Cognitive Investing: The Key to Making Better Investment Decisions

© 2011 Rich Willis. All rights reserved.

No part of this book may be reproduced, stored in a retrieval system, or transmitted by any means without the written permission of the author.

First published by AuthorHouse 2/25/2011

ISBN: 978-1-4567-2841-0 (sc)

ISBN: 978-1-4567-2840-3 (e)

ISBN: 978-1-4567-2839-7 (dj)

Library of Congress Control Number: 2011901556

Printed in the United States of America

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Table of Contents

Introduction

Part 1: Welcome to Planet Confusia

1. What makes understanding the investment landscape so difficult?

2. Why do stock prices go up and down?

3. Are rising markets always good and falling markets bad?

4. What is the relationship between financial markets and the economy?

5. Should my investments be based on a particular prediction of the future course of the economy?

6. Why do all these different types of financial companies want my business?

Part 2: Verbs are More Important than Nouns

7. Why is an investment process better than an investment plan?

8. What is the difference between investing and gambling?

9. What is the problem with treating my investments like a collection?

10. What are the characteristics of a thorough and effective investment process?

Part 3: Risk is not a Ruler

11. What is the relationship between risk, reward, uncertainty, and volatility?

12. What are the different types of risks one should consider when making investment decisions?

13. How should I determine an appropriate level of risk for my personal portfolio?

Part 4: Your Gut Feeling is Wrong: The Ten Spectrums of Cognitive Investing

14. How do the various psychological biases lead to inferior investment decisions? What should one do to avoid the pitfalls from these psychological biases?

15. Spectrum #1: Simple vs. Complex

16. Spectrum #2: The Trees vs. The Forest

17. Spectrum #3: Today vs. Tomorrow

18. Spectrum #4: Stories vs. Concepts

19. Spectrum #5: Pictures vs. Numbers

20. Spectrum #6: Light vs. Dark

21. Spectrum #7: The Middle vs. The Edge

22. Spectrum #8: Me vs. Everyone Else

23. Spectrum #9: Static vs. Dynamic

24. Spectrum #10: Craftsmanship vs. Systematic Rules

Part 5: Portfolio Design

25. Why should investment decisions be framed as asset allocation, security selection, or market timing decisions? Which is most important?

26. Why is diversification important?

27. How important is correlation in the asset allocation process?

28. How should I decide what my asset allocation should be?

29. Should risk be controlled through asset allocation or security selection?

30. How should I pick securities? How concerned should I be about costs? Taxes?

31. Should I own individual bonds or bond funds?

32. Should I own individual stocks or stock funds?

33. Should I own actively-managed funds or index funds?

34. How should I choose index funds?

35. Why do individual investors make poor market timing decisions and how can I avoid making similar mistakes?

36. Should I use stop loss orders to control risk?

37. How does dollar cost averaging work?

38. Why rebalance?

Part 6: Template Portfolios for the Cognitive Investor

39. How about furnishing some sample portfolios?

40. What is so great about this portfolio management process?

41. How should these portfolios be managed over time?

42. How will these portfolios behave in the next several years? What should I expect?

43. How can I convert my existing portfolio to a cognitive investor’s portfolio?

Conclusion

Appendix

Acknowledgments

Bibliography

Notes

Introduction

Would you like better results from your investment decisions? Is someone else reaping the rewards of your investments while you bear the risk? Are you making emotionally charged decisions that you later regret? Is your investment success dependent on a particular course of future events? Is there any relationship between the economy’s health and your portfolio’s performance? Are you gambling with your wealth? Do you feel that your financial plan is out of sync with the financial markets? Do the actions of other investors unduly influence your decisions? Do you have difficulty distinguishing a sales pitch from useful investment advice? Do you feel that the deck is stacked in favor of the professional investor?

If you answered yes to a majority of these questions, you are not alone. Many individual investors are unsatisfied with the results of their investment decisions and are looking for a better way to approach the task of investing. The fundamental reason investors make poor investment decisions is that they use the wrong part of their brain. Cognitive Investing will explain two different modes of thought and why relying on the wrong one leads to a multitude of problems when making investment decisions. Cognitive Investing details how to sidestep these problems by using an alternate mode of thinking, leading to far superior investment results.

What is cognitive investing?

Cognitive investing provides a perspective and a set of useful tools and techniques for individual investors to prosper in today’s complex investing environment. Cognitive investing is based on principles and insights that are independent of the current market conditions and will stand the test of time.

• Cognitive investors understand the many ways psychological biases can negatively affect investment decisions and adhere to a process that minimizes the effects of these biases.

• The cognitive investing process is based on a thorough understanding of how the financial ecosystem actually works, not on how it should work, how others want it to work, or erroneous interpretations of how it works.

• Cognitive investors understand the many types of risks and their paradoxes.

• Cognitive investors intelligently use the principles of asset allocation, security selection and market timing to build portfolios customized to fit their unique needs and circumstances.

• They know what changes to make to their portfolios and when to make them as asset prices inevitably fluctuate.

• Cognitive investors are satisfied with their investment results because they steadily and reliably surpass the results derived from other more random approaches.

