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Cognitive Biases & How to Avoid Them


DooDiligence
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This discussion has come up before in a number of different threads, a few of which are listed below in a semi-random order:

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/the-12-cognitive-biases-that-prevent-you-from-being-rational/msg99293/#msg99293

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/two-infographics-on-cognitive-biases/msg262662/#msg262662

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/cognitive-biases-the-anchoring-bias/msg301328/#msg301328

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/cognitive-bias-in-military-intel-analysis-(and-investing)/msg93675/#msg93675

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/cognitive-biases-the-hindsight-bias/msg302184/#msg302184

 

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I have to agree with Libery. It’s not an interesting discussion, it’s sanity versus a bunch of drivel and cognitive biases. Chasing losses, gambling with house money, getting back to break even, that’s the stuff losers and idiots do who fool themselves in the casino (or in the bitcoin market or stock market).

 

The history of your net worth is utterly irrelevant for optimal (financial) decision making - even if doesn’t always feel that way.

 

It may not be particularly interesting to those of you guys who have a firm grasp on their cognition and behavior but

to me, this is a very helpful discussion.

 

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Sunk cost fallacy = BTFD, when you've been unpleasantly surprised by a big/small downward price move?

 

How do you figure out if you're deluding yourself when averaging down, as in the case of BRK or MO or DVA, if you believe that the businesses have a long runway & management is doing what's good for owners?

 

What are the warning signs that you're screwing up?

Confirmation bias & refusing to account for negative narratives?

 

I'm trying hard to imagine the worst scenarios for everything I own & may actually end up selling off a few positions, next year, as a result.

I'm pretty sure that neither of those sales will be BRK, MO or DVA.

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if you have thought things through reasonably carefully and have come to a conclusion with some conviction, then staying with that conviction is not evidence of cognitive bias.  as additional information/events arise yes you have to take those account as new information, but sticking to your guns usually makes sense for me unless it comes to my attention that I made some important mistake in my original analysis...meaning weighing new information usually doesn't make me change my conclusion, unless it becomes clear that I was wrong-headed about things in the first instance

 

or, just because you are paranoid, doesn't mean someone is not out to get you

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How do you figure out if you're deluding yourself when averaging down, as in the case of BRK or MO or DVA, if you believe that the businesses have a long runway & management is doing what's good for owners?

 

What are the warning signs that you're screwing up?

Confirmation bias & refusing to account for negative narratives?

 

 

I solve this problem by never averaging down. I realized it's too fertile a ground for psychological biases to take hold in. These days I set a maximum position size when I first buy a stock and leave it. If I'm wrong I know the max I can lose. I don't con myself into buying more and more all the way down, which is VERY easy to do. After all, if you invest for a long time, you will eventually find a stock you love that is going to zero!

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How do you figure out if you're deluding yourself when averaging down, as in the case of BRK or MO or DVA, if you believe that the businesses have a long runway & management is doing what's good for owners?

 

What are the warning signs that you're screwing up?

Confirmation bias & refusing to account for negative narratives?

 

 

I solve this problem by never averaging down. I realized it's too fertile a ground for psychological biases to take hold in. These days I set a maximum position size when I first buy a stock and leave it. If I'm wrong I know the max I can lose. I don't con myself into buying more and more all the way down, which is VERY easy to do. After all, if you invest for a long time, you will eventually find a stock you love that is going to zero!

 

 

This is very smart.  I have wrestled with this a number of times.  Nearly every time I have averaged down in the last few years I have gotten stung.  Stock A looked real good at my buy in price, therefore, it must be better at a cheaper price.  The problem arises when the position gets bigger and bigger, and keeps dropping in price.  And then it drops way beyond any expectation I could have dreamt up.  At this point I should buy more after all: "there is blood on the streets, we should buy at the point of maximum pessimism, If it was a good buy 50% higher then its a great buy now... etc."

 

At that point I am now looked into a course of action where my capital is used up on a losing position and my manuevering is constrained.  In order to switch out of Stock A I need to sell at a loss. 

 

A case in point for me is Whitecap Resources (WCP-T).  On this I have averaged down.  It was all well in good when it was trading at 7.50 to 8.50 but it is now at 5.50 and I have too much in it.  In order to right size the position I will end up selling a good chunk on the way back up when I hit break even.  The position is just too large to carry for very long comfortably.  I still believe that WCP is a great company but I dont want to hold the whole company.

 

When I really crunch the numbers honestly the amount I will make on the way back up from averaging down will not be very much, IF there is a back up.  By averaging down I have reduced my aggreagate purchase price from perhaps 8.50 to 7.20.  Is it really worth it to get trapped in a position, for who knows how long, to make a spread of 1.30.  I have concluded that it is not. 

 

For me position sizing is the most important thing now.  Its a tricky thing to figure out but I try to do the best I can.  Once I figure out the right size for a position it is best to stop and ignore it. 

 

Its hard and takes discipline.  Someone on the BAM thread was bemoaning the stock price of BEP.  I suggested the person just ignore the stock gyrations.  Gotta take my own advice. 

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It may not be particularly interesting to those of you guys who have a firm grasp on their cognition and behavior but

to me, this is a very helpful discussion.

