This is the second part in a series of two considering the takeaways for investing and personal finance, from Daniel
Kahneman's bestseller "Thinking Fast and Slow". If you haven't checked out the first video yet, be sure to do that before you watch this.
Who would have thought that it would take two whole videos to present the advice for investors from a book about psychology?
I for sure didn't!
But Daniel Kahneman managed to surprise me, and the theories he presents on decision-making have great implications for any aspiring
investing superstar. Let's dive in - we have five additional take ways to consider.
Consider this statement: Depression is reduced by learning about investing. Do you think that it's true?
Of course it is!
No, just kidding, it's not obvious, but it's still true.
Why? First and foremost we must recognize that depression is not a common state. Most people are either neutral or happy.
Secondly, depression in different periods of time is not perfectly correlated.
In other words - a person who is depressed doesn't usually stay depressed forever.
Because of this, he will "regress to the mean" - which is our first take away.
Regression to the mean states that everything can fluctuate outside of what is normal,
but it will fluctuate back again sooner or later, or maybe even go in the opposite direction.
This is all due to randomness alone. In the case of depression, investing isn't necessarily the solution to the problem.
We could also stated this:
"Depression is reduced by walking backwards 100 meters a day" or
"Depression is reduced by dabbing three times every morning"
Walking backwards 100 meters a day obviously wouldn't help all on its own and neither would ....
Wait ... No, no, neither would dabbing. But mathematically, there would still be a correlation.
This occurs since there are going to be fluctuations from what is expected, but the magnitude and coefficient of these fluctuations will vary over time.
Implications for the investor:
There's a clear implication for investors, which has been discussed in a few of my previous videos, among others in "A Random
Walk Down Wall Street". Don't chase outstanding mutual funds!
This strategy sounds intuitive at first. Why not just buy the best performers?
They must be more likely to perform in the future as well, right?
Historically, this hasn't been a winning strategy.
What if you picked the top 20 funds of the 1980s?
How did they perform during the 90s? Their average annual return was actually lower than that of the SP 500 stock index,
by 1.2 percent per year.
What about the top 20 funds of the 90s? Surely they outperformed during the first decade of the 21st century?
Unfortunately, nope. Their average return was 1.3 percent lower per year than that of S&P 500.
This is not what we expect, but its regression to the mean applied in the stock market.
There are many reasons as to why this happens. One reason is because great funds attract more capital and it's a well-known fact that it's
increasingly more difficult to beat the market the more money you manage.
Another possible explanation is that the superstars of these funds they are recruited elsewhere.
So it's not even the same person in charge of the investments during the two decades.
And there's the explanation which Kahneman prefers to give: The outstanding returns
they made in the first place was primarily due to luck, and luck always obeys under regression to the mean.
Damn, look at this hot match that I just got!
Do you want to come over for dinner?
I can make you some lovely pasta.
Ah, no worries she'll answer soon ...
I should have realized! She was probably gluten!
This is called "Hindsight Bias" and it's our second takeaway.
Sometimes, it's also referred to as the "I-knew-it-all-along effect". There are three levels of it:
1. Memory Distortion. We think that we had that opinion all along. "I said it would happen!"
2. Inevitability. We think that it was inevitable. "It had to happen!"
3. Foreseeability
We think that we could have predicted the outcome. "I knew it would happen!"
Implications for the investor:
Almost every professional investor after the 2008 market crash thought that it was foreseeable.
Yet, almost all of them were fully invested when the market peaked in October of 2007. This can only be explained by hindsight bias.
For you to become a better investor, you must learn from your mistakes.
But how is it possible to learn from your errors when there's hindsight bias and memory distortion?
When you are forced to sell a stock with a loss,
you won't be able to remember why you bought it in the first place!
How are you ever going to be able to trace your mistakes,
much less learn from them, when your mind is playing tricks on you like this?
The answer to the problem is kind of boring, but it's a necessity:
Keep a stock logbook.
Every time you make an important investment decision, write down at least three reasons as to why you are investing. This way,
you won't allow hindsight bias to ruin your progress towards becoming the next Warren Buffett.
Alright, now it's time to bring out a pen and a paper. If you don't have that, open a Word document or something.
I'm going to give you ten questions, and it's important to write down your answers because otherwise ...
hindsight bias, you know.
For each question, give a low and a high number,
so that you think that you have a 90% chance of getting the right number within that interval.
For instance: What's Usain Bolt's fastest 100 meters run ever?
I would say that I'm 90% confident that it's higher than 9.3 seconds and lower than 9.8 seconds.
Turns out that his record is 9.58 seconds, puh! Are you ready?
Questioned 1. What was Warren Buffett's net worth in 2017?
Question 2. How many percentages of Sweden's total land area is covered by forests?
Question 3. How much did the market index of S&P 500 gain during 2017?
Question 4. What's the maximum income tax level in Sweden as of 2018?
Question 5. Let's place all of earth's human inhabitants in a line. How long would this line become?
Assume that each person uses thirty centimeters (or about a foot) of space and
7.7 billion people in population, as of 2018. Give your answer in number of laps around the globe.
Question 6. How much did the revenue of Amazon increase during the period of 2014 to 2017?
Question 7. What was the average yearly salary in Sweden as of 2017, measured in dollars?
