Mental Models: Anchoring Bias

The investing community is well-known with all kinds of mental models which influence our decision-making and therefor our investing successes and failures. Charlie Munger eloquently introduced the concept of mental models and cognitive biases to investors in the 1990’s. During my years of investing I’ve read quite a lot about cognitive biases. I think we all did. Speaking for myself, I read and understand the impact, occurence and consequences of cognitive biases. But I‘m still an amateur in recognizing them in real-life and taking actions to prevent myself from making irrational decisions. One of my all-time pitfalls is anchoring bias.

What Is Anchoring Bias?

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. Once an anchor is set, subsequent judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information relative to the anchor.

Checking 52-week Lows And Highs

Just like most investors I selected different companies as “must haves” for my dividend stocks portfolio. My selection criteria are fundamentals like valuation multiples, dividend yields, payout ratios and growth rates of revenues, earnings and dividend. It’s a list of 25 to 30 businesses qualified from dividend contenders to dividend kings. The majority of these companies currently trade at a P/E of or higher than 20. I’m talking about Accenture (ACN), Automatic Data Processing (ADP), Home Depot (HD), McDonalds (MCD) and Microsoft (MSFT) for example. All high-quality businesses trading at high valuation multiples.

Several days a week I check the trading prices of the companies I selected. During my weekly run-through of companies and their market prices I automatically compare their current price with their 52-week lows and 52-week highs. This has become my proxy for determining if a selected company is an interesting pick or not. I know this is anchoring bias at work, because the 52-week low is implicitly my reference point for qualifying a business as cheap and the 52-week high as expensive. But that reference point is actually, in several ways, quite meaningless. Let me explain along three lines.

Price itself is no actionable information. As Buffett said: “Price is what you pay. Value is what you get.” The gap between these two is valuable information. Scrolling the list of companies and their trading prices is maybe fun to do on a Saturday night while hot girls are twerking in your local club, but the price alone is not a good determinant for whatever decision; price holds no value. 

Valuation is a spectrum. A company is undervalued or reasonably valued within a certain price range. Let’s put it simple: a stock is undervalued between $10-13 and reasonably valued at $14-15 if you think the fair value is $15. Of course multiple principles and metrics do apply such as which margin of safety you’d like to have, the debt ratios, dividend yield and free cash flow to name a few. Pinpointing on a random trading price such as a 52-week low leads to a false sense of accuracy. The stock in the simplified example above is a good buy at $10, but also at a price of $11. The use of a bandwith of prices, always relative to fair value, is a better indicator to buy a stock or not. In other words, the stock is a buy within a buy zone, a certain price range. As Keynes strikingly stated: “It’s better to be roughly right than precisely wrong”.

The stock price in relation to its 52-week low or high does say something about the current mood of Mr. Market. Waiting for the price to drop to the level of Mr. Market’s most depressive day during the last 52 weeks means you think you’re able to time the market. Like I wrote about the mental models and cognitive biases above: I read and know timing the market is impossible to do, but my actions in real-life prove it’s difficult for me to act in that way. So again, the reference point of the 52-week low is meaningless. That specific price wasn’t knowable or rational in advance. “Mr. Market is there to serve you, not to guide you” is a famous quote by Warren Buffett.

A Real-Life Example: Fasten Your Seatbelts

At the end of 2015 I had my eyes on Boeing (BA), because of their attractive dividend yield, large order book and low valuation multiple. Prospects were rosy for this company. The stock price went sideways for a couple of months within the price range of $130-140. During a short period of time in 2016 it even traded for as low as $115, a P/E of 15 and a dividend yield of 3.70% in other words, undoubtedly cheap. See the graph below.