 

I was absolutely not trying to imply that I'm an expert on the subject. It's much easier to spot faulty reasoning when others are doing it .. Anyway, some random thoughts on this:

 

First I think you have to know a little bit about how people tend to fool themselves. For that, you can read Kahneman, Wikipedia, whatever. Or visit the casino or Yahoo Message Boards :) . Be aware of the traps many investors fall for (confirmation bias, loss aversion, hindsight bias, etc.). Unfortunately it's far more difficult to spot this behavior when you are doing it yourself. Some random things that I think are helpful (obviously not all will apply to everyone)

 

- Most important: avoid hasty decisions. Much easier to make mistakes if you are in a hurry. Don't buy shares 5 minutes before you have to go to a birthday. Don't trade on your phone. Don't trade at work. Don't buy shares 'before they go up'. If you want buy/sell something, let ideas percolate in your head for a while. Don't trade if you are angry, scared or jealous, only trade if you are totally calm.

- Write down your thoughts (i.e. an investing diary or something). It's very easy to delude yourself afterwards: "I always thought this was a no-brainer", "this thesis worked out perfectly" but if you write down your thoughts you can't fool yourself afterwards as easily. It's humbling to read all your own crap a few years later and to find out you were spectacularly wrong. Also, writing slows you down. See point above.

- The above especially holds if you share your thoughts with others: i.e. discuss what you are doing in person, on this board, on your blog or per e-mail. Again, it's much easier for others to spot your faulty reasoning.

- In similar fashion, it's also interesting to write down the confidence you have in your ideas. Do you think an idea is 10/10? Absolutely top notch and risk-free? Write that down and marvel about your own stupidity two years down the line.

- Watch out for thesis drift. I think a lot of people fall for this. First you buy a stock because they have a great new product. Then you suddenly own it because, even though the new product was a failure, their other products are great. Then sales drop but surely the company has a great balance sheet and will never go bankrupt. And finally you will own it because it is heading to bankruptcy, but surely the assets will fetch a nice price in a liquidation. Again, write down your thesis.

- It's easy to make mistakes when your thesis is vague, say: "this is a great business, I will buy it until it stops growing" or "until it is fully valued". Try to make your thesis measurable in some ways. I.e. write down: I expect sales to grow by 20% the next five years. I expect this to trade at 65% of book value. My price target is 15x earnings. Peg a 'fair value' price label to all your holdings.

- People have a tremendous tendency, for example on this message board, to _defend_ their ideas when somebody is critical of them. Of course this is good, up to a point. However, you don't have to refute every criticism. Appreciate the fact that something might be wrong with your ideas. If you valiantly defend a stock for years (for example on this message board) it is very hard to change your mind. Some posters here have silently left this forum after being spectacularly wrong about a few stocks rather than admitting they were wrong. Make it easy for yourself to stay flexible.

- In line with the above: try to keep a neutral attitude towards your investments. Don't think: this stock is perfect and will make me rich no matter what, think: I like this stock but there are some risks here, like so and so and so. Share your ideas with the intention that others can poke holes in them, not to convince others that you have found the best opportunity of the decade. Don't participate in giant circle jerks where everybody congratulates everybody for being a super good investors

- Don't focus too much on what management is saying. It's hard to stay neutral about Berkshire if you are the biggest fanboy of Warren Buffett on the planet. Hard to form a rational opinion on Victoria's Secret if you let the shows distract you :) . In general it's hard to stay impartial if you focus too much on people.

- Don't focus too much on results either, neither your own nor others'. Is your portfolio underperforming the S&P? Underperforming Bill Ackman? Is holding X up or down 5%? Who cares. Focus on your own analysis and decisions. Do your own work and if you do it well results will follow.

- Ignore most financial news. Watch CNBC all day and you will eventually become just as crazy as Jim Cramer. As I said before, don't hurry things. Ignore most day-to-day financial news that makes you want to act, act, act on everything.

- I think that sometimes it is severely underrated to sit (or even lie down) and think. Slow down, don't research anything, don't make any spreadsheets or forum posts but take a step back, relax and think about all the facts you have gathered, about what the key issues are of your thesis and how likely it is that you are wrong. It's very easy to get lost in the heat of the moment or to focus on the wrong things, i.e. the Valeant thread is like thousands of pages of mostly irrelevant discussion (about how effective their foot creme is or whatever) while the whole company was burning down. Make sure you see the big picture.

- Maintain a skeptical attitude. If something sounds to good to be true it probably is. Most things regress to the mean.

- I usually keep small positions in a diversified portfolio. Makes it far easier not to get emotionally attached to a single idea. Also means you don't get bored as easily and start doing stupid stuff.

 

In short, slow down and write down.

 

I agree with others that 'doubling down' is difficult and people tend to do it too early and too large (at least I do!). Usually whenever you feel the urge to add to a position it is perfectly fine to wait for a week or so. I.e. Berkshire drops 10%? Don't feel compelled to immediately start buying again.

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It may not be particularly interesting to those of you guys who have a firm grasp on their cognition and behavior but

to me, this is a very helpful discussion.

 

In this interview, Daniel Kahneman (one of the pioneers of the discovery of cognitive biases, nobel price winner etc) says that he still experiences (or is not "immune to") cognitive biases: https://soundcloud.com/bloombergview/interview-with-daniel-kahneman-masters-in-business-audio (37:00 into the interview, but the whole thing is great).

 

"I am not smarter than I was when I started in this line of research more than 50 years ago. Because my system 1 is just the same way that it was". But then he says that he recognizes "This person is trying to anchor me. It still works by the way. But I can recognize it".

 

If Daniel Kahneman is still "fooled by" cognitive biases, I think it would be arrogant of most of us to think we can avoid it.

 

How do you figure out if you're deluding yourself when averaging down, as in the case of BRK or MO or DVA, if you believe that the businesses have a long runway & management is doing what's good for owners?

 

I am struggling with this myself. Am I under the influence of the typical biases (e.g. Endowment effect), or is my hypothesis just as valid as it was when I bought it?