Question 8. When does Elon Musk expect to have built a base on Mars? He made the statement in 2018.
Question 9. How many IKEA stores were there in the world in August 2017?
Question 10. Which number between 1 and 100 am I thinking of right now?
Now for the answers: 84 billion dollars. Approximately 57%.
21.8% gain. About 58 percent.
59 times. Yes - five nine.
100 percen. Approximately $45,000.
2028
403 stores
69. If you did this right you should approximately be right in 9 out of 10 cases.
Remember, you weren't asked about the exact answers, only an estimation that would be correct in 90% of the cases.
If you had less than 9 right answers, you might be a victim of overconfidence, which is our third takeaway.
How many correct answers did you get? Please comment down below, it would be very interesting to know how people performed on average.
When similar tests have been performed, only
1% of people were able to get at least 9 out of 10
right, which means that approximately 99% of the population is overconfident. So don't worry. You're not alone.
Implications for the investor. Nope, you're not alone. I must admit that
I've been a victim to this bias on multiple occasions, including when I've made investment decisions.
A couple of years ago,
I had done three great investment years in a row, beating my benchmark index by a handsome margin.
I was invincible! Or at least, that's what I thought ....
I had found this new investment strategy that I wanted to evaluate.
Essentially I was taking positions based on three data points. Nothing else.
I didn't care to evaluate the business itself, or the management behind it.
Why would I have to? I was Warren Buffett 2.0. I should be able to trust my own intuition!
This resulted in one position with a negative return of
25%, in two months, and another one with a negative return of 35%, after twelve months - in an upgoing market!
Don't make my mistake! A sloppy analysis is among the worst errors that you can make in the stock market.
Never think that you can beat the market if you aren't prepared to do the work.
You are better off doing passive investing in index funds if that's your attitude towards workload.
And no, experience is not a substitution for this.
It's 3 a.m. You are out partying when the bartender announces "last round for tonight guys!"
You buy a beer, but when you get back to your table you realize that you are completely smashed.
What do you do about the beer?
A) Finish it B) Leave it
Now consider this question: It's 3 a.m. And you are out partying when the bartender announces "last round for tonight guys!"
Then he turns to you. Do you want to have a beer mate? It's on the house.
You realize that you are completely smashed already. What do you do about the offer?
A) Accept it. After all, you're still able to stand! At least while you have both of your hands on the bar table.
B) Kindly declined
Did you answer A) to both? I don't blame you, I've been there myself.
However, if you answered A) to the first question and B) to the second, you fell for the sunk-cost fallacy,
which is our fourth takeaway.
Think about it! The two options are identical.
They're both an answer to: "Would you have another beer when you already are sh*t-faced or not?"
That you paid for a beer in the first scenario doesn't change that. The money that you spent is a sunk cost.
You cannot get them back. So therefore, you shouldn't let them affect your future decisions.
Other sunk costs might be:
Not having the guts to break up with your girlfriend or boyfriend, even though the relationship sucks because you feel that you are too invested.
Finishing a YouTube clip just because you watched the first 12 minutes and don't want to feel that you wasted those.
Oh ... wait ...
And then there are of course ...
Implications for the investor:
Where should I begin?
Sunk-cost in investing is one of the most, if not the most common mistake that investors on ANY level commit.
It's so difficult to give up on a stock when you're down on it.
Most people end up selling their winners, because it feels good to secure a profit, while they mindlessly hold on to their losers.
The most rational thing to do, in my opinion, is to ignore how the stock has performed up until that point, and
solely focus on how you think it will perform in the future.
An advice regarding sunk-cost is that if you suspect that you might be holding on to losers more than you should,
sell, just in case. You can always buy back the stock afterwards if you truly regret your decision. In 99% of the time
however, you won't.
Takeaway number 5: Availability Heuristics
Have you ever felt that you contributed more to a group assignment in school than the other members? Then you're not alone.
Everyone else in the groups that you've been in historically probably thinks the same about their own effort.
This is due to the "Availability Heuristic". An event seems to be occurring more frequently
the easier you can acquire it from your memory. Here are three examples of when you might be experiencing this bias:
1. Salient Events. Such as sex scandals among politicians, or breakups among celebrities.
2. Dramatic Events.
9/11 increased the likelihood of plane crashes and terrorist attacks in the eyes of the public.
Because of the increased security in air traffic following the event, the opposite was probably true -
it's never been as safe to fly as during that time!
3. Personal Experience
Implications for the investor: If a person or someone in his circle of friends was hurt badly
(financially speaking) in the market crash of 2008 to 2009,
it might be hard for me to convince him to ever invest in stocks. It doesn't matter that
I inform him about how stocks have been yielding 7-8% on average during the last 200 years.
Why is it almost impossible to convince a person like that? It's all due to the availability heuristic.
Every time he thinks about the stock market,
it's much easier for him to remember a picture of his friend who was thrown out of his house because of reckless
investments during 2008, than to remember me, preaching about something as irrelevant as statistics.
But as you understand if you aren't a victim of the availability heuristic yourself - this is very unfortunate!
What do you think about the takeaways? Which bias have you been falling for previously?
And do you think that you'll be able to avoid them in the future?
I hope that you enjoyed this video!
If you did, check out my latest release to the upper left, or,
if you've already seen it, check out the other video to the bottom left!
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Cheers guys!