The AAA problem for investors

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The somewhat well-known (and very smart) US investor Howard Marks recently released a book called The Most Important Thing. The title was a self-deprecating dig at himself – the book is made up of letters he’d written to his investors, where he’d laid out many “most important things” over the years.

It’s the same when it comes to the old “you’re your own worst enemy” line. It’s invariably true, for investors, at least, but there are many reasons. Today, I want to present three, chosen only from the first letter of the alphabet, but don’t worry, this won’t be a 26-part series.

Arrogance

Despite my opening, and there being many “worst enemy” causes, I have long been convinced that once you have a decent level of intelligence, arrogance is your worst enemy. And, in my experience, the smarter you are, the worse you are affected by it.

Which shouldn’t be a surprise: smart people are used to being right. The same goes for those who are used to being experts in a related field. When you’re used to being right, you get lazy. You stop validating your ideas, probing them for holes and flaws. When you can do algebra in your head, how hard can investing really be? Here’s a handy guide: the more certain you are about anything, the more worried you should be that you may have overlooked something.

Assumptions

This is closely related to arrogance, but comes from a different direction. Humans have developed a very good set of mental shortcuts when it comes to decision making. It was both necessary and smart – can you imagine how long it’d take to get out of bed each morning if you had to consciously and deliberately consider how each muscle would move, where you’d place each foot, and the entire list of potential risks, no matter how unlikely?

So we developed short-cuts – ways to subconsciously filter out risks and focus on the most important and most likely problems. But then, God made classical economists. They took the idea to extremes, building beautifully simple models that operated on one assumption: ceteris paribus. The Latin translates to “all else being equal”. With that single, simple assumption, difficulties were wiped away, replaced by a hermetically sealed petri dish … that had little to do with reality.

Now, if you had to consider each and every risk and opportunity – no matter how big or small – you’d never finish a single piece of company analysis. So assumptions and shortcuts are necessary. So, consider this simple trick: count the number of times you use the word ‘if’ when you’re thinking about a company: if sales grow at a decent rate, and if the competition isn’t too tough and if the new product works … the more “ifs”, the greater the risk. Assumption really is the mother of all stuff-ups.

Arbitrariness

Our last “A”, a somewhat clumsy word, can separate the investing wheat from the chaff. And, as our previous two were related, so is this one. Because it’s a form of assumption. Along with giving us mental short-cuts to allow us to function, evolution taught us some rules of thumb: if it roars, it’s probably a lion. Dirty water is probably bad for you.

Investors, too, have developed their own set of what they call “heuristics”: rules of thumb that make decisions easier. They’re not universal – it depends on each person’s approach, but some won’t buy commodity companies, others eschew debt while yet others believe past share price movements can inform the future. Some treat underlying earnings as management obfuscation and others take a strictly mechanical approach to things like P/E ratios and return on equity.

Those are useful rules of thumb. But here’s the thing: when everyone believes them, it’s just possible that such arbitrary rules risk throwing the baby out with the bathwater. Sure, debt adds risk, but it can also magnify returns. Used well (our own mortgages, for example) it can be a useful financial tool. Commodity companies can be risky – they can’t control the prices of their goods – but bought at the right price, they can potentially be a good investment. And even billionaire investor Warren Buffett, who swore off airlines for decades, changed his mind when he saw a change in the competitive dynamics of that industry. (But sorry, using charts to predict share prices is still silly).

Foolish takeaway

Investing isn’t easy. And we make it harder by using the only tool we have, our evolutionarily compromised brains. But if you can avoid the traps of arrogance, assumption and arbitrariness, you’ll stand a better chance of success. At least, until we get to the letter B.

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Scott Phillips is the Motley Fool‘s director of research. You can follow Scott on Twitter @TMFScottP. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).


Source: einnews.com