 

I don't have a definitive answer, but I think that for me personally, it might help to mechanize parts of the decisions somehow. Or make some rules, checklists etc, that take part of the second-guessing out of the equation. Perhaps a rule could be "after I have bought, I have to hold the stock for at least a month before re-evaluating it". Given that I did proper research before buying.

 

I like many of the points on writser list. In particular, I have started writing down my reasoning before buying or selling a stock. In addition to help crystalize my thoughts, I hope that it can help accelerate my learning by looking back on the notes later.

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...

How do you figure out if you're deluding yourself when averaging down...

I solve this problem by never averaging down... 

This is very smart.  I have wrestled with this a number of times.  Nearly every time I have averaged down in the last few years I have gotten stung.  Stock A looked real good at my buy in price, therefore, it must be better at a cheaper price.  The problem arises when the position gets bigger and bigger, and keeps dropping in price.  And then it drops way beyond any expectation I could have dreamt up.  At this point I should buy more after all: "there is blood on the streets, we should buy at the point of maximum pessimism, If it was a good buy 50% higher then its a great buy now... etc."

...

A case in point for me is Whitecap Resources (WCP-T).  On this I have averaged down.  It was all well in good when it was trading at 7.50 to 8.50 but it is now at 5.50 and I have too much in it.  In order to right size the position I will end up selling a good chunk on the way back up when I hit break even.  The position is just too large to carry for very long comfortably.  I still believe that WCP is a great company but I dont want to hold the whole company.

 

When I really crunch the numbers honestly the amount I will make on the way back up from averaging down will not be very much, IF there is a back up.  By averaging down I have reduced my aggreagate purchase price from perhaps 8.50 to 7.20.  Is it really worth it to get trapped in a position, for who knows how long, to make a spread of 1.30.  I have concluded that it is not. 

 

For me position sizing is the most important thing now.  Its a tricky thing to figure out but I try to do the best I can.  Once I figure out the right size for a position it is best to stop and ignore it. 

 

Its hard and takes discipline...

My experience with averaging down has been quite consistently satisfactory and I wonder why.

 

From FFH AR 2011, experience with International Coal:

 

As an example of our long term value investing approach and the need to be patient and calm through adverse market fluctuations, in the table below we show you the results of our purchase and sale of shares of International Coal. This is a company of which Wilbur Ross was Chairman and owned 16%. Our Sam Mitchell, who originated this purchase idea, joined the Board in 2008, after we had acquired 13.8% of the shares.

-Purchases of International Coal Sales of International Coal

        Number of Shares  (millions)      Cost per Share    Total Cost 

2006            1.4                                      $4.58                6.4

2007            19.7                                      4.39                86.3

2008            9.1                                        1.81                16.5

2009            15.0                                      2.87                43.1

Total            45.2                                      $3.37                152.3

 

-Proceeds per Share Total Proceeds

        Number of Shares  (millions)      Cost per Share    Total Cost

2010            22.6                                    $7.26              163.9

2011            22.6                                      14.60              329.6

Total            45.2                                    $10.93              493.5

 

Total realized gain: 341.2M

 

The table shows how we averaged down from our initial cost of $4.58 per share to an average cost of $3.37 per share. We sold half our position at $7.26 per share (a 115% gain) and only five months later, there was a takeover offer for the whole company at double that price. In spite of not buying only at the low and not selling only at the high, we earned $341.2 million by selling at over three times our cost. Our experience with International Coal is exactly what we have done over 35 years of investing – average down when buying and average up when selling! An added advantage in this case – we got to know Wilbur and he is an excellent partner.

Obviously the excerpt is a selection of a selection bias but I could put up similar tables for my gradual involvements in Fairfax, OdysseyRe and The Brick among others, including some cyclical stuff.

 

Maybe it's just luck and I agree with others about checklists, slow thinking, writing down etc but I wonder if the factor you mention about position sizing may not be an important determinant ie deciding in advance about a potential maximum percentage of portfolio with quantitative triggers (price vs intrinsic value) on the way down and up, hopefully in that sequence. I think Newton did the opposite once with his South Seas investment but that's another story and maybe by quoting the difficulty of quantifying the madness of men, he was the father of behavioral finance. A clear potential disadvantage with this strategy is the implicit need to have available fire power and this perhaps ties in with what SharperDingaan is trying to explain in a different thread (house money etc).

 

Take the above with a grain of salt as I seem to become more and more confused in today's markets.

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...

How do you figure out if you're deluding yourself when averaging down...

I solve this problem by never averaging down... 

This is very smart.  I have wrestled with this a number of times.  Nearly every time I have averaged down in the last few years I have gotten stung.  Stock A looked real good at my buy in price, therefore, it must be better at a cheaper price.  The problem arises when the position gets bigger and bigger, and keeps dropping in price.  And then it drops way beyond any expectation I could have dreamt up.  At this point I should buy more after all: "there is blood on the streets, we should buy at the point of maximum pessimism, If it was a good buy 50% higher then its a great buy now... etc."

...

A case in point for me is Whitecap Resources (WCP-T).  On this I have averaged down.  It was all well in good when it was trading at 7.50 to 8.50 but it is now at 5.50 and I have too much in it.  In order to right size the position I will end up selling a good chunk on the way back up when I hit break even.  The position is just too large to carry for very long comfortably.  I still believe that WCP is a great company but I dont want to hold the whole company.

 

When I really crunch the numbers honestly the amount I will make on the way back up from averaging down will not be very much, IF there is a back up.  By averaging down I have reduced my aggreagate purchase price from perhaps 8.50 to 7.20.  Is it really worth it to get trapped in a position, for who knows how long, to make a spread of 1.30.  I have concluded that it is not. 

