How to Not

Be Your Own
Worst
Enemy
Get to know yourself better and
Become a Better Investor
1. Your Rationality

2. How Rational Are YOU?

3. The (IR)Rational Market

4. How Rational is the Market?

5. The Value of Information

6. Does More Information =

More Money?

7. Learn To Not Be Your Own

Worst Enemy

8. 5 Behavioral Biases You

Should Be Aware of Now

9. Join Us and Become A Better

Investor!

10. About The Author

11. Disclaimer
 Your Rationality
“Nothing sedates rationality like large doses of
effortless money.”

— Warren Buffett
How Rational Are YOU?

The Rational Investor

Traditional financial theory assumes that investors are rational and utility
maximizing. Utility here is a wider concept than just profit, as it can include
non-monetary value. For example, an ethical investment could generate a
lower return but increase utility for certain individuals.

According to Expected Utility Theory (EUT), an investor will base their decision
on the expected utility of different outcomes, and choose the option with the
highest expected utility. The expected utility is equal to the probability of the
outcome, multiplied by the utility the outcome gives. To keep it simple, I will
assume that investors are only investing to maximize monetary profit, i.e.
money = utility, the more money, the more utility.
To give an example, if an investor has two investment options to choose
between:

The investor will probably choose Investment A, as it has the highest expected
value of $500, compared to Investment B that has an expected value of $400
(as 50% x $1,000 = $500, and 20% x $2,000 = $400). Makes sense, doesn’t it?
And you got the math too? Awesome, then let’s play around a bit…

Below I give you four bets. You have to choose between A or B for each
bet, and if I contact you tomorrow and ask you to honor your bets, you’ll
have to do it (I won’t, but that's how serious I want you to consider
them).

Bet 1

Please choose A or B and note it down.

Bet 2
In addition to however much money you have, I give you $10,000, now
choose between:

Note down your answer.

Bet 3
In addition to however much money you have at the moment, I’m being
even more generous and give you $20,000, now choose between:

Note down your answer please.

Bet 4

Please choose A or B and note it down.

Have you noted down all your answers?

Ok, then go to the next page and learn more about your
rationality.
Loss Aversion
In Bet 1, A has an expected value of $50 and B has an expected value of $0. If
you’re as described in EUT you should go with A. However, most people go
with option B, and the reason for that was explained by Kahneman and
Tversky in 1979.

They found that losses hurt more than gains give satisfaction. On average
studies have concluded that a loss is about twice as painful as an equal gain
which makes you feel as good, i.e. a loss of $50 can feel as bad as a gain of
$100. This leads to people trying to avoid losses, i.e. they are loss averse.

Risk Seeking in Losses

In Bet 2 and 3, all choices have the expected outcome; that you walk away
with $15,000 in your pocket. In Bet 2 you were given $10,000 up front, and
both A and B have an expected value of $5,000. Indifferent of your choice,
you’re expected to walk away with $15,000 in your pocket.

In Bet 3 you were given $20,000 up front and both A and B have an expected
value of you actually losing $5,000. No matter your choice, again you’re expect
to walk away with $15,000 in your pocket.

So, in both Bet 2 and 3, a rational person should be indifferent to A and B, as

they have the same expected outcome. However, most people tend to prefer
option A in Bet 2, i.e.to get $5,000 with 100% certainty, and A over B in Bet 3,
i.e. 50% chance that you lose $10,000 and 50% chance that you get $0.

The only difference is the ‘framing’: Bet 2 is framed as a gain and so people
tend to be risk averse and go with A; as you get $5,000 for sure and give up
the 50% chance in option B to win $10,000. Bet 3 is framed as a loss and so
people tend to be risk seeking, i.e. choosing A to take the 50% chance of not
losing anything at the risk of losing $10,000, rather than just taking a $5,000
certain loss.
Probability weighting
People tend to again prefer option A over B in Bet 4 even though the expected
value is exactly the same; $5. Because $5 isn’t that much money and there is a
chance that you’ll win $5,000. You don’t really care about 5 bucks when you
see there is an opportunity to win 5 grand! Kahneman and Tversky (1992)
found that people tend to overweigh small probabilities and underweigh large
probabilities.

So How Rational Are YOU?

You might already have suspected that you aren’t always rational, or you may
think that you’re rational but know that people in your surroundings aren’t. In
fact, rationality depends on how we define it. I won’t give you a definition of
what being a rational individual is right now, I won’t even try.

My only wish with this chapter is that if you didn’t do it before, begin to
question rationality as it’s defined by traditional financial theory and
expected utility theory. By doing that, in my view, you have ‘become’
more rational.

And so then, you will also consider how many financial models—which
are still used today—rely on traditional financial theory. Which will lead
you to maybe question their reliability and accuracy; and that I believe,
makes you become a better investor.
 The (IR)Rational
Market
“The market can stay irrational longer than you
can stay solvent.”