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But I decided to sit on my hands, and wait till it hit $100. Why? “The beauty is, with $1,000 I can exactly buy 10 shares. Nice round numbers, 10 pieces of $100 each makes $1,000.” Sounds like a strategy right? 🙁 But the thing is, the price never dropped that low. In 2,5 years it went straight to $420, with one big price decline, as you can see in the graph, hitting $300. Opportunity missed at $115 you may think. Well, that’s for sure. But I also missed it at $125, $150, $200, $250 and even at $300. Let’s keep it simple:

I MISSED THIS OPPORTUNITY FOR THREE YEARS. 😩

I remember that run-up in price like yesterday. My thoughts were the price would certainly come down to $115 again. When it hit $150 in no time I had missed a $35 profit or 23% a share. “I can’t buy this stock right now, no way. That would be insane.” I promised myself to immediately buy shares, when the price dips back to 130. Then it went up all the way to $200. Hey, that’s a 75% profit in comparison with my psychological anchor of $115. “It wouldn’t be rational to buy it at this price. Let’s wait for the next price correction and it trades at $175. At that price, I’ll be all over it.” The stock price easily rose to $300 within six months. But the shareholder returns didn’t stop there. Management of Boeing (BA) declared one dividend raise after another. In February 2016 the quarterly dividend was $1.09. In the same month, but only two years later the quarterly dividend was raised to $1.72!

You can see how wanting an extra $15 dollar discount on every share ($115 – $100) has eventually cost me an unrealized profit of more or less $285 (400 – 115) and missing a yield on cost of more than 7% (4 * 2.055)/115. Not good…

Conclusions

If you’re going down the wrong path, it’s likely that the next decision to turn left or right isn’t a good decision either. What I mean by that is: a dominant focus on market prices with investing leads in many cases to more irrational behaviour. Holding on to low trading prices in the past isn’t a good buy strategy as no one is capable of timing the market. To wait for a further price decrease, is a risky thing to do if the business is significantly undervalued already. I’ve missed many investing opportunities by wanting another 10% discount to fair value or wanting a buy price closer to the 52-week low. Boeing (BA) is just one of them. I can think of Lockheed Martin (LMT), Nike (NKE), Parkin Haniffin (PF) and T. Rowe Price (TROW).

Although I have done my homework on many stocks and looked into their fundamentals as good as I can, I’m still too much price-oriented. Do you recognize this? What do you do to minimize your anchoring bias?

Happy investing!

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Mental Models: Confirmation Bias

Two weeks ago I started the series My First Years of Investing in which I share my experiences and beginner mistakes. You can read the first article here, and the link to the second article is here. Before I dig into my motivation to start buying stocks of dividend growth companies, which will be the third part of this series, I wanted to elaborate more on the mental model of confirmation bias. The reason for this is that it has played a significant role in my decisions to buy, hold or sell a stock during my first years of investing. Those days haven’t been particularly successful. To say the least. At the same time I don’t really feel I bottomed this one out yet. I don’t control this recurring bias yet, it owns me. There’s still enough to reflect on in order to get a better understanding of this instinctive reflex.

“Remember this: the pain is all in your head. If you want to evolve, you need to go where the problems and the pain are. By confronting the pain, you will see more clearly the paradoxes and problems you face. Reflecting on them and resolving them will give you wisdom.”

– Ray Dalio

What’s This All About?

Confirmation bias is deeply rooted in our way of thinking and comes into play when we judge information on its relevance. It impacts how we gather information, but it also influences how we interpret it. We’re not mentally wired to have an open mind once we’ve taken a position on something, especially on emotionally significant issues. But the reason why confirmation bias has such a firm grasp on us is the elimination of a correction mechanism. It disconnects us with reality, or at least an opposing explanation of events or argumentation. The ground for critical thinking, doubt, suspicion and alternative views have been cut off. This is exactly the reason why confirmation bias will only get stronger with time and activity. I believe this works two ways. At one hand, confirmation bias makes us to only select and order pleasing information to be stored in our memory. You seem to be right in your conviction so satisfaction guaranteed. I call this the one-time-event effect. There’s no reason to change our mode of reasoning. At the other hand, the confirmation bias is fed every time it processes affirmative information. Its base gets stronger, severe and more absolute. It has become a little bit harder to overcome. You could call this the stacking effect.