 

For me position sizing is the most important thing now.  Its a tricky thing to figure out but I try to do the best I can.  Once I figure out the right size for a position it is best to stop and ignore it. 

 

Its hard and takes discipline...

My experience with averaging down has been quite consistently satisfactory and I wonder why.

 

From FFH AR 2011, experience with International Coal:

 

As an example of our long term value investing approach and the need to be patient and calm through adverse market fluctuations, in the table below we show you the results of our purchase and sale of shares of International Coal. This is a company of which Wilbur Ross was Chairman and owned 16%. Our Sam Mitchell, who originated this purchase idea, joined the Board in 2008, after we had acquired 13.8% of the shares.

-Purchases of International Coal Sales of International Coal

        Number of Shares  (millions)      Cost per Share    Total Cost 

2006            1.4                                      $4.58                6.4

2007            19.7                                      4.39                86.3

2008            9.1                                        1.81                16.5

2009            15.0                                      2.87                43.1

Total            45.2                                      $3.37                152.3

 

-Proceeds per Share Total Proceeds

        Number of Shares  (millions)      Cost per Share    Total Cost

2010            22.6                                    $7.26              163.9

2011            22.6                                      14.60              329.6

Total            45.2                                    $10.93              493.5

 

Total realized gain: 341.2M

 

The table shows how we averaged down from our initial cost of $4.58 per share to an average cost of $3.37 per share. We sold half our position at $7.26 per share (a 115% gain) and only five months later, there was a takeover offer for the whole company at double that price. In spite of not buying only at the low and not selling only at the high, we earned $341.2 million by selling at over three times our cost. Our experience with International Coal is exactly what we have done over 35 years of investing – average down when buying and average up when selling! An added advantage in this case – we got to know Wilbur and he is an excellent partner.

Obviously the excerpt is a selection of a selection bias but I could put up similar tables for my gradual involvements in Fairfax, OdysseyRe and The Brick among others, including some cyclical stuff.

 

Maybe it's just luck and I agree with others about checklists, slow thinking, writing down etc but I wonder if the factor you mention about position sizing may not be an important determinant ie deciding in advance about a potential maximum percentage of portfolio with quantitative triggers (price vs intrinsic value) on the way down and up, hopefully in that sequence. I think Newton did the opposite once with his South Seas investment but that's another story and maybe by quoting the difficulty of quantifying the madness of men, he was the father of behavioral finance. A clear potential disadvantage with this strategy is the implicit need to have available fire power and this perhaps ties in with what SharperDingaan is trying to explain in a different thread (house money etc).

 

Take the above with a grain of salt as I seem to become more and more confused in today's markets.

 

Cigarbutt, I generally like your posts: they are smart, and well thought out... you know a refutation is coming :-).

 

Averaging down: works until it doesn't.  Do yourself a favour and read the entire Pennwest post.  There was thesis drift through the entire thing.  Initially I got caught in it but realized that and got out with some loss.  Maybe SharperDingaan has somehow managed to trade in and out and make money along the way.  But read carefully what they write.  It is often dishonest in how they define their results.  They never come straight out and admit that they lost money on a situation.  Maybe they never do... but there is no honest disclosure so how would I know.

 

Using a Fairfax example to dispute this is all good unless you look at the situations where they have lost huge:  Invested 500 million in Canwest weeks before it bankrupted and they lost everything.  Blackberry, Torstar, SFK-Fibrek, Resolute, the market puts that cost hundreds of millions, or billions.  Without their bond desk they would have been gone long ago.  Invested (got lucky) in Sandridge because they liked the sleazeball in charge? 

 

If you want an exercise in studying cognitive biases you need only look at FFH and all the threads.  The thesis drift in the threads is pervasive.  For a long time it was about great investment results but crappy insurance underwriting, then it switches to great underwriting but lowsy investing.  Prem wrote for years how they were targeting 20% annual returns, then dropped it to 15% which they have never come close to meeting.  He wasn't going to give the company to his family but he has.  Then there are the nasty tricks along the way to maintain control of the company.  Investors on this board are blind to FFHs foibles. I made my decision to sell the stock in and around 2012 and never look back. 

 

I agree with you that Writser has created a great checklist.  Mostly it involves writing down your thesis, initiating and starter position, and then sitting with it.  I am endeavouring to work with the sit with it portion, for years if necessary. 

 

Cheers, Al

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It may not be particularly interesting to those of you guys who have a firm grasp on their cognition and behavior but

to me, this is a very helpful discussion.

 

I was absolutely not trying to imply that I'm an expert on the subject. It's much easier to spot faulty reasoning when others are doing it .. Anyway, some random thoughts on this:

 

First I think you have to know a little bit about how people tend to fool themselves. For that, you can read Kahneman, Wikipedia, whatever. Or visit the casino or Yahoo Message Boards :) . Be aware of the traps many investors fall for (confirmation bias, loss aversion, hindsight bias, etc.). Unfortunately it's far more difficult to spot this behavior when you are doing it yourself. Some random things that I think are helpful (obviously not all will apply to everyone)

 

- Most important: avoid hasty decisions. Much easier to make mistakes if you are in a hurry. Don't buy shares 5 minutes before you have to go to a birthday. Don't trade on your phone. Don't trade at work. Don't buy shares 'before they go up'. If you want buy/sell something, let ideas percolate in your head for a while. Don't trade if you are angry, scared or jealous, only trade if you are totally calm.

