damage preventing them from feeling fear, another group without brain damage, and a third group with unrelated brain damage. The results were intriguing. The group unable to feel fear invested in 84% of rounds, while the “normal” group invested in only 58% of rounds. The group with non-fear-related brain damage invested 61% of the time.

Furthermore, participants who couldn’t feel fear displayed optimal behavior by investing more than 85% of the time after losing money in previous rounds. In contrast, the other two groups exhibited suboptimal behavior, investing less than 40% of the time after experiencing a loss. This suggests that fear can significantly impact decision-making, leading individuals to ignore opportunities even when they are in their best financial interest.

Surprisingly, the impact of fear on decision-making tends to worsen with time. When the 20 rounds were divided into four groups of five games each, the group unable to feel fear consistently invested in a similar percentage of rounds. However, the “normal” group initially invested in about 70% of the first five rounds but decreased to less than 50% in the final five rounds. This pattern suggests that, over time, individuals tend to make worse investment decisions when fear lingers.

The behavior observed in this game mirrors the behavior of investors during bear markets. The fear of losing money often causes investors to overlook attractive opportunities in the market, particularly if they have experienced previous losses. This fear-induced decision-making paralysis can become more pronounced the longer the market downturn persists.

However, it’s crucial to note that the game in question is designed to reward risk-taking, making investment a profitable choice. In contrast, if taking risks led to poor outcomes, the “normal” group would outperform those who couldn’t feel fear. This game serves as an analogy to bear markets with undervalued assets, where future returns are likely to be favorable.

A recent study explored how individuals’ reliance on different thinking systems influenced their decisions in the game. Those who relied on intuitive, quick-thinking (X-system) were compared to those who used logical thinking (C-system). The study aimed to determine whether individuals who depleted their self-control resources during a test (Stroop test) would make worse decisions.

When participants had not undergone the self-control test, both X- and C-system thinkers made similar investment decisions, around 70%. However, after the self-control test, those who heavily relied on their C-system continued to invest at a rate of 78%, while those who favored the X-system invested only 49% of the time. This highlights the detrimental impact of relying on quick, intuitive thinking when emotions are running high.

In March 2009, during a severe market downturn, investors faced extreme fear and panic. However, some astute investors recognized the opportunity amid the chaos. Jeremy Grantham and Seth Klarman, renowned investors, emphasized the importance of having a well-defined plan for reinvestment during such crises.

Klarman’s advice about the necessity of a battle plan for reinvestment exemplifies the power of pre-commitment. Pre-committing to a strategy during turbulent times can help investors overcome the empathy gap and fear-driven decision paralysis. By establishing clear guidelines for reinvestment, investors can avoid making emotionally influenced decisions that might lead to missed opportunities.

Hubris

Optimism is a prevalent trait among human beings, ingrained in our psyche and influencing various aspects of our lives, including decision-making. Whether it’s overestimating our driving abilities, job performance, or even personal prowess, most of us tend to view ourselves in a positive light. This optimism often extends to the world of investing, where individuals tend to have a sunny outlook on their own investment skills and the future of their investments. However, this optimism can lead to overconfidence and biases that affect our financial decisions. In this segment, we will explore the nature of optimism, its evolutionary roots, and the importance of critical thinking and skepticism in investing.

Optimism is deeply ingrained in our human nature. It is reflected in the fact that most people tend to believe they are above average in various aspects of their lives, whether it’s driving, job performance, or even lovemaking. This unwavering positivity is so prevalent that it is often referred to as the “Lake Wobegon Effect,” named after Garrison Keillor’s fictional town where “all the children are above average.”

When it comes to the financial world, optimism is equally abundant. A survey of professional fund managers and analysts revealed that a substantial percentage believed they were above average at their jobs and superior to their peers in forecasting earnings. This overestimation of abilities is not limited to the investment industry; it is a cognitive bias that affects people across various domains.

The optimism bias is often compounded by the illusion of control. People tend to believe that they can influence outcomes even when their control is minimal or non-existent. This phenomenon is evident in behaviors such as paying more for a lottery ticket with self-selected numbers, as if the act of choosing the numbers makes them more likely to win.

In the realm of investing, the illusion of control can lead individuals to believe that they have a significant influence over the performance of their investments. This belief is amplified when they experience early success, are dealing with familiar tasks, have access to a wealth of information, and are emotionally invested in the outcome. These conditions closely resemble those encountered in the world of investment, making it susceptible to the illusion of control.

