I’m an individual investor, exercising a completely discretionary approach in selecting investments for my portfolio. While the approach imposes no constraints, the flexibility comes at a cost – as we all know, one can easily be trapped in an array of cognitive biases (and not only). Numerous publications available describe and explain the characteristics of the biases, but none of them offer a comprehensive and holistic approach on how to control them. It seems to me a decision support / tracking system may be helpful in addressing the problem, at least up to a certain level. Ideally, such system should allow prescreening of raw ideas, taking potential biases into account (may be just in a form of questionnaire); provide a functionality to assign both qualitative (possibly with some elements of fuzzy logic) and quantitative criteria supporting or rejecting an idea and generating some kind of a metric indicating a strength of belief; allow to aggregate ideas and calculate an aggregated measure of strength of belief. Once a position is established, the system has to provide a functionality to trace back to the initial ideas, based on which the position has been established; demand a periodic review of ideas or readjusting the strength of belief for individual ideas to make sure they are still relevant. If at some point the aggregated metric of belief falls under a certain threshold, it should prompt a reassessment of the position. Does such system exist? Can it be made or is it a pipe dream? How do people integrate cognitive bias control into the decision making process? How to keep track of the original assumptions/ideas and review/adjust their relevance?
Welcome, my friend, to the world of Value Investing.
Here’s a starting point: Pompian-“Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases”
you might want to look up kahneman and tversky as well as richard thaler. those 3 guys are prominent figures in behavior finance. pick up the book, prospect theory if you’re more interested.
richard thaler utilizes a 3 factor framework (fundamentals, quantitative, and behavioral) to investing. you might want to read up on his process and how he incorporates behavioral factors into his “model”.
Charlie Munger
It’s always a great idea to write down your initial thesis. I am not sure an elaborate system is necessary where you quantify the strength of your idea and sell-out once a threshold is breached. Periodic revaluation is part of the investment process and can be triggered by a number of developments - most commonly a large drop in price. Which brings us back to step # 1 - your initial thesis. Does it still hold? Has there been a permanent impairment in capital or significant deterioration in business conditions to warrant a sell. If the thesis still holds, buy some more. I think part of the problem too on the individual investor level is that for those of us not running a large portfolio, transaction costs pose a significant penalty on performance and averaging down is costly. I try to establish half positions and buy on the downswing (if it occurs) - otherwise just hold on. I feel the issue of conviction is addressed on how much weight in the portfolio you give it at the time.
Thank you everybody for suggestions, will look up each of them. But besides academia, it is interesting to know what people in the field, you guys and girls on the buy side, are doing to control biases? ValueAddict, glad you brought up the averaging down subject because in my opinion this is where an attempt to control one bias can translate in getting into another. You can argue if one establishes the whole position in a single transaction (market impact issues aside), he exhibits “overconfidence” in assessment of the entry point. On other hand, if you establish a position over multiple days with each consequent transaction at more and more favorable price (averaging down), at what point should you start asking yourself if perhaps you’re no longer controlling overconfidence, but instead got caught in loss aversion trap? When do you admit to yourself that the whole decision was wrong?
risk management with limit triggers.
Thaler runs a hedge fund based on behavioural finance. Fuller & Thaler:- http://www.fullerthaler.com/strategies/Default.aspx
I think loss aversion is sort of a generalization. People hold onto losers because of fear of recognizing a loss. The question is what constitutes a loss? Which is dependent on your time horizon. I view a loss as a permanent impairment of capital. Its only when there is no chance of a recovery of principal and no promise of earning a satisfactory return that this loss becomes permanent. Loss aversion more speaks to the fact that individual investors 1.) speculate (to begin with) having no adequate thesis 2.) when it moves against them hope to regain their original investment and then sell out once they break-even
Second Value Addict that many people are to lax with how they buy stocks. When I buy a stock it is usually due to a simple thesis: two or three events that I expect to play out. If these events to not play out or are delayed, then I need to question my original thesis. Small difference, just because you’re the price depreciates and your thesis holds does not mean you should buy more. You have to think of the opportunity cost versus other positions. Also, sometimes following a sharp price drop you just cannot really know whether your thesis has been violated, in which case I always sell.
Alright, it seems like setting return expectation AND time horizon IN ADVANCE will help to control loss aversion. Obviously, both return and time horizon should be defined in intervals to prevent one from getting into overconfidence bias. Also, by setting entry price for a position as a range, coupled with a pre-defined time period allocated to establish a position, may help to overcome excessive “averaging down”. Let’s say a position is established, with a pre-defined time horizon and expected return ranges; thesis statements underlying the decision are written down. As time passes, what’s the proper way to assess the progress without getting into other traps, like “myopic bias” and “it just hasn’t happen yet”. Yes, you have your return expectation and time horizon, but how to assess what kind of return should be already “banked” in the middle of the period, ¾ in, etc? How to avoid telling yourself, “Okay, I underperformed in first 3/4 of the period but will make up in the final quarter”. But at the same time not become too paranoid and change strategy by focusing on short term performance?