Monday, May 08, 2006
Financial Decision-Making Mistakes
Premise For My Future Book
Investing is a life long experience and adventure, and sometimes a nightmare. Academic intelligence does not guarantee success. In fact rote-learning and ivy league MBAs mostly lead to decision by numbers or an aggregation of numbers and spreadsheets. By looking at how people make the most common decision-making mistakes in investing, we can know and understand better what makes good decision-making in investments. As I am still thinking through this, the list is not exhaustive:
1) Academic deduction does not equal right investing decision (the "trigger factor") - When the information in front of you and the amount of research you did agrees with you, it still may not be the right investing decision. Warren Buffet warned about US' trade deficit and put his money where his mouth is by betting heavily against the US dollar over the past few years. He has lost heavily on that bet, but may make some back this year. All the economic and financial indicators point to an unsustainable trade deficit and consumption pattern. Where did Buffet go wrong? Timing. Timing is everything, they say. Although you may not be doing it perfectly, you try to get as close as possible, not a few years off, because even a year off the mark will ruin some careers. Arriving at the right academic solution is having the "right thing to do" lever at your disposal. That in itself is insufficient for making a correct financial investing decision. What Buffet lacked is knowing the "trigger factors". There are many investing situations every day, every week, every month... we cannot make a decision on every issue. We can only bet according to what we know best. Even if we know Google is overpriced, we may not short because we do not know what the "trigger factors" will be for its correction. Having the opinion that Google is overvalued may be an academic conclusion, I might act on that if I have a few "trigger factors" appearing in the horizon... it could be: "valuation of Nasdaq tech sector has jumped 25% over the last 3 weeks"; or "there has been a sharp increase in insiders (senior execs) of tech stocks selling over the last 2 weeks"; etc... So for the case of the US dollars, I have argued in January that it will be resilient. However, last two weeks have made me conclude that all asset classes seem to be ganging up to whack the dollar down at least 15%-20% from current levels (read blog on Global Rising Rates Repercussions Apr 30), and that is sufficient enough for me to regard it as a "trigger factor" - translating the academic conclusion that can now be acted on. So, beware of what is written and said by experts, a buy may be a buy, and a sell may be a sell, but prices would not move in the "correct" direction if the trigger factors are not apparent. An undervalued stock will remain undervalued and not budge unless there are trigger factors.... jumps in liquidity, corporate exercise, insider share movements, jumps in coverage, jumps in volume, etc... Making a decision based on academic conclusions alone is a half-baked financial bet. Make sure you have the "trigger factors" covered.
2) Expert talk (Anchor & adjust mechanism) - Many experts will say the same BS over and over again. Analysts, strategists and especially economists will come up with figures to justify their conclusions and opinions. Mainly, the figures are based on "anchor & adjust" decision making and not really sound in most cases. If you ask an expert what Bank of America's share price will be end of the year - the expert will take current price and adjust upwards or downwards according to what he knows (banking outlook, company strategy, etc...). The problem with anchor & adjust mechanism is that you can only take in finite number of variables. In any projection, we will take in 3 or 5 variables, sometimes even less. Whereas in reality, most actually require 20 or 30 variables, some experts may not even be able to note the 3 or 4 crucial variables in their estimation. A&A methodology automatically rules out "out of range volatility", they are not able to cater to that. For example if the GDP growth of Country A was 3.5% in 2005, an expert cannot readily commit to projecting 9.5% for GDP growth in 2006 - the variables under his justification table is not there to support such a hypothesis. Plus you will stand out like a sore thumb. That is also why if 100 economists predict the growth of US economy - I would not care about the weighted average but I would be very interested to know the two extremes' prediction and their arguments. Consensus is BS, only the ridiculed is worth noting.
3) Intellectual integrity and muscle - Many experts do not have the intellectual integrity or muscle to support their opinions or platforms. Shouting and volume alone (especially by American business commentators) do not add to credibility. Good conclusions are always defensible, always persuasive and usually sheds some "new light" on the matter.