The Psychology behind the ‘No Maximum Size’ approach
Right, now we are finally onto the nitty gritty of the Blog Series – sorry it has taken so long but I felt a strong need to set the scene in Part 1 and make sure Readers had a decent understanding of what the Techniques practically meant before we plough on with the Psychology and Thought Processes lying behind them. If you have not read Part 1 yet, I suggest you read that first as this one may not make a whole load of sense otherwise.
It is hard for me to know 100% for certain, but I suspect the following Psychological Biases are fairly accurate regarding Practitioner’s motivations for using the ’No Maximum Size’ approach – this is because I do not use such an Approach myself so I am simply attributing likely Biases that might drive this behaviour (the word ‘Bias’ must not be taken here as necessarily a negative thing – I mean it more as an innate and probably mostly subconscious part of our Thought Processes. In terms of Daniel Kahneman, it is your ‘Fast Brain’ making snap judgements and introducing certain predispositions with regard to how you assess the individual Approaches, driven perhaps more by Emotions than by truly careful Rational thinking by your ‘Slow Brain‘. Something to appreciate here is that recognising your own Psychological Biases is an essential Starting Point – and one way of overcoming them is simply by repeated practicing which really means Time and Experience – it is for such reasons, that Experience is so valuable in Trading / Investing):
An ‘Anchoring Bias’ towards “Running your Winners” – it is almost a dogmatic belief that because some or other Guru has told us we should “Run our Winners” we think that is always the right thing to do and we almost don’t want to question that Approach. This may also be linked to a ‘Halo Effect’ where a certain Guru has enormous power over the way we think because we see / hold them in very high esteem and regard and in psychological terms we “Put them on a Pedestal”. They can do no wrong because they are the Guru. Wow, this keeps building – I have now suddenly realised there is a ‘Survivorship Bias’ here as well – we all hold up examples of Gurus and of course we rarely consider that perhaps they are not as amazingly talented as we think – it might simply be that by sheer Luck and/or Coincidence or whatever, they have ‘Survived’ whereas all those millions of other Investors that we never hear about have fallen by the wayside (or equally likely they might just be happily going about their business in private without shouting about it – unlike all us egomaniacs running Investing Websites !!) – this is a huge topic and too big for this Blog, but here is a link to Survivorship Bias from Wikipedia:
Whilst doing the final edit of this Blog, I have realised there is another element called the ‘Availability Heuristic’ – this is where we tend to overweight and attach more importance to Information that is easily to hand – in this example the sheer fact that the Guru is everywhere will tend to make us focus on what they are saying – whether or not they are right, and irrespective of how what they are saying fits in with our own Portfolios and different Approaches (whether or not these differences are subtle or profound, they can still be sufficiently unlike what the Guru does so as to make his/her ’advice’ irrelevant and perhaps even dangerous for us in our context). You can read more on the Availability Heuristic here:
Hindsight Bias (Outcome Bias) and/or Recency Bias – this arises from the Individual Position having done really well especially in the very recent past. Holders project onto the Rally and make the Assumption that this performance will continue. Apart from the ‘Free Lunch’ aspects of Momentum (which without exception always come to an end eventually), the History of a Stock or Asset has no bearing whatsoever on what will happen to it in the Future – it is impossible for us to know the Future with certainty and I sometimes get the impression that People really misunderstand this. For myself I use the ‘September 11th Test’ – what would happen to the Stock and to your Portfolio if we had a repeat of something like the 9/11 Terrorist Attacks on the Twin Towers? For a less extreme Test, we just need to think about what would happen to a Stock we hold and to the Portfolio if we get a Shock ‘Black Swan’ Profit Warning the next day. It might sound far fetched, but once you have been around the Markets for any length of time you will know that such events are not particularly rare (in fact, there is much Academic writing about the ‘Fat Tail‘ of how such Black Swan events are far more common than they statistically should be – Nicholas Taleb‘s ‘The Black Swan‘ covers this kind of thing – you can get a copy from Wheelie‘s Bookshop). As an example, who would have expected Tesco TSCO to have had an Accounting Scandal? As if to back up my contention, just in recent Weeks we have had Profit Warnings from formerly high performing Stocks like NCC, Easyjet EZJ, Victrex VCT, Senior SNR, Capita CPI, Michelmersh Brick MBH, Next NXT, Laird LRD etc. etc. etc. (far too many for my liking and it suggests to me that things are tougher out there than Markets realise at the moment, but that is a topic for another day…..)