• Cognitive investors know what to do if they are faced with an unexpected or sudden influx or outflow of cash.

• Cognitive investors can confidently tune out and ignore the media assault of dire predictions, attention-grabbing headlines, and pundit maxims.

• They have peace of mind in knowing that their financial lives are under control.

What are examples of investing behavior that are not cognitive?

Many common investing mistakes are made because of an inaccurate understanding of the financial ecosystem. Others are a direct result of common psychological biases. Some of the common investing behaviors that violate the principles of cognitive investing are:

• Gambling, which is closely related to investing, but different in several key aspects that should be well understood;

• Relying on the investment guru of the month to make a case for various types of investments based on that guru’s guess as to the future path of markets and specific investments;

• Emulating a judge by weighing two alternative viewpoints (like the bullish and bearish arguments about the short term direction of the stock market) and deciding which one seems more plausible;

• Buying an investment with no intention of ever selling at least a portion of it;

• Making investment decisions based on mood and emotions;

• Allowing psychological biases to dictate simplistic solutions to complex situations or to distort the truth about the prospects for an investment’s success;

• Assuming that past performance is indicative of future results;

• Searching for the undiscovered relationship between some economic statistic and the future direction of the stock market;

• Determining the course of financial markets by examining the results of coincident and lagging economic indicators;

• Paying above-average costs for below-average results; and

• Relying too much on a single future scenario or a single investment idea.

Why is my brain ill equipped for investing?

Our brains are the biggest obstacle to investing success. They are being asked to perform a task they were never designed to do. The human brain is a special purpose device evolved to solve a set of problems frequently encountered by foragers in small nomadic bands on the African savannah. It was not designed to compare the value of thousands of potential investments in an ever-changing financial environment. The difference between the two environments is vast, and evolution has not had enough time to change how our brains work to solve the problems arising in our modern world. However, evolution did give us a powerful tool for dealing with unfamiliar situations—the ability to learn and to communicate what we learn to others. We need to apply this tool effectively so that our stone age-vintage brains can better function in modern society.

Two brains are better than one

Dividing our thinking processes into two contrasting modes helps to illuminate why our brain causes us to make decisions counter to our best interests. One part of our brain is intuitive, is guided by emotions, makes quick decisions, and operates below our level of consciousness. The other part of our brain is more deliberate, reasons with logic, is more comfortable with abstract concepts, and requires our attention. Psychologists and other scientists have given these two modes of thought many different names, and no single set has reached the level of wide scale acceptance yet, since this is still a young science. Some of the names for the first type of thinking are reflexive, intuitive, instinctive, automatic, experiential, heuristic, emotional, visceral, snap judgment-oriented, and implicit. The second type has been referred to as reflective, analytical, rational, conceptual, logical, deliberative, systematic, and abstract, among others. I prefer the terms reflexive and reflective, as used by Jason Zweig in his book, Your Money and Your Brain.¹

The reflexive brain is the fast-acting, uncontrolled, effortless, associative, and unconscious portion of our brain that we use for most activities requiring little thought. The reflective brain, on the other hand, is slow and controlled, requires effort, and is deductive and self-aware. The reflective brain can only do one thing at a time and requires our full attention to operate optimally. I will not attempt to describe any of the findings from neuroscience that attempt to locate the particular parts of the brain for each system except to say that this is not the same as the differences between the functions of the left brain and the right brain. That division is used to describe our thought processes in an alternative way that is less applicable to the task of investing. The following table contrasts the two types of thinking.

Making decisions directed by the thought processes of the reflexive brain is the primary cause of our investment-related problems. Following our intuition causes us to do the wrong things at the wrong times. It leads us to imitate the crowd and buy high when everyone is exuberant. It scares us into selling at low points when others are despondent. It is swayed by fear and greed. It picks the wrong analogies. It does not make the right match to past situations, since important aspects of each new situation vary from the past. It draws the wrong lessons from past events. It bases its decisions on inaccurate mental models. It attempts to apply learned patterns of past situations to current situations without understanding the key differences that make old solutions ineffective for solving new problems.

The fact that the reflexive brain usually works below the level of consciousness is another contributing factor to our lack of investment success. Most investors are unaware of the extent that their financial decisions are driven by emotions and gut feelings as opposed to rational analysis and logic. Logic is used to justify emotionally-driven, intuitive decisions.

When the two brain systems reach conflicting conclusions, the reflexive brain usually wins. It is the default system and is far more energy efficient than the purposeful, deliberate reflective brain. The reflective brain fatigues much more easily and is more than willing to let the reflexive brain take over. During our ancestors’ days on the savannah, food was not always abundant, so those individuals who consumed less energy would be more likely to survive when food was scarce. Because the brain uses a disproportionate amount of our caloric intake—two per cent of our body mass consumes twenty per cent of our energy—the reflexive brain with its reduced energy needs is the default mode of thinking.² It is the part of the brain we use first, and we only engage the reflective brain when the reflexive brain does not seem up to the task. In most areas of life, this works fine. The reflexive brain is great at telling you what foods are good to eat, who your friends and enemies are, and where is a safe place to sleep. However, it fails when faced with the vastly more complex problems created by our modern, information-driven society. These problems require the full attention of the reflective brain. And in order to keep the reflexive brain from interfering, some reprogramming may be required.