Psychologists have conducted experiments to demonstrate the deep-seated nature of optimism. Participants were asked to evaluate statements about future life events, both positive and negative. When given sufficient time to consider these events, individuals displayed a clear bias towards optimism. However, when placed under time pressure, their optimism became even more pronounced, suggesting that optimism is a default response ingrained in the way we process information.

Neuroscientific research has also shown that when people contemplate positive future events, certain areas of the brain associated with emotional processing, such as the rostral anterior cingulate cortex and the amygdala, become more active. These areas are thought to be neural correlates of the X-system, the part of our cognitive process that operates under time pressure and emotional influence.

The origins of optimism can be attributed to both nature and nurture. From an evolutionary perspective, optimism may have served as a survival advantage for early humans. As our ancestors transitioned from a hunter-gatherer lifestyle to hunting large and potentially dangerous animals like mastodons, courage and optimism would have been necessary traits. Optimism may have helped them overcome the fear of pursuing such formidable prey.

Additionally, optimism might have offered benefits in the form of endorphin release. Endorphins, which produce feelings of euphoria, were likely released when early humans were injured while hunting. These positive emotions could have encouraged them to continue hunting and reinforce their willingness to face potential dangers.

While optimism can serve as a valuable life strategy, it can be detrimental when applied to investment decisions. Ben Graham cautioned against the dangers of over-optimism, emphasizing that investors often misinterpret favorable conditions as a guarantee of safety.

Investors must strike a balance between optimism and skepticism. Maintaining a critical and skeptical mindset is crucial when evaluating investment opportunities. Instead of asking, “Can I believe this?” they should adopt the mindset of asking, “Must I believe this?” Skepticism is the intellect’s safeguard, protecting investors from making irrational decisions driven by unfounded optimism.

Indiscretion

In the world of investment, there is a pervasive obsession with predicting the future. Whether it’s forecasting economic trends, interest rates, sector performance, or individual stock prices, many investors place undue faith in the accuracy of these predictions. However, as Lao Tzu wisely noted, “Those who have knowledge don’t predict. Those who predict don’t have knowledge.” This segment explores the folly of forecasting, the limitations of predictions, and alternative approaches to successful investing.

The investment industry often teaches investors to rely on forecasts, particularly in valuation methodologies like DCF analysis. In DCF, one must project cash flows far into the future and then discount them back to the present. However, the reliability of such forecasts is questionable. The overconfidence bias further compounds the problem. Even if an investor is accurate in their forecasts 70% of the time, requiring all forecasts to be correct results in a mere 24% chance of overall success.

Moreover, forecasts can only be profitable if they deviate significantly from the consensus. This adds complexity to the already challenging task of forecasting accurately. The evidence against forecasting is overwhelming, as demonstrated by economists’ inability to predict recessions and analysts’ consistent forecasting errors. Instead of futilely attempting to predict the unpredictable, investors should embrace alternative approaches. One such approach involves reversing DCF models to determine what growth rates are implied by current market prices. If these implied growth rates significantly exceed historical achievements, caution is warranted.

Bruce Greenwald’s method of comparing asset value to earnings power value offers a different perspective. It focuses on understanding a business’s intrinsic value and competitive environment rather than making predictions.

Howard Marks of Oaktree Capital suggests that investors can’t predict the future, but they can prepare for it. Rather than attempting to forecast cycles, investors should acknowledge their limitations and focus on understanding where they are in the current cycle. This approach acknowledges the importance of context without relying on precise predictions.

Discontentment

In the world of investing, information is readily available and abundant. We live in an age where data flows incessantly, and the financial industry is often obsessed with gathering more and more information. However, this segment delves into the notion that in the pursuit of knowledge, investors may fall prey to the illusion that more information is always better. It explores psychological studies that challenge this belief and highlights the importance of distinguishing the signal from the noise in decision-making.

Daniel J. Boorstin once said, “The greatest obstacle to discovery is not ignorance; it is the illusion of knowledge.” This quote resonates particularly well in the context of investing, where investors and professionals alike often suffer from an insatiable thirst for information. The assumption that more information is inherently beneficial can lead to misguided decisions.

Psychological studies have examined the impact of information overload on decision-making, shedding light on the limitations of human cognition. One study involved experienced bookmakers tasked with predicting racehorse outcomes based on 88 variables from past performance charts. These bookmakers ranked the importance of these variables and were then provided with data for 45 past races. Surprisingly, the study found that as more information was made available to the bookmakers, their accuracy in predicting race outcomes remained stagnant. Additionally, their confidence in their predictions increased significantly, despite no improvement in accuracy. This suggests that more information did not lead to better decision-making but made the bookmakers more overconfident.

