How often do you make investing decisions on analysis and how often do you follow an instinct?
I have heard said that the human brain is the most efficient pattern recognition machine in existence. Being a software engineer myself I believe it: I can easily see patterns in data I work with which are anywhere from difficult to impossible to recognize in code I write. Which has me wondering … do we actually make decisions on analysis of the company, market, etc., or do we look at this information in order to recognize patterns we use to make the real decisions?
This is particularly relevant to this board as it touches on one aspect of Saul’s investing style which has been a large factor of his success: Saul has an ability to pick remarkably good entry and exit points but I have never seen a clear cut answer on how this is done other than: experience.
Looking at my own investments this year and my notes on trades I did not make, I see a very clear trend: My instincts are more likely to be correct than my decisions made purely by analysis. 8 months is far too short a time to say there is anything significant to this (could be just luck). But still, I do have to wonder.
So, I am curious: For all you more experienced investors, how important are your instincts in making investment decisions?
Markets have the incredible ability to squeeze out any unnecessary profits by which I mean profits that don’t increase the flow of goods and services. This is what promotes a better standard of living but makes life difficult for investors whose job is to maximize profits. This is “the investing problem.”
We have two forms of thinking, the rational (conscious) and the subconscious. The market is too complex to deal with it only rationally. We train our subconscious on a daily basis. What starts out as “beginner’s luck” slowly transforms into “expertise.” I know that my subconscious has come up with some great solutions but only because it was fed information that it could use to create or discover these solutions. There might not be anything new under the Sun but there are innumerable ways to rearrange the pieces which is what the subconscious (which never sleeps) does.
Why we need to reeducate our conscious and subconscious investing minds all the time:
Finding a Better Way to Value Companies in the Digital World
In a world rapidly switching to digital business models, the old ways of classifying industries and measuring business performances do not suffice anymore. So argue Barry Libert, CEO of OpenMatters, Megan Beck, the chief insights officer, and Wharton marketing professor Jerry (Yoram) Wind. In this opinion piece, they say it’s time to upgrade Standard & Poor’s Global Industry Classification Standard (GICS) and GAAP (Generally Accepted Accounting Principles) to more fully reflect the value of intangible assets as digital companies take the lead in this economy. The top market cap rankings in the S&P 500 already show this shift, with tech titans coming out on top and supplanting industrial firms.
Instinct that says, “Yes, invest in this” is not to be trusted without analysis. It’s far more important to develop the instinct that says, “No, something is wrong here.”
The problem is that any analysis must be based on information provided by company management. And company management always has an incentive to fudge the numbers to look better and smoother from quarter to quarter. When they can’t fudge the numbers to look good, they are likely to dump all of their problems into that one quarter and clean house. If you’re going to have a bad quarter, you may as well make it really bad and clean up as much of the previous fudging you can. It takes very strong management to resist this incentive. Very few resist completely, although most resist enough to keep the fudging to a reasonable level.
But some will outright lie to investors. Those can be very hard to spot from a purely analytical point of view. Their analysis will look good, but it’s an instinctual gut feel that will tell you something is not quite right. That’s why CPAs who do want to do auditing must have a couple of years of experience under the guidance of an experienced CPA before they can audit on their own. It takes time to develop that instinct which says something is not right and makes the CPA continue to dig further.
The only way to properly develop that instinct is to do a lot of analysis and then follow up on that analysis to see how things turn out.
It’s kind of a decision tree using both analysis and instinct. If your analysis says “no,” stop there and use your analysis. If your analysis says “yes” but your instinct says “no”, listen to the instinct. When both analysis and instinct say “yes” you’ve probably got a good investment.
So fatal and disastrous have I found instinct that my analysis sheet has ‘Discipline overrides conviction’ in huge type across the top. (The phrase is not mine, I read it somewhere and liked it.)
It is true that an investor needs to do a certain amount of imagining about the future but the essential point is surely that the imagining should only come after a likely prospect has been identified by DD.
Imagining is not instinct however. Nor is a situation already seen playing out again, which is memory. Instinct is worthless in my view. It is a cop-out from making the case.
"What starts out as “beginner’s luck” slowly transforms into “expertise.”
do you know what luck really looks like? much luck passes for “expertise”.
Any outcomes is the result of a combination of luck and correlations to some parameters that may be recognized. In this equation the attribution to luck is always too small and in some really misguided assessment is totally absent. On the ‘expertise’ side, we need to find a real correlation. That can be done with algorithms but again what are the parameters to look at may be a difficult decision to make. Is my headache
correlated to the drop in the market? or is the gut feeling of a well followed talking head any indication of correlation?
and you never can untangle these even after the fact. But you should know it takes a lucky one to predict correctly the future.
I don’t think I’ve mentioned Edward Thorp before. He is one of the godfathers of the quants, maybe the godfather. He may be the best example of the power of analysis.
Before going into finance, he was already famous as the math professor who developed blackjack card counting.
He was given a chance, many years before any scandal broke, to invest in Bernie Madoff’s operation. Mostly though basic analysis, he was able to tell that what Madoff was doing was impossible, because there wasn’t enough fluctuation in the returns over time.
Though he was not implicated (and he strikes me as a very honest man), he did not detect some serious improprieties in his staff’s activities (the details are all available online), and I think one of his companies closed down or at least had some serious trouble. So perhaps he was lacking in instinct? Or maybe he just lacked experience in that area, but learned something from what happened.
do you know what luck really looks like? much luck passes for “expertise”.
