Limits to Learning
We all think we
learn from our mistakes, but do we? When we make a losing
investment, do we recognize our mistake and
learn from it, or do we attribute it to some outside
factor, like bad luck or the market? Well, to be
successful as an investor and trader, we must
recognize our mistakes and then learn from them.
Unfortunately, learning from these mistakes is much
harder than it seems.
Some of you probably have heard of this experiment. It is an
example of a failure to learn during a simple
investment game devised by Antoine Bechara. Each
player was given $20. They had to make a decision on
each round of the game: invest $1 or not invest. If
the decision was not to invest, the task advanced to
the next round. If the decision was to invest,
players would hand over one dollar to the
experimenter. The experimenter would then toss a
coin in view of the players. If the outcome was
heads, the player lost the dollar. If the outcome
landed tails up then $2.50 was added to the player's
account. The task would then move to the next round.
Overall, 20 rounds were played.
The chart below shows there was no evidence of
learning as the game went on. If players learned
over time, they would have realized that it was
optimal to invest in all rounds. However, as the
game went on, fewer and fewer players made decisions
to invest. They were actually becoming worse with
each round.
So how do we learn from our mistakes? What techniques can we use to
overcome our "bad" behavior and become better
investors? The major reason we don't learn from our
mistakes (or the mistakes of others) is that we
simply don't recognize them as such. We have a gamut
of mental devices all set up to protect us from the
terrible truth that we regularly make mistakes. We
also become afraid to invest, when we have a losing
experience. Let's look at several of the behaviors
we need to overcome.
I Knew That
Isn't hindsight a
wonderful thing? As a Monday morning quarterback we
can always say we would have made the right
decision. Looking again at the experiment mentioned
above, it is easy to say, "I knew that, so I would
have invested on each flip of the dice". So why
didn't everyone do just that? In my opinion they let
their emotions rule over logical decision making.
Maybe their last several
trades were losers, so they become afraid to
experience another losing trade.
The advantage of hindsight is we can employ good
logic as we evaluate the decision we should have
made. We also avoid the emotion that gets in our
way. This emotion is the worst enemy of any good
investor. To help overcome this emotion, I recommend
that every investor write down the reason they are
making the decision to invest. Documenting the logic
used to make an investment decision goes a long way
to remove the emotion that leads to poor decisions.
To me the idea is to get into the position where you
can say "I know that" rather than I knew
that. By removing the emotion from
your decision you are using the logic you typically
use in hindsight to
your advantage.
Self
Congratulations
Whenever, we make a winning
investment, we congratulate ourselves for making
such a good decision based on our investing
prowess. However, if the investment goes bad, then
we often blame it on bad luck. According to
psychologists, this is a natural mechanism that we,
as humans possess. As investors it is a bad trait to
have.
To combat this bad human trait, I
have found that I must document each of my trades,
especially the reason I am making the decision.
I can then assess my decisions based on the outcome. Was I
right for the right reason? If so, then I can claim some skill,
it could still be luck, but at least I can claim
skill. Was I right for some spurious reason? In
which case I will keep the result because it makes
me a profit, but I shouldn't fool myself into
thinking that I really knew what I was doing. I need
to analyze what I missed.
Was I
wrong for the wrong reason? I made a mistake and I
need to learn from it, or was I wrong for the right
reason? After all, bad luck does occur. Only by
analyzing my investment decisions and the
reasons for those decisions, can I
hope to understand when I was lucky and when I have
used genuine investment skill. But first I must
document my rationale for making the trade decision.
For my
Premium Members, I give the rationale for
each trade as my way to demonstrate this necessary
discipline.
Luck Becomes Insight
The market we work so hard to
understand is comprised of a series of cause and
effect actions which are not always transparent.
This cause and effect has created some
interesting behaviors by some very successful
people. For example, some baseball pitchers are known to not step
on the white chalk line when they are playing. I am
sure you have heard of many "superstitions" that
people hold to be true to help them perform well.
In an experiment by Koichi Ono's in 1987, subjects were asked to earn points in response to a signal light.
They could pull 3 levers, though they were not told
to do anything in particular. They could see their
score on a counter, but did not know that points
were awarded completely independent of what they
did. Nothing they did influenced the outcome in terms of points awarded. During the
experiment they observed some odd behavior as the
participants tried to make the most points possible.