- Write down your thoughts (i.e. an investing diary or something). It's very easy to delude yourself afterwards: "I always thought this was a no-brainer", "this thesis worked out perfectly" but if you write down your thoughts you can't fool yourself afterwards as easily. It's humbling to read all your own crap a few years later and to find out you were spectacularly wrong. Also, writing slows you down. See point above.

- The above especially holds if you share your thoughts with others: i.e. discuss what you are doing in person, on this board, on your blog or per e-mail. Again, it's much easier for others to spot your faulty reasoning.

- In similar fashion, it's also interesting to write down the confidence you have in your ideas. Do you think an idea is 10/10? Absolutely top notch and risk-free? Write that down and marvel about your own stupidity two years down the line.

- Watch out for thesis drift. I think a lot of people fall for this. First you buy a stock because they have a great new product. Then you suddenly own it because, even though the new product was a failure, their other products are great. Then sales drop but surely the company has a great balance sheet and will never go bankrupt. And finally you will own it because it is heading to bankruptcy, but surely the assets will fetch a nice price in a liquidation. Again, write down your thesis.

- It's easy to make mistakes when your thesis is vague, say: "this is a great business, I will buy it until it stops growing" or "until it is fully valued". Try to make your thesis measurable in some ways. I.e. write down: I expect sales to grow by 20% the next five years. I expect this to trade at 65% of book value. My price target is 15x earnings. Peg a 'fair value' price label to all your holdings.

- People have a tremendous tendency, for example on this message board, to _defend_ their ideas when somebody is critical of them. Of course this is good, up to a point. However, you don't have to refute every criticism. Appreciate the fact that something might be wrong with your ideas. If you valiantly defend a stock for years (for example on this message board) it is very hard to change your mind. Some posters here have silently left this forum after being spectacularly wrong about a few stocks rather than admitting they were wrong. Make it easy for yourself to stay flexible.

- In line with the above: try to keep a neutral attitude towards your investments. Don't think: this stock is perfect and will make me rich no matter what, think: I like this stock but there are some risks here, like so and so and so. Share your ideas with the intention that others can poke holes in them, not to convince others that you have found the best opportunity of the decade. Don't participate in giant circle jerks where everybody congratulates everybody for being a super good investors

- Don't focus too much on what management is saying. It's hard to stay neutral about Berkshire if you are the biggest fanboy of Warren Buffett on the planet. Hard to form a rational opinion on Victoria's Secret if you let the shows distract you :) . In general it's hard to stay impartial if you focus too much on people.

- Don't focus too much on results either, neither your own nor others'. Is your portfolio underperforming the S&P? Underperforming Bill Ackman? Is holding X up or down 5%? Who cares. Focus on your own analysis and decisions. Do your own work and if you do it well results will follow.

- Ignore most financial news. Watch CNBC all day and you will eventually become just as crazy as Jim Cramer. As I said before, don't hurry things. Ignore most day-to-day financial news that makes you want to act, act, act on everything.

- I think that sometimes it is severely underrated to sit (or even lie down) and think. Slow down, don't research anything, don't make any spreadsheets or forum posts but take a step back, relax and think about all the facts you have gathered, about what the key issues are of your thesis and how likely it is that you are wrong. It's very easy to get lost in the heat of the moment or to focus on the wrong things, i.e. the Valeant thread is like thousands of pages of mostly irrelevant discussion (about how effective their foot creme is or whatever) while the whole company was burning down. Make sure you see the big picture.

- Maintain a skeptical attitude. If something sounds to good to be true it probably is. Most things regress to the mean.

- I usually keep small positions in a diversified portfolio. Makes it far easier not to get emotionally attached to a single idea. Also means you don't get bored as easily and start doing stupid stuff.

 

In short, slow down and write down.

 

I agree with others that 'doubling down' is difficult and people tend to do it too early and too large (at least I do!). Usually whenever you feel the urge to add to a position it is perfectly fine to wait for a week or so. I.e. Berkshire drops 10%? Don't feel compelled to immediately start buying again.

 

All of the above.

 

Thanks for taking the time as I really respect your ideas.

I don't invest in the equities you write about because they're way over my head, but I do learn from your discussions of them.

 

---

 

A year ago, I imposed a 7 day rule on myself which prohibits me from buying when an idea 1st grabs my attention.

After the cooling off period, and at least a shallow dive, my jets are usually cooled & I sit on my hands again.

Case in point, my recent re-attraction to Louis Vuitton (I'm still waiting on a recession to drive this one down into an abyss.)

 

I keep notes on everything I own but they're not of the calibre of a VIC writeup or the majority of the analyses which are done on here on COBF.

I agree that a journal helps avoid thesis drift & when prices start dropping (like with DVA & MO recently) I re-read my entries & the panic goes away.

 

I also agree with regards to averaging down, and I have been good about assigning a dollar value that I'd like to own of an issue and sticking to it.

For better or worse, I like to buy 1/3 & then average down until I get to my allotment.

 

I did this with NVO but only got 2/3 of what I wanted.

I've gotten pretty much all I wanted in DVA & MO and added some long dated calls (Jan 2020) to the MO equity.

 

I plan on doing re-dives on everything I own over the semester break / Christmas holidays.

I'm doing a little bit of work on DVA & MO now, and trying to find disaster scenarios.

This is a big departure from looking mainly at rosy, crystal ball nonsense.

We'll see how it turns out.

 

Thanks.

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It may not be particularly interesting to those of you guys who have a firm grasp on their cognition and behavior but

to me, this is a very helpful discussion.

 

In this interview, Daniel Kahneman (one of the pioneers of the discovery of cognitive biases, nobel price winner etc) says that he still experiences (or is not "immune to") cognitive biases: https://soundcloud.com/bloombergview/interview-with-daniel-kahneman-masters-in-business-audio (37:00 into the interview, but the whole thing is great).