Overconfidence – In a similar way to the Paragraph above, I think many People are prone to overestimating their own Skills when it comes to Stockpicking. It is the classic thing that everybody thinks they are better than the Average Investor – which is of course totally impossible (it‘s called Mathematics or ‘Math‘ for American readers). It would probably do us good to reflect upon how we Invest / Trade and to really consider if we do have Superhuman Stockpicking Skills or have we just been lucky? Are our Returns in fact as good as we think they are? (this is particularly relevant after 6 years of a raging Bull Market). I have no doubt that we need to keep some humility and realise that we do get things wrong and of course if we have let a Position grow to be extremely oversized within our Portfolio, you can almost guarantee that it will be that particular Stock that blows up on us !! It must always be at the forefront of our minds that Share Price performance is largely unpredictable. Maybe we should adopt Approaches and Rules which help to minimise our own Psychological failings. See my ‘Monkey with a Pin’ Blogs – there is a link at the end of this Blog Series in Part 3 but you should be able to find it using the Search Box if you can‘t wait.
The ‘Halo’ Effect comes into play in another way as well – something I have noticed over the years is that we tend to favour and ‘like’ Stocks we hold that go up or that we have done well on in the past. For instance, if I hold a Stock which has steadily risen over the last year or so and someone says “What do you think of x Stock?”, I will probably reply with something like “Oh, I think that is a superb Business and I really like the CEO and it’s good Value etc. etc.” – the problem here is that I might not be answering the correct question. It is a Psychological Bias where you are really asking me if you should Buy the Stock but I am answering a different question which I have substituted via my ‘Fast Brain’ (the Emotional bit) which could be something like “Has the Stock performed very well for you while you have been holding it?”. This is obviously quite complicated stuff but it is a pretty well established Psychological Principle how we regularly “only hear what we want to hear” and it is something we need to recognise in ourselves if we are truly going to overcome the worst impacts of how our primitive Animal Brains mislead us. In a similar way, if you ask me about French Connection FCCN, I will tell you that it is the worst piece of Poo to ever exist in the Business World – but what I really mean is that I am hugely underwater on it and it frustrates the hell out of me !! I introduced this Bullet as the ‘Halo Effect’ but it is really more to do with ‘Question Substitution’ maybe. In terms of how it impacts the ‘No Limit to Position Size’ approach – it might well be the case that we are looking at the superbly performing Stock with Rose Tinted Specs and with a Halo Effect of thinking it can do no wrong (you can guarantee that once we start thinking like that it will kick us hard in the nuptials.) Sorry to labour the point but it is important – another way of putting it is that as Long Term Investors we should really be focused upon what is happening in the Business itself and less so on the Share Price and what that is up to. By allowing the Positive Halo Effect type emotions of the rising Share Price to cloud our objectivity, we might be believing that the underlying Business is performing much better than it actually is – we will without conscious effort just skim over news that is not quite so positive and maybe even downright negative. Remember the Benjamin Graham saying, “in the Short Term the Stockmarket is a Voting Machine and in the Long Term it is a Weighing Machine” – this emphasises the point that good Short Term performance might not be representative of what is really happening within the Business but because it has done so well in Share Price terms, there is a risk we will think the Business is doing well and be less objective and critical in our analysis.
Confirmation Bias – this is linked to the Overconfidence thing – because a Stock does well it confirms what truly exceptional Investors we are. If we buy a Stock and it goes down, it is not because we are terrible Investors (because our many Huge Winners ‘prove’ we are geniuses) but it is because “the Directors are useless and let us down” – it is rarely our fault for buying such a turd (when of course the reality is that it is entirely our fault and even if the screw up in Stock Selection was unavoidable, we could have managed the Position Size better to prevent it having an unnecessarily large damaging effect on our Portfolio. Maybe picking Dodgy Stocks goes with the Territory but poor Risk Management must not be excused).