As confirmation bias has grown in magnitude with time and activity I believe it can only be broken by an event with an undeniable and painful impact. The reason for this is that under the usual circumstances of confirmation bias, the unpleasant new information can easily be ignored, denied or rationalized. Just like we always did. So, more is needed to open our eyes.

“This old truth is coming to an end.”

– Friedrich Nietzsche

Sorry, But What Does This Have To Do With Investing?

An important principle of value investing is you can’t time the market. Time in the market is better than timing the market. No one knows what the future holds. So we can’t tell whether we’re buying at the bottom. The advice to buy low and sell high is meaningless in this regard. We are only able to conclude if we bought a stock at a low price in hindsight. However, in hindsight nearly every mistake seems unnecessary and every investment success looks smooth. So, you really have to focus on the underlying fundamentals to determine whether a stock is trading at a low price and compare that to the intrinsic value of the business.

What really fascinates me, is at what point do you start to be wrong? I used to look at stock prices and thought declines of 30-40% or more are indicative. It’s only now that I see this is the wrong perspective. If you would like to know if you’re right or wrong about a company, you shouldn’t look at trading prices. It’s the core fundamentals that matter. To determine whether you’re right or wrong about a business, you have to know the contraview, which is the short thesis and track whether the fundamentals deteriorated. Is the company on its way down? But I didn’t search or read that information when I started investing in magic formula stocks or small growth companies. I didn’t do it at all. Not once. The section about risks in a long thesis didn’t even get the attention it deserved. I can see now that I was only interested in the upside. That’s one of the reasons I lost some of my money. I was only looking for supporting analysis or facts for the long position. You can think of insider buys, investors adding to their position or even investment pitches of years ago. Most of the times I bought more stocks without studying the fundamentals and analyzing for negative trends. A recipe for disaster, that’s for sure. You can see how confirmation bias is into play here. It really impacts how we gather information and how we neglect crucial information. This was a fundamental flaw in my decision-making process.

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When the share price of a stock I owned, went south for a while I was inclined to say: “See, value investing is not easy, I’m just being contrarian, Mr. Market is depressive again.” I justified my position in a stock with multiple quotes of famous and succesful investors and (unconsciously) made sure that the price movement was a confirmation of my opinion. But if the stock price increased I witnessed the long thesis playing out beautifully, I told myself I outsmarted everyone, and thought “I OWN Mr. Market. 😎” I just assumed my thesis was right and the moment I stepped in was spot-on. So whether the price went up or down, I was just right. Period. This is how confirmation bias influenced my way of interpreting information. I was in search for confirmation at all costs. No matter what happened. I even clung to the tiniest details of another bad quarter report of a magic formula stock or the second share issuance by a micro cap stock in a very short period of time.

Another one. Stock ownership by hedge fund managers was always an important check box for me when I invested in magic formula stocks. I always considered it because these guys are undoubtedly smarter than I am and have more time to analyze industries, companies and valuation multiples than I have. I thought, let them do the analysis and I invest a bit of my money in the same companies. Just driving shotgun, baby… But, so many hedge fund managers, so many positions. I focused on a handful in the beginning like Warren Buffett, Joel Greenblatt, Seth Klarman and Mohnish Pabrai. Later on I was also impressed by the track records of Leon Cooperman, Kenneth Fisher, Bill Ackman, Howard Marks and Ray Dalio. There was always an investing guru invested in a stock which had my interest. And if a hedge fund manager sold a stock I owned, there was always another big boy initiating a position in the same quarter. So my long thesis was always confirmed by one or an other one. Hey, they see value in this company. Let’s hold it, don’t sell yet. But at a lower price the same stock could offer a margin of safety. If the trading price of my stock collapsed with 50% over time, but the hedge fund manager stepped in at that low price he had a nice margin of safety if he analyzed the intrinsic value was 50% higher. Let’s assume he was right and that gap closed. Well, in that case he would have made a nice 50% gain. But with that increase in stock price I would still be down with 25%. So, it’s nonsense to find safety in guru ownership, especially at a much lower price.

