Sunday, 9 February 2014

Reflections on Thinking, Fast and Slow

My apologies for the long absence. Sometimes life gets busy, and other times it gets incredibly busy. Such is the case when your day job consistently occupies 13.5 hours per day (due in part to a long commute), compounded by family demands. But enough whining... the good news is that the day job involves investing, my favorite hobby. It is safe to say though that what I do during the day does not overlap at all with any ideas presented on this blog. As for the commute, it is a net positive given the round trip provides a solid hour each day to read anything of my choosing.

I recently finished Daniel Kahneman's "Thinking, Fast and Slow".  It is essentially a psychology book published in 2011 that a number of people referred to me. The interesting thing is that I don't know anyone else who actually finished the book. I suspect this is because the content is somewhat akin to a text book (i.e. not conducive to scanning), and at nearly 500 pages, not a quick read.

The book is worth buying because it will give you awareness of certain psychological tendencies we have as human beings that sometimes lead to bad decisions. The key finding is that everyone makes decisions based on their subconscious ("System 1") and more rationally through calculated thought ("System 2"). Although it was not written specifically for investing, the direct application of several concepts is striking. For example, one chapter goes through our tendency to take quick averages. This applies to sum-of-parts type investments, where opportunities present themselves because the market throws a multiple over a company's net profit instead of determining the value of each segment.

As an illustration, assume a company's income is $100mm but is a sum of $200mm from Division 1 and a loss of $100mm from Division 2.  A price of $1,000mm would equate to 10x earnings, but assuming that Division 2 could in the worst case scenario be shut down, you are effectively paying 5x earnings for Division 1 and getting Division 2 for free.  This would have been the basic gist of Brookfield Residential a few years ago, when the stock price at $6.50 implied you are paying less than the intrinsic value of the Canadian division and getting the U.S. assets for free. A current example would be News Corporation, which in my estimation trades at a 30%+  discount to the sum of its parts.

Other concepts that I thought are particularly applicable for investors are:
  • Anchoring: The tendency to be influenced by numbers seen in recent memory. An example you may be familiar with is the over-use of comparable multiples, or relative valuation. This leads to the market underpaying for entire industries for prolonged periods, and conversely overvaluing them later on. 
  • Loss aversion: When agony associated with realizing a loss outweighs the positive feeling of achieving an equal gain (e.g. -$50 vs. +$50). This can lead to irrational follow-up decisions, such as doubling down when unwarranted, and/or setting up a mental account for the stock in question. By keeping a mental account for each stock (as I have been guilty of doing in the past, and still do), we are prone to taking profits on winners while waiting to breakeven on losers before moving on.
  • Overconfidence: How important is luck in determining our investment results, or life in general? Howard Marks discusses the importance of being lucky in a recent write-up.  For me, luck played a role in almost every big life decision, from becoming interested in Buffett, to being told about the HHC opportunity by a friend months before the spin-off, to meeting my life partner, to my choice of school... the list goes on and on. By not crediting luck enough to past successes, we become vulnerable to overconfidence. And overconfidence in turn will lead to errors such as overweighting investments without doing the necessary due diligence, or leaving a high-paying job to start a sole proprietorship without having realistically weighed the odds of success.

My personal belief is that psychology is just as important to being a good investor as anything else. Had I read this book sooner, I would have recognized a mental error (excessive loss aversion) sooner and saved myself an amount that works out to >1,700x the cost of the Kindle version... and that is assuming I took only a 50% loss on that particular mistake (instead of selling at -85% last week after reading Kahneman - ouch!)

Disclosure: The author owns shares of Brookfield Residential and News Corporation.