Mental Accounting – this is a difficult concept to explain but I will have a go and once I give a practical example it might make more sense. The theory is that with Mental Accounting you put pots of money into different ‘Compartments’ in your Brain and by doing so you are sort of blanking out your mind to the true Risks you are facing. The practical example of this is that I have heard people who run their Winners without ever TopChopping say that “I’m only risking my Initial Capital” which of course is not true because in reality they are risking their Initial Capital PLUS all the Gains they have made on Paper and not yet Banked – remember, “A Profit is not a Profit until you Bank it” and this is a really important adage to remember and in my view apply by TopChopping at an appropriate time. Slightly off subject but it will help with understanding; the other day I heard someone say “I am getting 6% Dividend Yield on my Initial Capital” on a Stock they held which had doubled. This is classic ‘Mental Accounting’ – in reality they were justifying to themselves holding the Position because they were “Getting 6% Dividend Yield” but because the Stock had doubled in reality they were only getting 3% Dividend Yield on the Total Money Invested now and this is obviously nowhere near as good as they were mentally fooling themselves into believing. This could be a serious error brought on by their Brain tricking them because if they were to sell the Position and buy something else they might be able to get perhaps 5% Divvy on the whole lot – and after the original Stock had doubled, there might even be a large element of Valuation Risk introduced as well.
Fear of Missing Out (FOMO) – many People struggle to do a TopChop – they feel it means they will miss out on maximising Gains (this FOMO is very related to other Psychological Concepts I have listed – especially Overconfidence, Hindsight / Recency Bias, and Halo Effect. There is possibly an Optimism vs. Pessimism aspect to this – Optimists will expect their Beloved Stock to rise to the Universe and this makes them cling on for sheer life, whereas Pessimists will sell too early because they want to snatch at their Gains. Maybe the Best Approach is that of the Realist – a Halfway House where you TopChop so you are still in the game and satisfying your Optimistic side but you have Banked some Profits to placate the Pessimist. This could also be viewed as the Mental Fight we have between Fear and Greed – our Pessimistic Inner Self feels the Fear as the Market plays on our emotions with all its usual Price Gyrations and ’Noise’ dressed up as ’News’, and our Optimistic side fires the Greed. Obviously Pessimism and Optimism can be inbuilt overall Traits we all have but I suspect that in all of us we can swing between Optimism and Pessimism from Day to Day and maybe even Hour to Hour (I know my mood can be massively changed intraday by a change in the Markets – for instance, in the morning Stocks can be down and I am peed off but then later in the day we get a rally and we end the day Up and I am needless to say far happier !!). I have no doubt this is part of the ‘Seasonal Investing’ effect (“Sell in May and Buy on October 31st”), where Optimism in the Spring as we head into Summer drives up Shares Prices and Pessimism in the Autumn as Winter looms makes drives down Prices as people sell due to their subdued mood. Booze, Crystal Meth and lack of Sleep can also impact our moods…..
The Disposition Effect – this is where we are more attached (and psychologically we value it far higher) to something we own as opposed to something we don’t own. The sheer act of ‘owning’ a particular thing makes us Humans loathe to Sell it, lose it or otherwise be deprived of it. Many Investors say that one of the hardest things for them is working out when to Sell a Stock – this could be partly down to the Disposition Effect which makes them psychologically reluctant to Sell something they hold. It is also why many people dislike using Stop losses – I am definitely afflicted by this !! In terms of TopChopping, if you use a Rule along the lines of “I will never let a Stock become bigger than 8% of my Portfolio”, then you take the emotion and angst out of a Selling Decision and you just obey the rule once the Position grows too big. Simples.
That’s it for Part 2 – this is pretty heavy stuff so feel free to read it again (don’t worry, I am monitoring what you read via Google Analytics and I won’t let on that you had to read it 12 times….). In Part 3 I will apply some Psychology thoughts towards the TopChop Approach – although that will be a lot shorter because of my own innate Bias towards TopChopping !!
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