“What should separate investors from speculators, Graham argued, was not what they chose to buy but how they chose it. At one price, any security could be a speculation; at another (lower) price, it became an investment. And in the hands of different people, the same security even at the same price—could be either a speculation or an investment, depending on how well they understood it and how honestly they assessed their own limitations.”

– Jason Zweig

What To Do, What To Do?

To erdicate confirmation bias I have to confront it right in the beginning. Otherwise it has a real chance to grow. Therefor it’s absolutely necessary to read the long and short thesis and pay no small attention to the risks of the long thesis. It’s also essential to focus on the underlying fundamentals of the business. I must be aware of my tendency to price-orientation. Another one is, stop rationalizing price swings as we’re better at rationalizing than at being rational. And last, but not least, don’t line up behind investing gurus. They’re often wrong and betting against eachother.

I want to finish this post with a wonderful and simple line by Jana Vembunarayanan from his post Self Deception and Denial:

Refusing to look at unpleasant facts doen’t make them disappear. Bad news that is true is better than good news that is wrong.

I really hope this post has offered you something to think about. Please feel free to comment.

My First Years of Investing, Part II

Dividend growth investing hasn’t always been my investment strategy; I tried different approaches of value investing to eventually reach my goal of financial independence. In my previous article I wrote about how I got to investing in the first place and my personal experiences with magic formula investing as thought up by Joel Greenblatt. After two years of disappointing investment returns and the awareness that I wasn’t on the right track I decided to do things differently.

Making Big Money Under The Radar… I Thought

As I wrote in my previous article I read hours and hours about investing. I regularly had read about micro and small cap stocks outperforming stocks of mid and large cap companies. This has many causes of which I’ll highlight two here. The outperformance of the stocks of micro and small cap businesses is primarily driven by their lack of visibility within the investment community, which leads to a disconnect between their stock prices and fundamentals. Investors can take advantage of this discrepancy. Another reason for their outperformance is stocks of micro caps and small caps are thinly traded. This presents a great opportunity. If the company survives the imminent struggle of being small in terms of market capitalization (like cashburn, loans with high interest, customer concentration) and becomes larger and profitable, analysts will start coverage which will attract more investors. The paper of O’Shaughnessy Asset Management Microcap as an Alternative to Private Equity highlights that 2.1 analysts only cover the typical micro cap stock on average. Some stocks aren’t even covered at all. If future growth prospects of these under the radar businesses remain solid, then demand for the stock inevitably perks up. But there’s only a very limited amount of stock which gives micro and small cap stocks the potential to rise substantially.

Partly based on the above mentioned reasons I decided to allocate more capital in micro and small cap stocks. I sold many positions with a net loss, but I told myself this was necessary. “Things will only get better from now.” Based on paid newsletters and analyses of authors on public websites who had made significant amounts of money (according to themselves) I invested more and more money in these companies. The investment pitches were more or less identical. Most often it was a very small company of which the CEO was the original founder who owned large piles of stocks. So the shareholder interests were aligned with the interests of the CEO. The business was cashflow negative but this would certainly change within 4 or 5 quarters. However, revenues and earnings were rising with growth numbers in the 30-50% range. The companies were one-trick ponies or sold lots of stuff but couldn’t manage the costs of growing this fast in such a short period of time. Hey, but that didn’t matter, because if they could get their gross margins under control, earnings would skyrocket. And if we just extrapolate those earnings to the future, then the company traded at very, very low multiples right now. So you better be quick…