I vividly recall a conversation on this subject from over 50 years ago at my first job as an IBM programmer. I created a bug that had the whole technical staff baffled so they called in the chief guru who was an eccentric genius. He looked at the problem, asked a lot of questions, did some tests, and after a while fixed the bug. Hugo had a running rivalry with my boss who called out “Hugo, you were really lucky!” Hugo, unfazed, replied “Yes, but I’m the only lucky one.”
That may not have been luck but pure skill.
I don’t think stock picking is of the same nature as finding a bug. Playing 21 or poker definitely involve skills but there is also much left to chance. That everyone accept. In stock picking, I think skills take a much (much) smaller place. We easily confuse skills with statistics.
In stock picking, I think skills take a much (much) smaller place.
I disagree. In stock picking most people lack the skill. I’ve been at it for 25 years and for most of that time I was using the wrong approach. But there is a problem. As Kenneth Fischer put it, the only advantage you have is what you know that others don’t know so I shouldn’t be talking about it.
But you are right, using the popular investing skills most people who make money in the market are just plain lucky. LOL
…In stock picking, I think skills take a much (much) smaller place.
“I disagree. In stock picking most people lack the skill…”
if it is a skill then it can be learned by anyone who cares to. There is not much of a science to it apart from a high dose of statistics. You can learn how to play chess and you can become better than others. You can learn about finding a bug or hit a small ball with a stick extremely well. It needs practice and experience. There are people more or less skillful. Skills can be learned.
But playing the market, I think we all have some sense of it and we think we know but we really don’t. We still have to play the odds. There are definitely some momentary pattern that may become entrenched as we see it but that pattern can fizzle a bit later. I am not saying that stock picking does not require any skill. It does. But not as much as the so called experts think. But maybe they have enough followers that on the end it becomes a self fulfilled promise. when they are wrong most people don’t really pay attention. They are just dazzled by the times they go it right.
a lot in this game is about what other participants do and not so much what they know. But we cannot always know what others will do. There is often herding and going against the flow can sometimes be the best thing to do. But sometimes it is not. who knows really?
what do you know I don’t? what can you know I don’t?
Suppose you had lived in the first century AD, you would have known that the Earth was at the center of the universe, the best science of the day said so. Later some people did some calculations and others did some observations and concluded that the science of the first century AD as wrong. Newton also managed to show that the Aristotelian concept of motion was wrong. Newton admitted he did not know how gravity worked, science had to wait for Einstein to explain it.
I think that the “science” of investing, security analysis, is mostly wrong but since I’m no Newton, Galileo, Copernicus, or Kepler, no one takes me seriously. LOL
Now, If I’m right about the current state of security analysis, then people don’t have the skills required for successful investing. I have been trying to pick stocks for over 25 years and it has been the most difficult job I have ever attempted. For the past ten years I have been developing a different way of investing. In some areas I reinvented the wheel, in others I think I have a novel approach. The bits and pieces that I have posted have received a similar response to what Galileo Galilei got from the Church because it is contrary to dogma.
If you accept the Investing Bible, Graham and Dodd’s Security Analysis, then in your view investors have the skills but are unlucky. If you think that the Investing Bible is outdated, as I do, then the view is that investors don’t have the skills.
There is no difference between instinct and analysis. Instinct is simply your subconscious reacting to the information it has taken in, in a manner that is more profound and “artful” and more holistically examining all the facts, than simply responding to analysis numbers that anyone can turn out.
Certainly there are processes that investor follow with widely different results.
If yours is so good then why not share it (with a select subset)and see if people who follow it also make good? They might not.
and remember one case does not mean it is law. if everyone uses it then it would become the norm and maybe the results will tend to average. But a subset that is statistically significant could show if that really works or not. By significant, I definitely don’t mean one and I don’t mean 5 or 10 participants using it.
“…in your view investors have the skills but are unlucky. If you think that the Investing Bible is outdated, as I do, then the view is that investors don’t have the skills.”
No I am not saying that. You can have it right some of the times and wrong some other times. A skill if mastered would give you the desired results every time. You can know exactly the orbit of the earth yesterday, today and tomorrow. I would not wait for an Einstein of investing to come up with the General Theory of Investing. There will not be one.
Again I think you may discern some statistically significant pattern with mathematics and try to take advantage of them but those are fleeting. I don’t know about that one.
The problem is you don’t have an equation to describe any of it because you can’t know the dynamics. It is always forming and changing depending on the perception of the future and what others feels and think and do.
Some interesting viewpoints, thank you all. Personally, I found this particularly insightful:
Tinker: There is no difference between instinct and analysis. Instinct is simply your subconscious reacting to the information it has taken in, in a manner that is more profound and “artful” and more holistically examining all the facts, than simply responding to analysis numbers that anyone can turn out.
trust pure instinct? Never
Investing by relying on hunches, your gut and instinct is a rationalized way to avoid doing the work on a company. Understanding a company is a time sink of incalculable irritation and work and if one can simply get a feeling about a company it’s a nice way to convince yourself you have great instincts and can bypass all the SEC generated company BS because it’s all just company generated numbers and can’t be trusted.
Do the work. Sometimes you get it wrong and miss a great instinctual momentum stock but once you get good at it it will save you from disaster enough times to make it worth the effort