This post is a continuation of my earlier posts. I suggest reading The Art of Selling - Preview,
The Art of Selling - Winning the Loser's Game,
The Art of Selling - Who is on the Other Side?,
The Art of Selling - 10 Commandments,
The Art of Selling - Coffee Can Portfolio,
The Art of Selling - Psychology of Investing, and
The Art of Selling - Do Colours Nudge our Investing Behaviour?, before you read this post.
The Affect Heuristic
The stock market is a game of incomplete information. It involves decision-making under conditions of uncertainty, important information remains hidden, and there is an element of luck in any outcome. Incomplete information acts as the tool for our beliefs, and we trade our beliefs. Invariably, the person on the other side of the trade is better informed than we are. How does all of this actually happen in real-time?
Affect is defined as the goodness, or badness that we feel based on a stimulus. For example, a word like ‘treasure’ generates positive affect, while a word like ‘hate’ is negative. The basic concept is that how we feel about something influences how we decide about it. Affective responses occur quickly and automatically, are difficult to manage, and remain beyond our awareness.
People base their judgments of an activity or a technology not only on what they think about it but also on what they feel about it ('Affect Heuristic'). We delude ourselves that we are proceeding rationally. Often “I decided in favour of X” is no more than “I liked X.” We buy the cars we “like,” choose the jobs and houses we find “attractive,” and then we rationalise our decision-making. Has it ever occurred to you, we ‘like’ stocks that climb higher every day and we 'dislike' those that don’t? Hence:
1. When investors feel good about an investment idea, they deem the risks low and the returns high, irrespective of more objective probabilities. And when they dislike an idea, the inverse is true.
2. Positive or negative emotional impression of a stimulus influences decisions. Businesses like tobacco and alcohol lead to a negative affective response. Hence, investing in sin stocks (like tobacco and alcohol) is taboo. This, too, has been exploited by the fund management industry. Globally, expense ratios for ESG funds - those that don’t invest in sin stocks are way higher. They use our bias to dip into our pockets!
3. Affective responses are rapid and automatic. We need to heed the biases that are the direct outcome of our affective responses. Since we have already let our emotions influence our decision-making, we pretend we are being rational - all of us are, in fact, great rationalisers.
4. When the outcomes of an opportunity are potent with affective meaning, we overweight probabilities. Contrarily, when outcomes are vivid, people pay little attention to the probabilities and too much on the outcomes.
5. Affective responses also lead us to take buy and sell decisions in the heat of the moment - this happened a lot in the calendar year 2020 when the pandemic broke out. In fact, last year, most of the selling was institutional, not retail. Even ‘they’ couldn’t control their emotions and mind you, the institutional selling cascade was global. Letting our emotions interfere with our decision-making in the stock market seldom works. Nassim Taleb calls it hitting our ‘Uncle Point’. Charlie Munger has described it in the following words:
"[Our investment in] USG hasn't worked out very well. It wasn't just asbestos - the market for wallboard went to hell. We missed that too. What can I say? It reminds me of a story about a man who had a wife and three kids. He conceived an illegitimate child with a woman he'd just met. When asked why he did it, he said, 'It seemed like a good idea at the time.'"
And when we take emotionally driven decisions, they always appear to be sensible, when we are taking those decisions, they really do. I have highlighted just two human biases. There are many more.
Conclusion
The Art of Selling - Winning the Loser's Game,
The Art of Selling - Who is on the Other Side?,
The Art of Selling - 10 Commandments,
The Art of Selling - Coffee Can Portfolio,
The Art of Selling - Psychology of Investing, and
The Art of Selling - Do Colours Nudge our Investing Behaviour?, before you read this post.
The Affect Heuristic
The stock market is a game of incomplete information. It involves decision-making under conditions of uncertainty, important information remains hidden, and there is an element of luck in any outcome. Incomplete information acts as the tool for our beliefs, and we trade our beliefs. Invariably, the person on the other side of the trade is better informed than we are. How does all of this actually happen in real-time?
Affect is defined as the goodness, or badness that we feel based on a stimulus. For example, a word like ‘treasure’ generates positive affect, while a word like ‘hate’ is negative. The basic concept is that how we feel about something influences how we decide about it. Affective responses occur quickly and automatically, are difficult to manage, and remain beyond our awareness.
People base their judgments of an activity or a technology not only on what they think about it but also on what they feel about it ('Affect Heuristic'). We delude ourselves that we are proceeding rationally. Often “I decided in favour of X” is no more than “I liked X.” We buy the cars we “like,” choose the jobs and houses we find “attractive,” and then we rationalise our decision-making. Has it ever occurred to you, we ‘like’ stocks that climb higher every day and we 'dislike' those that don’t? Hence:
1. When investors feel good about an investment idea, they deem the risks low and the returns high, irrespective of more objective probabilities. And when they dislike an idea, the inverse is true.
2. Positive or negative emotional impression of a stimulus influences decisions. Businesses like tobacco and alcohol lead to a negative affective response. Hence, investing in sin stocks (like tobacco and alcohol) is taboo. This, too, has been exploited by the fund management industry. Globally, expense ratios for ESG funds - those that don’t invest in sin stocks are way higher. They use our bias to dip into our pockets!
3. Affective responses are rapid and automatic. We need to heed the biases that are the direct outcome of our affective responses. Since we have already let our emotions influence our decision-making, we pretend we are being rational - all of us are, in fact, great rationalisers.
4. When the outcomes of an opportunity are potent with affective meaning, we overweight probabilities. Contrarily, when outcomes are vivid, people pay little attention to the probabilities and too much on the outcomes.
5. Affective responses also lead us to take buy and sell decisions in the heat of the moment - this happened a lot in the calendar year 2020 when the pandemic broke out. In fact, last year, most of the selling was institutional, not retail. Even ‘they’ couldn’t control their emotions and mind you, the institutional selling cascade was global. Letting our emotions interfere with our decision-making in the stock market seldom works. Nassim Taleb calls it hitting our ‘Uncle Point’. Charlie Munger has described it in the following words:
"[Our investment in] USG hasn't worked out very well. It wasn't just asbestos - the market for wallboard went to hell. We missed that too. What can I say? It reminds me of a story about a man who had a wife and three kids. He conceived an illegitimate child with a woman he'd just met. When asked why he did it, he said, 'It seemed like a good idea at the time.'"
And when we take emotionally driven decisions, they always appear to be sensible, when we are taking those decisions, they really do. I have highlighted just two human biases. There are many more.
Conclusion
In the very first post of this series I wrote:
To be fair, some of us follow a mixed method by constructing two separate portfolios. One portfolio is for the ‘buy low and sell high’ trades and the other one is where we are investing in the business, and not in the stock. This is doable, though I don’t know of many who actually have the fortitude and discipline to distinguish one from the other….
I have written only for the long-term investor in this series of posts. In the next post, I will try to write about the other type of portfolio - the trading portfolio. I will assume that we do in indeed have the discipline and the fortitude to separate our investing from our trading. That is a very optimistic assumption, but this series of posts will be incomplete if I don’t write about trading. The rules of the game are totally different when one is trading as compared to if we were investing.
I have been following a weekly schedule to date on this topic. The next one might just take a little longer. Let’s see how fast I can scribble that one.
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