Most subjects developed superstitious
behavior, mainly in patterns of lever-pulling, but
in some cases they performed elaborate or even
strenuous actions. Each
of these superstitions began with a coincidence. In
some cases the participants would pull levers in a
particular sequence. In other cases even more odd
behavior was observed including a person who jumped
off a table and then later jumped up to touch the
ceiling to "score" points. Keep in mind the points
were awarded either on a fixed time schedule or on a
variable time schedule, not based on the action of
the participant.
The point of this is that as humans we tend to think
that luck is insight. We fail to effectively analyze
the situation and the real reason for our success or
failure. As investors this behavior will lead to
ruin. To help overcome our natural tendency, we must
document our investing decisions and then assess the
results. This assessment process helps us learn from
our success and from our failures. It is critical
for each of us if we hope to become successful
investors. Conclusion
So what should you document before you make an
investment trade? For my
Premium Members each stock on the watch list
includes three groups of items to document. First, I
look at a series of fundamental information such as
Earnings yield, Return on Capital, revenue growth,
insider holdings, sector, and dividend yield. The
fundamental information helps me identify if this is
a good company with growing earnings, good
management and has potential. After reviewing the
appropriate financial information including SEC
documents, I identify the risks inherent in the
company. These risks might include competition,
market share, insider transactions, and any
litigation that the company is experiencing. Here
one needs to try to identify every possible risk and
assess them critically. Finally, I look at the chart
of the stock, seeking to identify support and
resistance zones. This gives me potential entry
points, exit targets, and the trailing stop loss. I
complete this section with a written trading strategy
describing how I expect to make my trades. All these
investment factors should be documented before
making a trade. Below is an example for N S Group
from the Stock Watch list.
|
N S Group
Inc. |
NSS |
6/28/06 |
|
NS Group, Inc. manufactures and supplies tubular
products to the energy market in North America.
The company’s energy related products include
seamless and welded tubular products, such as
drill pipe, casing, and production tubing used
in oil and natural gas drilling and production
operations. It also manufactures seamless and
welded line pipe primarily used as gathering
lines for the transmission and distribution of
oil and natural gas by utility and transmission
companies. NS Group’s line pipe is also used in
various construction applications. It also
offers other products comprising standard pipe,
piling, and steel billets. The company produces
its products in various diameters, gauges,
grades, and end finishes. It sells its products
to distributors and end users. |
|
Fundamentals |
|
Pre Tax Earnings
Yield |
17.3% |
Sector |
Energy - steel & composite pipe |
|
Pre Tax Return on
Capital |
95.9% |
Trailing P/E |
8.4 |
|
Quarterly Revenue Revenue
Growth (YOY) |
37% |
Price/Sales |
1.8 |
|
Dividend Yield |
0% |
Price/Cash Flow |
7.9 |
|
Market
Capitalization |
$1.19B |
Price/Book |
3.4 |
|
Earnings date |
7/24/06 |
Conference Call |
7/24/06 |
|
Insider holdings |
.4% |
Cockroaches |
None found |
|
Risk Assessment:
Closely tied to drilling for oil and gas in the
US. Should the price of oil and/or natural gas
fall it will negatively impact the earnings and
therefore the price of the company. |
|
Technical’s
stock chart from
StockCharts.com |
|
|
|
Ave Volume (50 day) |
520k |
Pattern |
Ascending triangle |
|
Trade Management |
|
Buy Range |
45 |
Holding period |
1 year |
|
Stop Loss |
7.3% or 3.66 points |
Risk-Reward |
2.9 & 5.4 |
|
1st Sell
Target |
55.8 |
2nd Sell
Target |
65 |
|
Trade Strategy:
Look to buy at or near support. The 50 day
moving average (DMA) is acting as support as
well. Sell 1/2 at 55-56, while moving up
stop, possible tightening to 2.7-3 below current
price. If resistance at 55.85 is broken with
strong volume (130% or more of 50 DMA consider
holding and buying more. Remember keep up with
your stops to preserve capital. |
To change our behavior we need to document our actions before we make the
decision. We also need to be honest with ourselves
when assessing our results. As we have seen it is
quite easy for each of us to put on rose colored
glasses and think we are better as investors than we
really are. We need to critically assess our
investing abilities without distorting the feedback
we receive from our decisions. Those of us who are
able to learn this valuable skill will greatly
benefit. Those of us who are unable to apply this
learning will be destined to mediocrity at best and
likely lose much of their capital before they quite
investing. |
