Why We’re Wired to Make Bad Investments

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

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

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

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

Question: Is it best to take a contrarian \r\nview of the market? 

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

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

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

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

Recorded on May 14, 2010
Interviewed by Jessica Liebman

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

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