Why We’re Wired to Make Bad Investments

We like to follow a bullish or bearish trend. But the best investors sell when everyone’s buying, and buy when everyone’s selling.
  • Transcript


Question: Why are we wired to make bad investing decisions? 

Michael Mauboussin: The wisdom of crowds tends to work when you have you have three conditions in place. The first is diversity, so all of us are acting and thinking and operating in different ways. A properly functioning aggregation mechanism would be the second; so ways to bring our information and our varied views together. And then, finally, properly functioning incentives, which are rewards for being right and penalties for being wrong and of course, they can be monetary, but they don’t have to be. 

So when those things are happening, you tend to get very good results from groups and markets themselves tend to be pretty well functioning and "normal." Now the flipside is what happens when one or more of those conditions are violated and by far the most likely to be violated is diversity. So rather than each of us thinking independently, with our own points of view, we start to coordinate our behaviors. And this is a very, very natural human reaction. We like to be part of the group and we like to go with what is working and this, I think, is ultimately the bane of most people when they invest, which is when things are going really well, all the fibers in your body says "I want to be a part of that group and I want to be making money along with that group." And inversely, when things are going badly, you become very fearful and you want to avoid it. It’s almost a notion of disgust, you almost push it away when. in reality, we know from a lot of experience that you want to be selling when everyone’s buying and buying when everyone’s selling. 

So it's very... our innate sort of motivations are almost counter to what makes you a successful investor and I guess the last comment I’d make on that is you find that many of the great investors, very successful investors, are those that really, in some ways, can be an emotional check. They don’t tend to be swayed by the views of others around them; they tend to be very independent, which, you know, I think is a fairly unique trait that can be developed to some degree, but think it’s a very unique trait for most great investors. 

Question: Is it best to take a contrarian view of the market? 

Michael Mauboussin: I think it’s a little bit deeper than that. There’s a really successful investor in Boston named Seth Klarman, he runs something called the Baupost Group and they’ve done really great over a long period of time and he’s got a line which I just love which is "Successful investing is the marriage of a calculator and a contrarian streak." So maybe start with a contrarian streak. It really is important to be a contrarian, sort of do what everyone else is not doing. That said, that’s not enough, right, because sometimes being a contrarian for the sake of being a contrarian is a really bad idea. In other words, if the movie house is on fire, by all means, do run out the door, right, don’t run in. So sometimes the crowd is correct. 

The calculator part is the second one, which is if the group is off on one side or the other of the ship, tilting the ship, then you have to apply a calculator, which is determining whether the expectations built into the asset price, let’s say a stock to make it concrete, misrepresents the fundamental prospects for that company. So are the expectations and fundamentals mispriced relative to one another? And that does require some analytical work.  

The best metaphor for the expectations of fundamental really is the racetrack; horse racing, so you know there are two different things. One is the odds and the tote board, which dictate the probability of a horse winning or coming in at some place, and then the actual performance of the horse. 

Knowing which horse is going to win every race doesn’t make you money because, of course, it’s already reflected in the price. The key is to find mis-pricings between the tote board and the performance of the horse and it’s a very similar thing. So it’s the contrarian streak plus the calculator, I think, is the one/two combination. 

Recorded on May 14, 2010
Interviewed by Jessica Liebman