Cognitive Investing road map

This book has six parts. The first part describes counterintuitive characteristics of the financial landscape that make investing difficult to understand for those who take the default path and rely too heavily on the reflexive brain. Part two discusses the processes we use to make investment decisions and contrasts several commonly-used, but flawed processes with a more thorough, rational process directed by the reflective brain. Part three discusses risk, which is too often oversimplified. The fourth part discusses the ten spectrums of cognitive investing. These spectrums highlight the differences between how our reflexive and reflective brains deal with many different investment issues. Part five focuses on the specific steps of portfolio construction by applying the lessons from the previous sections. Part six gives examples of several template portfolios and describes how they should be managed.

The overarching theme of Cognitive Investing is answering the fundamental questions faced by the individual investor. Too often the focus is on ancillary questions that should not really be considered until the fundamentals are firmly established. For example, before you examine how to pick a particular stock to buy, you should first answer the question of whether picking individual stocks is something you should be doing in the first place. Thus most of the chapter titles are phrased as fundamental questions, and this format should prove useful for those who want to reread sections that apply to particular situations as they arise.

The path less chosen

We enjoy the process far more than the proceeds. – Warren Buffett

This quote highlights one of the defining differences between the approach of the world’s best investors and the average individual investor. The best investors focus on the process of investing and how they make decisions. The average investor is much more focused on the proceeds, asking instead, how can I make lots of money? The paths required by these two lines of inquiry diverge dramatically, leading to entirely different ways of thinking about investing. If the process is fundamentally sound, the proceeds will follow. If you focus on the proceeds, a sound process will never materialize.

The investing process involves markets, marketing, and human behavior. Why do people buy product A instead of product B? Why are they willing to buy stocks now rather than one month ago? Why do market prices gyrate? The answers to these and similar questions have intrigued me ever since I received my college degree in materials science and mechanical engineering, even though they had little to do with my course of study. Rather than pursue a purely technical career, I wanted to combine technology with the human element. Marketing was a logical choice. I spent the better half of my corporate career in marketing departments of high technology companies, learning how to market telecommunications and computer products. At the same time, I closely followed financial markets and invested my savings in a variety of stocks, bonds, and funds. One of the notable observations I made was that most of the marketing people I met were not very interested in financial markets and the financial people I met were not interested in other aspects of marketing. Everyone seemed to be focused on the proceeds instead of the process. Unlike those who were only focused on one discipline, I found that many of the insights I gleaned in one area were helpful in the other.

In my never-ending quest for ultimate truth and understanding, I read voraciously and continue to do so. I am an extreme lifelong learner. I have read many hundreds of books and many thousands of newspaper, magazine, and Internet articles about investing, finance, and economics. I studied the techniques and the secrets of the world’s best investors and read many journal articles of peer-reviewed academic research. I also read widely outside the field, gaining many of the most profound investing insights from studying other disciplines, most notably social psychology. Successful investing requires knowledge of both quantitative disciplines, such as mathematics, economics, and accounting, as well as humanitarian disciplines such as psychology, sociology, and ethics. Many people are comfortable with one or the other, but not both. Those focused on the quantitative aspects frequently view the softer sciences as fluff. Many of those who are most comfortable with the softer sciences shy away from numerical concepts. A comprehensive interdisciplinary understanding is required if one hopes to reach a level of proficiency sufficient to thrive in the complex world of 21st century investing.

A heavy dose of skepticism is needed. The financial field is loaded with false prophets—the profits they promise rarely materialize. Many claims by pundits do not stand up when examined critically. Compelling evidence is required, and this evidence is frequently lacking. Are positive results because of luck or brilliance? Is the pundit carefully choosing his data set to support his claim? Can the methodology be duplicated with equal success?

Testing ideas under real world conditions is imperative. For more than thirty years, I experimented with many different ways to choose securities and determine optimum times to buy and sell them. I ruthlessly judged their success on the merits of the decision-making process, rather than attributing all successes to brilliance and all failures to external events. Over that period, I had some huge winners, such as owning Qualcomm in 1999, when it appreciated by roughly 2600% (that is not a typo). I also experienced some miserable failures, owning stocks that declined by 100%. I owned Worldcom and Enron. Oddly enough, I once owned a stock that hit a yearly high and low in the same month.

To grossly oversimplify, investor mistakes can either be classified as buying too high or selling too low. After about 12 years of investing experiments and study, I learned how to avoid selling low. It took much longer for me to figure out how not to buy high. In 1993, I started tracking every trade I made and I periodically reviewed all trades based on a common investing idea. Most of my ideas did not pan out, but a few did. In 1996, I started managing portfolios for other investors. At the same time, I started writing about the investing process, which helped to clarify my thinking. There is value in being able to revisit your thoughts at key market turning points. Today, I can read what I was thinking about during the Internet stock boom and