 

"I am not smarter than I was when I started in this line of research more than 50 years ago. Because my system 1 is just the same way that it was". But then he says that he recognizes "This person is trying to anchor me. It still works by the way. But I can recognize it".

 

If Daniel Kahneman is still "fooled by" cognitive biases, I think it would be arrogant of most of us to think we can avoid it.

 

My favorite quote of his was the one about "familiarity becoming confused with truth."

 

It applies not only to authoritarian regimes, but to investment theses as well.

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My experience with averaging down has been quite consistently satisfactory and I wonder why.

 

Maybe it's just luck and I agree with others about checklists, slow thinking, writing down etc but I wonder if the factor you mention about position sizing may not be an important determinant ie deciding in advance about a potential maximum percentage of portfolio with quantitative triggers (price vs intrinsic value) on the way down and up, hopefully in that sequence. I think Newton did the opposite once with his South Seas investment but that's another story and maybe by quoting the difficulty of quantifying the madness of men, he was the father of behavioral finance. A clear potential disadvantage with this strategy is the implicit need to have available fire power and this perhaps ties in with what SharperDingaan is trying to explain in a different thread (house money etc).

 

Take the above with a grain of salt as I seem to become more and more confused in today's markets.

 

I rarely have to salt your cooking.

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Averaging down: works until it doesn't...

...

I agree with you that Writser has created a great checklist.  Mostly it involves writing down your thesis, initiating and starter position, and then sitting with it.  I am endeavouring to work with the sit with it portion, for years if necessary. 

 

Cheers, Al

All your points are valid and have nothing further to add.

The future, as always, is uncertain but, from my perspective, full of confidence and eyes wide shut, I would say the best is yet to come.

Wherever we may sit, let's enjoy the ride.

CF

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...

How do you figure out if you're deluding yourself when averaging down...

I solve this problem by never averaging down... 

This is very smart.  I have wrestled with this a number of times.  Nearly every time I have averaged down in the last few years I have gotten stung.  Stock A looked real good at my buy in price, therefore, it must be better at a cheaper price.  The problem arises when the position gets bigger and bigger, and keeps dropping in price.  And then it drops way beyond any expectation I could have dreamt up.  At this point I should buy more after all: "there is blood on the streets, we should buy at the point of maximum pessimism, If it was a good buy 50% higher then its a great buy now... etc."

...

A case in point for me is Whitecap Resources (WCP-T).  On this I have averaged down.  It was all well in good when it was trading at 7.50 to 8.50 but it is now at 5.50 and I have too much in it.  In order to right size the position I will end up selling a good chunk on the way back up when I hit break even.  The position is just too large to carry for very long comfortably.  I still believe that WCP is a great company but I dont want to hold the whole company.

 

When I really crunch the numbers honestly the amount I will make on the way back up from averaging down will not be very much, IF there is a back up.  By averaging down I have reduced my aggreagate purchase price from perhaps 8.50 to 7.20.  Is it really worth it to get trapped in a position, for who knows how long, to make a spread of 1.30.  I have concluded that it is not. 

 

For me position sizing is the most important thing now.  Its a tricky thing to figure out but I try to do the best I can.  Once I figure out the right size for a position it is best to stop and ignore it. 

 

Its hard and takes discipline...

My experience with averaging down has been quite consistently satisfactory and I wonder why.

 

From FFH AR 2011, experience with International Coal:

 

As an example of our long term value investing approach and the need to be patient and calm through adverse market fluctuations, in the table below we show you the results of our purchase and sale of shares of International Coal. This is a company of which Wilbur Ross was Chairman and owned 16%. Our Sam Mitchell, who originated this purchase idea, joined the Board in 2008, after we had acquired 13.8% of the shares.

-Purchases of International Coal Sales of International Coal

        Number of Shares  (millions)      Cost per Share    Total Cost 

2006            1.4                                      $4.58                6.4

2007            19.7                                      4.39                86.3

2008            9.1                                        1.81                16.5

2009            15.0                                      2.87                43.1

Total            45.2                                      $3.37                152.3

 

-Proceeds per Share Total Proceeds

        Number of Shares  (millions)      Cost per Share    Total Cost

2010            22.6                                    $7.26              163.9

2011            22.6                                      14.60              329.6

Total            45.2                                    $10.93              493.5

 

Total realized gain: 341.2M

 

The table shows how we averaged down from our initial cost of $4.58 per share to an average cost of $3.37 per share. We sold half our position at $7.26 per share (a 115% gain) and only five months later, there was a takeover offer for the whole company at double that price. In spite of not buying only at the low and not selling only at the high, we earned $341.2 million by selling at over three times our cost. Our experience with International Coal is exactly what we have done over 35 years of investing – average down when buying and average up when selling! An added advantage in this case – we got to know Wilbur and he is an excellent partner.

Obviously the excerpt is a selection of a selection bias but I could put up similar tables for my gradual involvements in Fairfax, OdysseyRe and The Brick among others, including some cyclical stuff.

 

Maybe it's just luck and I agree with others about checklists, slow thinking, writing down etc but I wonder if the factor you mention about position sizing may not be an important determinant ie deciding in advance about a potential maximum percentage of portfolio with quantitative triggers (price vs intrinsic value) on the way down and up, hopefully in that sequence. I think Newton did the opposite once with his South Seas investment but that's another story and maybe by quoting the difficulty of quantifying the madness of men, he was the father of behavioral finance. A clear potential disadvantage with this strategy is the implicit need to have available fire power and this perhaps ties in with what SharperDingaan is trying to explain in a different thread (house money etc).