This insight aligns with Warren Buffett's approach of focusing on businesses with "strong underlying economics, managed by honest and capable individuals, at reasonable prices." Sometimes, simplicity trumps complexity.

A similar pattern emerged in a study involving football fans with expertise in college football. Despite their knowledge, these experts’ accuracy in predicting game outcomes did not improve with additional information. However, their confidence levels soared as more information was introduced. Thus, the study revealed that confidence, rather than accuracy, increased with the amount of information available.

These studies highlight a crucial aspect of human decision-making: our cognitive limitations. Unlike computers, humans have limited processing capacity, which affects our ability to make use of vast amounts of information effectively. When faced with information overload, our decision-making can suffer, leading to suboptimal outcomes.

A study on car choice exemplified this phenomenon. Participants were asked to choose between four cars, with one clearly superior option. When provided with only four attributes per car, nearly 60% of participants correctly chose the best car. However, when given 12 attributes per car, the number of participants selecting the best car plummeted to around 20%. The overload of information led to poorer decision-making.

The lessons from these studies can be applied to investment decisions. Investors should be cautious about drowning in a sea of information and instead focus on what truly matters. Buffett emphasizes simplicity in his approach, emphasizing the importance of buying businesses with strong underlying economics, managed by honest and capable individuals, at reasonable prices. This focus on the essentials is key to his investment success.

Jean-Marie Eveillard stresses the importance of knowing “what three, four, or five major characteristics of the business really matter.” The critical takeaway is that investors should identify the key factors relevant to their investment approach and concentrate their analysis on these elements.

Conformity

Warren Buffett once remarked, “A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth.” This humorous but insightful observation highlights the tendency of individuals to conform to the group’s behavior, even if it means sacrificing their independent thinking. In this segment, we delve into the psychology of conformity, the pain of going against the crowd, and the essential qualities of a contrarian investor. Contrarians, who swim against the tide of popular opinion, are often the ones who achieve superior investment results.

Conformity is a deeply ingrained human behavior, where individuals often subjugate their own thoughts and beliefs for the sake of group consensus. To illustrate this phenomenon, consider the classic experiment where individuals are asked to pick a line that matches a reference line from a set of options. When participants are alone, they easily make the correct choice. However, when placed in a group where others unanimously select the wrong answer, a significant portion of participants conform and choose the incorrect option.

Psychological experiments have shown that people tend to conform to the majority view in group settings, even when they know it’s wrong. In such situations, the fear of going against the crowd often overrides logical thinking. Neuroscientists have found that conformity is associated with decreased activity in parts of the brain responsible for logical reasoning, suggesting that individuals stop thinking critically when they conform.

Moreover, going against the majority can trigger fear and even physical pain, as demonstrated in experiments where participants were socially excluded during a computer game. The brain regions associated with emotional processing and pain were activated in response to social exclusion, highlighting the discomfort that nonconformity can evoke.

In the realm of investment, being a contrarian means buying stocks when everyone else is selling and selling when others are buying. This contrarian strategy can be emotionally painful, akin to enduring social rejection or physical discomfort. Nevertheless, it is integral to successful investment, as it allows investors to avoid overvalued assets and capitalize on undervalued ones.

John Templeton and John Maynard Keynes have emphasized the importance of going against the consensus opinion. Empirical research supports their wisdom, showing that stocks favored by institutional fund managers, who often follow the herd, tend to underperform in the long run. Contrarian investors who challenge the prevailing market sentiment have a better chance of achieving superior returns.

Conformity is often reinforced by the prospect of social praise and acceptance. People who bring information that aligns with the group’s views are rated more favorably and tend to rate themselves more positively. In group decision-making, individuals tend to focus on common information, while divergent perspectives are often overlooked.

Groups have a natural tendency to converge on common information, even when valuable insights are scattered among the group members. This phenomenon, known as group polarization, can lead to poor decision-making and reinforce conformity. Groupthink is the extreme manifestation of conformity, characterized by faulty decisions made under group pressure. It occurs when a group’s cohesion and the desire for consensus override critical thinking, reality testing, and moral judgment. Groupthink can lead to disastrous outcomes, as demonstrated in historical events like the Bay of Pigs and the Challenger space shuttle disaster. Groupthink is associated with several symptoms, including an illusion of invulnerability, collective rationalization, and direct pressure on dissenters. It results in poor decision-making and a lack of consideration for alternative viewpoints.