Unnoticed Cognitive Bias

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Source: Better Humans

I went on a buying spree and ended up with stocks of companies like Crossroads Systems, Digirad, Glu Mobile, Inuvo, Musclepharm, Noble Roman’s, On Track Innovations, Perion Network, Spark Networks and SuperCom to name a few. My decision to buy stocks of these kind of companies was often based on analyses of two or three authors. In a couple of cases they wrote follow-up articles about events related to the companies such as quarter reports, winning or losing clients, tender offers and renewed bank credit facilities. The perspective was mostly biased; the quarter report was not as expected, but the bigger picture still looked great; although the company lost a client, the focus of management has shifted to the higher margin products/services; share dilution was significant due to issuing shares, but this created the opportunity to accelerate investing in business opportunities; the interest rate on the new credit facility agreement was in the high single digits, but working capital has improved for the better. My confirmation bias made me average down like crazy. “Wasn’t that going against the herd?” I told myself. During the first year I added to my positions vigorously when prices went down more than 20%. I had read extreme price swings were typical for investing in stocks of micro and small cap businesses. So this was all part of the game, it seemed. Besides, the beauty of averaging down is your loss in terms of percentage points drops. So that looks good. If prices increase, well, that makes up that annoying red-coloured amount of money in the column next to my loss in percentage points.

It wasn’t all drama. Some stocks were up 30%, others 80% or even 700%. Companies like IEH, Marathon Patent Group, Pacific Healthcare Organization for example, This investment strategy certainly works if you pick the right companies, but that’s always the case with hindsight bias; these are backward-looking figures. Regarding my positions in green, I got greedy… Some positions were down 40-50% and my big winners masked that loss on a total portfolio basis. It’s nice if that number isn’t down too much. And, if it’s up 700%, why couldn’t it double again or maybe triple if I’m lucky? I read multiple times you only have to find one or two homeruns to really make a lot of cash with investing in micro and small cap companies. So, I didn’t sell my golden eggs. But I didn’t buy more of them either on their way up as it was emotionally hard for me to add to my positions at higher prices. I just loved the profits of 100% and 700% up in price and I didn’t want to screw that charming sight. So anchoring bias certainly kicked in. At some moment I had invested my savings in 25 of these companies. I fortunately acknowledged that diversification is a good thing when buying these high risk, high reward stocks. At least, I was that smart.

But I found out soon that investing is not easy and certainly not the way I practiced it. The stock prices of micro caps and small caps tend to move independent of what the Dow Jones Index or NASDAQ does. I didn’t feel comfortable when stock markets were up and at the same time the prices of stocks I owned were down. On those days I browsed Internet and all kind of forums for explanations. “What causes this price decline? Do these sellers know something what I don’t know?” During my period of investing in small companies I was often searching for more information supporting the long thesis. I didn’t want to read the short thesis as I believed that would only bring doubts and jeopardise my investing success in the long run. To convince myself of the plausibility of being long and the need to standfast I reread the investment case over and over. (I tried so hard to apply some fundamental value investing principles.) But, it was just simple pain-avoiding psychological denial leading to self-deception: denying or rationalizing away the relevance, significance, or importance of opposing evidence and logical argument.

How It Turned Out

As I mentioned earlier I had built big positions in underperfoming stocks by averaging down and small positions in stocks which were up significantly. It took only one thing to let reality set in: major price declines of the stocks that had an incredible run-up. The stock which was up 700% decreased at least 90%, because the business lost a big customer in terms of revenues. Another stock crashed more than 80% due to disappointing growth figures. With time I sold positions of which it was impossible to justify them any longer. Realized losses within the range of 40-50% were normal. I still had confidence in some stocks that were down, but I sold almost all positions except maybe five stocks. These were high-quality companies with a good business model, diversified customer base, growing earnings, low debt and so forth. Now, some stocks I sold were up 20% and 50%. I think my total loss at the end of this period was around $4.000.

After three years of investing I felt pretty depressed. All I had to do was investing in good companies of which the metrics are publicly known and on various websites and buy their stocks at low prices which means only when the estimated value exceeds the stock price. Why is that so hard to do? All the big names are up around 20% a year and I can’t even generate 15% or at least 10% a year. And it has been a damn bull market for years now. LOSERRRRRRR! It looked like financial independence was completely out of reach. No apartment in Newport Beach and condo in San Diego for me, folks. Still, I refused to be a hack until my retirement age…

In the next part of this series I will set out how I came to dividend growth investing, my motivation to adopt this investment stategy and the things it has brought me.