 

Take the above with a grain of salt as I seem to become more and more confused in today's markets.

 

Cigarbutt, I generally like your posts: they are smart, and well thought out... you know a refutation is coming :-).

 

Averaging down: works until it doesn't.  Do yourself a favour and read the entire Pennwest post.  There was thesis drift through the entire thing.  Initially I got caught in it but realized that and got out with some loss.  Maybe SharperDingaan has somehow managed to trade in and out and make money along the way.  But read carefully what they write.  It is often dishonest in how they define their results.  They never come straight out and admit that they lost money on a situation.  Maybe they never do... but there is no honest disclosure so how would I know.

 

Using a Fairfax example to dispute this is all good unless you look at the situations where they have lost huge:  Invested 500 million in Canwest weeks before it bankrupted and they lost everything.  Blackberry, Torstar, SFK-Fibrek, Resolute, the market puts that cost hundreds of millions, or billions.  Without their bond desk they would have been gone long ago.  Invested (got lucky) in Sandridge because they liked the sleazeball in charge? 

 

If you want an exercise in studying cognitive biases you need only look at FFH and all the threads.  The thesis drift in the threads is pervasive.  For a long time it was about great investment results but crappy insurance underwriting, then it switches to great underwriting but lowsy investing.  Prem wrote for years how they were targeting 20% annual returns, then dropped it to 15% which they have never come close to meeting.  He wasn't going to give the company to his family but he has.  Then there are the nasty tricks along the way to maintain control of the company.  Investors on this board are blind to FFHs foibles. I made my decision to sell the stock in and around 2012 and never look back. 

 

I agree with you that Writser has created a great checklist.  Mostly it involves writing down your thesis, initiating and starter position, and then sitting with it.  I am endeavouring to work with the sit with it portion, for years if necessary. 

 

Cheers, Al

 

Just for completeness.

 

We have made money on PWE/OBE, but it hasn't been enough for the risk we've taken. It was also primarily made by repeatedly selling up to 1/2 the position at a higher price, and reinvesting the proceeds at a lower price. We averaged down our cost base, got a higher share count, and did not have to put up new outlay. On earlier occassions when we've spoken to the technique (hedging via a synthetic short) we've been criticised for it.

 

We materially reduced our posting on OBE, because we know folks are hurting, and it's not helpful. A lot of Albertans are in very real danger of losing their livlihoods, I know some of them, and the coming change will very likely cost some of them their families.

 

SD

   

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SD,  What you did was sell part of your position on an upswing and then rebuy it later.  And if you still hold it now you are losing money on it.  You have created a cognitive bias for yourself, and damaged your credibility with board members in the process.  You know the stuff Buffett has said about a reputation.

 

There is no such thing as a synthetic short.  Its called swing trading.  You are probably better at it, or luckier, so far.  Its just another thing I have tried that has worked for me until it doesn't.  Overbuy, sell on an upswing, then buy back at a new lower price, and then lose money on that.  And its another thing I am knocking off. 

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Problem with value investing is that you are hunting for gems in a pile of trash. And even if you find that gem, it is likely unpolished and in need of some love.

 

If done properly, it does work over time but, expect a lot of pain along the way.

 

I think that averaging down is a symptom of that or that we are way too early and/or not demanding enough compensation for the risk that we are taking with that so-so gem.

 

We also focus too much on fundamentals while there are a lot of mechanics that will come into play with an out of favour stock after we buy: tax loss selling, exclusion from some index, becoming non-marginable, below a certain minimum price for some funds to hold, all of which will create additional selling pressure.

 

Then we have technicians who will simply sell because the chart is bad and trend is downward. Short sellers too.

 

Bottom line is that you have to wait for incredible bargains, not just bargains. That takes a lot of patience and discipline because you will miss some winners doing that. However, it will avoid a lot of the pain described in this thread and allow time for company's fundamentals to truly surface.

 

Don't worry, I have not mastered it yet.

 

Cardboard

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Agreed a swing trade isn't for everyone.

 

Just keep in mind that if you only repurchase the quantity you sold, the $ difference is a partial return of your capital outlay. You can benefit through either (1) having more shares for the same outlay, or (2) the same number of shares for less outlay. When our focus is on capital recovery we're almost exclusively (2), and only progressively shift to (1) as outlay declines to zero. For us this is risk management.

 

Per full disclosure.

 

Swing or not, should be based on systematic periodic assessment. If you want to keep the stock, is next quarter likely to be better than this quarter?, if no - sell up to 1/2 your position, and buy it back later. Make your decision, live by it, and no new capital outlay.

 

We find that at best a swing trade will extract 20-30% of the potential value, and will go our way maybe 3 of every 5 times out. It is not sell on a double and you're done; it's a process, there will be a number of iterations, but persistence should eventually get you there.

 

We voluntarily post as a courtesy to others, and where relevant, try to suggest 'higher level' practical solutions to identified issues. We are not publishing a text-book of 'how-to' examples, and we are not a substitute for due-diligence.

 

We apologize if posters have interpreted our comments beyond that intended.

Hence, the disclosure.

 

SD

 

 

 

 

 

 

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very good thread.

 

my only thought to add is based upon Kahneman's system 1 vs system 2. 

