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Mar 1, 2016

Beware Of Magical Thinking

by Ken Finkelstein

Ken FinkelsteinLet’s say I have a friend named Ben who possessed seemingly unearthly wisdom together with the emotional fortitude sufficient to resist Facebook’s (FB) IPO hype onslaught back in May 2012. Instead of rushing to buy some of the more than half a billion shares trading on that first day at a price anywhere between $38 - $45 (USD), Ben waited on the sidelines, biding time. And during the next three months, he continued to wait and to watch as Facebook’s market price plummeted. As of September 4, 2012, the stock had shed about 60% of its initial value, closing at $17.73 (USD).

The next day, September 5, Ben had a feeling that now was the time to get into the game. Acting on intuition, on a hunch that Facebook had hitched itself to a shining light hovering not far above Bethlehem, he bought $100,000 worth of shares at little more than $18 (USD) apiece. Then he hurried back to the sidelines where he resumed waiting.

Nearly three years later, on November 5, 2015, seeing that Facebook was trading above $110 (USD), Ben considered whether to hold or to pull the sell trigger. Calculating that his investment had now risen six-fold, he was pleased to see that selling his shares would net serious money, even after paying capital gains tax.

Yet, Ben wanted more. He wanted Facebook to make him a millionaire, an after-tax millionaire, a thank you-very-much-Mark Zuckerberg-for-allowing-me-to-retire-early millionaire. His head bobbing about among dream clouds, and convinced that Facebook had been anointed as the chosen stock of the 21st century, Ben made his decision. His gut told him to hold, that Facebook’s ascension had a ways to go. There would be no gunsmoke that day.

Magical Thinking

Ah, magical thinking. Arriving at conclusions based on little more than…thin air, fantasy and delusion. Regardless of the investment merits of Facebook (or any other investment for that matter), what’s concerning is that Ben’s genius lay in little more than wishing upon a star.

Okay, you say, but so what? The fact is that Ben called it right. Just look at the results! Given Facebook’s impressive run, isn’t it fair to say that Ben’s crystal ball is the real deal, that genius may be extrapolated from his prescient sixth sense, that his forecasts will continue to be accurate and Ben’s dream will come true?

Not exactly. Gain or loss does not prove whether the decision to invest was right or wrong. Rather, the usefulness of the rearview mirror is limited to showing how an investment fared. In the long run, if Ben is to manage a successful portfolio, if his stable of stocks are to produce more winners than losers, he will need more than intuition to form the basis of his decision-making.

All About Process

Investing is far from an exact science; it’s an art form. It always has been and will remain an art form, meaning that it is interpretive, allowing ample room for differing approaches and paths to success. Even Ben’s wishful thinking approach qualifies within the investing art’s broad parameters. However, although it is easy to implement and commonly employed, reliance on intuition alone, without any substantive support, is foolhardy and ultimately doomed to fail.

Consistently, successful investors rely on a process for choosing securities. Within the framework of an investment process, the investor starts with an idea that, on the surface, appears to be an opportunity. Then research is conducted, far beyond the writings of an analyst, the jubilance of a crowd, or the loud promotion of a popular media outlet in the business of attracting reader eyeballs. The process is relied upon for as long as the investor holds a particular security, guiding the investor through to the time of sale.

Knowing that a closed mind is a dangerous mind, the investor gathers and analyzes objective facts and remains open to evaluating all relevant information. Regardless of what kind of securities market analysis is utilized (i.e. technical, fundamental, macro, behavioural) or what type of investor you profess to be (i.e. growth, value, income, contrarian, momentum), information should include that which does not support preconceived theories or biased feelings. Tellingly, George Soros is known to review and reflect upon at least one contrary opinion before deciding whether to proceed with an investment.

So, would anything change for Ben if he was diligent and relied on a rigorous process when investing? Well, the frustrating answer is…maybe, probably. Since there is no perfect investment process generating profit from every investment, the best an investor can do is stack the odds in their favour.

Investorís Oath

Every stock market investor experiences loss. Without exception. Not once or twice but many times. Loss is part and parcel of the game. That said, successful investors win more than lose. They do so by staying disciplined. They consistently execute their process, knowing that sticking to their road map reduces, or even eliminates, poor decision-making and ill-informed trading. Through strict adherence to the process, through honouring the Investor’s Oath (i.e. thou shalt do minimal harm to thy portfolio), the investor increases the odds of success.

Because the portfolio will suffer losers, a well-thought-out process plans for the inevitable. It prepares for loss by deciding beforehand when to fold. While this knowledge is essential, it is only a first step. The second and crucial step involves staying disciplined, and selling at a pre-determined price.

Such a plan might look something like this: when a stock is down fifteen percent from purchase price, it is automatically sold, thereby rendering magical thinking impotent. By letting go of hopes and dreams that a losing stock will rebound, by accepting loss and moving forward before the possibility of market carnage sets retirement plans back a few years, the winning investor limits downside and juices the odds that total portfolio gain will outweigh loss.

Running Interference

Investment process, comprehensive research, objective decision-making, and discipline—all of these are essential to the winning investor’s playbook. And what would help even more would be an entirely rational mind, one divorced from errant thinking and destructive emotion. However, investors are human too. Knowing this, and knowing that even superstar investors may get sidetracked, winning investors study their own behaviour so as to minimize the effect, or prevent the occurrence, of one or more of the following obstacles to success:

1. Optimism. Under most circumstances, optimism is considered to be a positive trait. However, it may become troublesome for investors when it leads to an unrealistically rosy view of themselves and the future.

2. Over-confidence. Often stemming from the illusion of knowledge, and overlapping with optimism, over-confident investors may fail to realize that their knowledge is limited, tend to chase returns, and underestimate risk.

3. Anchoring. After forming an opinion based on limited information, the anchored investor is not willing to change that opinion regardless of new information. Anchoring inhibits the investor from searching for evidence contrary to their opinion and even if found, this evidence is often dismissed. It causes an investor to stick with a losing investment or not buy a fundamentally strong company because, for example, they have determined that its price/earnings ratio is too high or they are irrationally attached to some other numeric metric that does not meet arbitrary criteria.

4. Ambiguity. Investors prefer certainty. Unfortunately, the stock market is not in the business of offering certainty. To compensate for lack of conviction in decision-making, an investor will seek expedient authority (i.e. media, experts) supportive of their position instead of taking the initiative to dig deeper on the research end.

5. Herding. We are programmed to feel that the consensus view is the correct view. As a result, most of us are hard-wired to follow the herd. Big mistake. You have heard it umpteen times: the crowd buys high and sells low, thinks like a lemming and is prone to falling off a cliff. As an investor, having the strength to break from the masses, or not blindly follow the crowd will serve you well.

Ken Finkelstein, LL.B. J.D., Private Equity Strategist,