Becoming a contrarian is not an easy path. It requires courage to challenge prevailing wisdom, critical thinking to evaluate investments independently, and perseverance to stick to one’s principles. Successful contrarian investors like Michael Steinhardt and Joel Greenblatt emphasize the importance of having the courage to be different, thinking critically, and maintaining unwavering determination.

Relentlessness

Investing in financial markets is a complex endeavor that requires a deep understanding of not only financial metrics but also the psychology that drives decision-making. This segment explores the various behavioral biases that can affect investment decisions, with a focus on loss aversion, the disposition effect, and the endowment effect. It highlights the importance of recognizing and managing these biases to make rational investment choices and maximize returns.

One of the most prevalent biases in investment decisions is loss aversion. Research has shown that people tend to hate losses more than they enjoy equivalent gains. This aversion to losses can lead to suboptimal decision-making. For instance, individuals are often unwilling to sell an investment that has declined in value, hoping for a rebound, even when it might be more prudent to cut their losses and move on.

Studies have revealed that even professional investors, such as fund managers, exhibit loss aversion. They tend to require a significantly higher return to consider an investment attractive when there is a potential for loss. This behavioral bias can result in missed opportunities and holding onto underperforming assets longer than necessary.

The disposition effect is another cognitive bias that affects investors. It describes the tendency to sell winning investments too early and hold onto losing investments for too long. Investors often believe that a loss isn’t realized until it’s sold, leading to a reluctance to part with losing positions. Research has shown that individual investors are more likely to sell winning stocks than losing ones. Even professional investors, such as mutual fund managers, exhibit the disposition effect. They are also prone to selling winning stocks prematurely. This bias can hinder investment performance and lead to suboptimal portfolio management.

The endowment effect suggests that people tend to place a higher value on things they own compared to similar items they don’t own. This bias can impact investment decisions when investors become emotionally attached to their holdings, making it difficult for them to sell, even when it might be the rational choice.

In experiments, participants who were randomly given an item, such as a mug, were often unwilling to sell it for a price that others were willing to pay. This behavior demonstrates how ownership can distort perceptions of value.

Now What?

Human behavior is often guided by psychological biases that can lead to poor decision-making. This segment delves into the importance of focusing on processes rather than outcomes to overcome these biases, drawing insights from various fields, including sports, gambling, and investing. By understanding the psychology behind decision-making, we can improve our ability to make sound investment choices.

In the world of sports, athletes are often asked about their mindset before a competition, with interviewers inquiring whether they were thinking about winning gold medals. Surprisingly, successful athletes tend to emphasize their focus on the process rather than the outcome. This approach, exemplified by elite athletes, underscores the importance of concentrating on the steps necessary to achieve a goal, rather than fixating solely on the end result.

Paul DePodesta, a prominent figure in baseball management and the inspiration behind Michael Lewis’s “Moneyball,” shares a revealing anecdote from a blackjack table in Las Vegas. He witnesses a fellow gambler making a seemingly poor decision by hitting on 17, a decision that miraculously worked out in the player’s favor. DePodesta reflects on how the casino industry operates with a strong emphasis on process, despite their ultimate concern being outcomes.

Investing, like sports and gambling, is inherently influenced by behavioral biases. Investors often grapple with biases such as overconfidence, availability bias, anchoring, and herding, which can cloud judgment and lead to suboptimal decisions. However, adopting a process-oriented approach can help mitigate these biases and enhance decision-making.

DePodesta’s insights on the importance of process in baseball management parallel the world of investing. In the investment realm, returns are elusive and uncertain, but processes can be controlled and refined. Investors who focus on developing a robust investment process are better equipped to navigate the complexities of financial markets.

Process accountability is a key factor in improving decision-making. Brian Wansink’s research on eating habits highlights the power of context, availability, and social influence in our choices. He shows that mere knowledge of healthier eating habits does not always translate into better behavior. People often struggle to align their intentions with their actions.

In investment, too, knowledge alone does not guarantee success. Investors frequently promise to make better decisions but find it challenging to follow through. Similar to Wansink’s findings, intentions often fail to materialize into concrete actions.

To overcome these hurdles, both in eating habits and investing, a combination of rebiasing and simple rules can be effective. Implementing gradual changes, such as smaller plate sizes for portion control or adopting a step-by-step approach to modifying investment behaviors, can lead to sustainable improvements.

We should not attempt to overhaul their entire investment approach at once. Identifying and addressing specific biases that impact their decision-making is a more manageable approach. By integrating these lessons from behavioral economics, we can build disciplined and process-driven strategies that help them stay on course, even during challenging market conditions.