 

what I try to do when considering whether to buy a stock is system 2 analysis.  this stock satisfies a checklist of attributes I want represented in an investment.  almost every other decision that I would make with respect to that stock (sell, add, double down) is system 1 analysis.  what seems right.  is this price appreciation/depreciation a tell to buy/sell?  because I have already done system 2 analysis and this usually doesn't change absent significant new developments.  if there are no new developments to consider then I am in system 1 realm and this is an area ripe for cognitive biases to play, and I am not sure how to deal with it other than make a decision in the system 1 realm knowing there is not a substantial analytical underpinning...eg yes sell, no-one ever went to the poorhouse making a profit

 

if I come to discover that my system 2 analysis is wrong or has become wrong, then I feel I can be more assertive in selling.  an example that comes to mind is FB.  one can have concluded that FB had satisfied various investment attributes at time of buying, and never have considered regulatory risk as an attribute to consider when buying.  you're system 2 analysis can be right when you buy, and become wrong when you hold.  if you say whoa, regulatory risk is not the kind of company risk I thought I was buying into, then you can be more certain about selling, because that sell decision is a system 2 decision.

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Just when stocks start falling, a bunch of people come out to say that they don't average down.  ;D

 

I'm surprised nobody yet said "stop cutting your flowers and watering your weeds". You guys are slacking.

 

Yes, never buy anything cheaper than you paid for it before. This is sucker's game. Only pay up. Especially after 10 years of rising market. Clearly if the stock price fell, it's a crap stock, crap company and it's going to zero. Yeah, even if it's BRK. I mean look what happened to SHLD - this is what happens if you average down. So don't even think to do it.

 

Will Rogers got it right: “Buy good stocks. When they go up, sell them. If they don’t go up, don’t buy them."

 

 

8)

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Just when stocks start falling, a bunch of people come out to say that they don't average down.  ;D

 

I'm surprised nobody yet said "stop cutting your flowers and watering your weeds". You guys are slacking.

 

Yes, never buy anything cheaper than you paid for it before. This is sucker's game. Only pay up. Especially after 10 years of rising market. Clearly if the stock price fell, it's a crap stock, crap company and it's going to zero. Yeah, even if it's BRK. I mean look what happened to SHLD - this is what happens if you average down. So don't even think to do it.

 

Will Rogers got it right: “Buy good stocks. When they go up, sell them. If they don’t go up, don’t buy them."

 

 

8)

 

1 word, Berkshire.

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Just when stocks start falling, a bunch of people come out to say that they don't average down.  ;D

 

I'm surprised nobody yet said "stop cutting your flowers and watering your weeds". You guys are slacking.

 

Yes, never buy anything cheaper than you paid for it before. This is sucker's game. Only pay up. Especially after 10 years of rising market. Clearly if the stock price fell, it's a crap stock, crap company and it's going to zero. Yeah, even if it's BRK. I mean look what happened to SHLD - this is what happens if you average down. So don't even think to do it.

 

Will Rogers got it right: “Buy good stocks. When they go up, sell them. If they don’t go up, don’t buy them."

 

 

8)

 

You bring up a good point, which is that many people confuse stock price fluctuations with the actual value of a business. The reality is that these things are positively correlated, but the correlation is, in the short to medium term, almost always less than 1. Psychologically, when a stock falls day-after-day, it's hard and painful to maintain the courage of conviction while also continuing to seek out new info. People tend to either give up or turtle up.

 

I'm a card carrying member of the averaging down society, but it's only appropriate in certain situations. I have lots of thoughts on this, but it mostly boils down to controlling position sizing, thinking hard about the downside, and taking advantage of volatility. I will also trim positions on the way up, something that I rarely see mentioned.

 

Finally, if you're still reading this you should go back and re-read writser's post in this thread, as it's very well thought out.

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The biggest problem I've had with this board over the years is the lack of obvious but simple critical thinking that would have avoided disasters like all the nat/oil gas plays, SHLD, etc.  Basically, I think a lot of folks on this site miss the forest for the trees.  The focus is on the granular, bottom up approach where instead one should step back and look at things from a top down perspective first.  I have numerous examples of this over the years from folks on this site. 

 

 

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The biggest problem I've had with this board over the years is the lack of obvious but simple critical thinking that would have avoided disasters like all the nat/oil gas plays, SHLD, etc.  Basically, I think a lot of folks on this site miss the forest for the trees.  The focus is on the granular, bottom up approach where instead one should step back and look at things from a top down perspective first.  I have numerous examples of this over the years from folks on this site.

 

I find you're able to concentrate selection bias, simplification bias, clustering illusion and the fallacy of anecdotal evidence to underline what seems to be an investment approach (bottom-up or top-down) issue.

Apologies since I may be missing the courtesy bias. :)

Please explain how it is easy to avoid a disaster, before it happens, if possible.

 

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The biggest problem I've had with this board over the years is the lack of obvious but simple critical thinking that would have avoided disasters like all the nat/oil gas plays, SHLD, etc.  Basically, I think a lot of folks on this site miss the forest for the trees.  The focus is on the granular, bottom up approach where instead one should step back and look at things from a top down perspective first.  I have numerous examples of this over the years from folks on this site.

 

I find you're able to concentrate selection bias, simplification bias, clustering illusion and the fallacy of anecdotal evidence to underline what seems to be an investment approach (bottom-up or top-down) issue.

Apologies since I may be missing the courtesy bias. :)

Please explain how it is easy to avoid a disaster, before it happens, if possible.

 

great thread, but the original question is a category mistake.  people cant generally avoid cognitive biases.  in fact, we have been programmed through evolution to develop and use cognitive biases.  Kahneman makes this clear.  we live 99% of our lives thinking in system 1.

 

frankly, I think the best way to try to deal with the pernicious effects of cognitive biases is to adopt a contrarian bias, to invert. may or not make you money, but at least you are forcing yourself to ask the questions that cognitive biases are working to suppress.

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