— John Maynard Keynes

How Rational is the
Market?
Alexander Wetterling, CIPM (@BkkBanker)

I asked you in the previous chapter just how rational YOU are, to follow in this
post we’ll instead focus on OUR aggregate rationality, i.e. the aggregate
rationality of many individuals, or to word it easier; the market. You’ll discover
how we are much smarter together rather than alone.

And even though I believe that is true, I will let you know why I don’t think that
is the case for stock markets, and why the market is more like a beauty
contest.
The Rational Market
Assuming the stock market participants consist of rational investors, it’s fair to
assume the market should be rational or efficient too. Market efficiency is
defined as the true value of a certain stock reflected in its market price at any
point in time. In a the previous chapter we looked at the following investment
choice example:

If an investor has two investment options to choose between:

If the decision-making process follows according to the expected utility theory

(EUT) that I described in the post; the investor should choose Investment A. It
has the highest expected value of $500, compared to Investment B that has an
expected value of $400 (as 50% x $1,000 = $500, and 20% x $2,000 = $400).

How Come There is Daily Trading in the Stock Market?

There are numerous reasons but let’s keep it simple and just say that
investors’ math skills differ, and they come up with different expected values
for Investment A, and B. Investment A and B could be any instrument, but let’s
continue and think about it as two stocks; called A and B and focus on Stock A,
which according to EUT has a value of $500.

Investor 1 doesn’t have a calculator, failing math since primary school he does
the calculation in his head and comes up with a value of Stock A as only $350.
Investor 2, an A grade student with a calculator, knows the true value of $500
and offers Investor 1 anything above $350 and then there will be a trade.
However, stock markets have thousands of participants and due to that, there
will be numerous estimates and numerous trades involved as markets’
function, this will end up in Stock A trading at a price of $500. Hence, its true
value and so the market is efficient.

The Wisdom of Crowds

Central to the concept of markets and market efficiency is vox populi or the
wisdom of crowds. In 1907, Galton went to the market and asked roughly 800
people or so to guess the weight of an ox. The median guess was that the ox
weighed 1,197 pounds, and it turned out its actual weight was 1,198 pounds;
which is a very small error.

Now you can just imagine that even if there are thousands of people guessing,
you probably feel quite confident that the price of a certain stock will be equal
or extremely close to its true value.

Requirements for Wise Crowds

Galton’s work has been built upon in more recent years, and there is still
evidence for the wisdom of crowds. In a book named just that, The Wisdom of
Crowds, James Surowiecki defined four requirements for wise crowds:

A diversity of opinions, i.e. that the many different opinions involved are
also different in themselves in the sense that they’re based on each
individuals’ experience, informational advantage, or at least, the belief that
they know something that others don’t and that it’s reflected in their guess.
Independent guesses, you asking your friend about the value of a certain
stock and her saying it is $100, therefore, you also guessing $100 or
something very close is not the definition of an independent. Everyone
needs to make their value estimates independent of others.
Being decentralized, or meaning that the guesses come from many places
with different types of people reflecting, or being affected by local or
specialist knowledge.
The aggregation of guesses, a system that can aggregate all those
guesses and make it a collective guess; a stock exchange is an example of
such a mechanism as the price of traded stocks will be the result of many
different investors’ estimates/guesses.
Of the four above I don’t see any issue with the latter two requirements. Stock
exchanges are functional mechanisms to aggregate guesses or estimates of
the value of a certain stock, and it is most often decentralized in the sense that
anyone with a brokerage account can participate. In most markets due to
internet and globalization, this means you can be whoever, located wherever
in the world, and still participate.

Why Crowds May Not Be Wise

It’s the first two requirements that make me doubt the wise crowd, at least in
a stock market context. How independent are guesses really? People read
similar newspapers, use similar data sources, and listen to similar opinions
broadcast across various media. Do you believe you or anyone else can truly
be uninfluenced by any of this? Or that you don’t at least consider even a
small part of this information when making a guess about the future?

I personally doubt that we can be unaffected by it, and therefore, we have to

question the independence of our guesses. If you disagree and think that my
opinion is questionable or even wrong, I would love to hear more about it and
discuss it further with you in the comments section below. As that’s how we
learn and become better.

If you do agree with my opinion, that guesses or estimates about the value of
a stock traded on a stock exchange are far from independent, then you may
already have figured out that a lack of independence in estimates will also
lead to less diversity in the estimates or opinions. As these two requirements
aren’t fulfilled in the stock market, stock markets are not a wise crowd, and
hence, not rational or efficient.

How a Stock Market Actually Works

Let’s say you have estimated the true value of a stock that you bought for $50
to be $100. One day the bids for buying this stock reach and exceed $100, and
so as nothing has changed you will sell the stock for $100 or more.

However, you see the share price continue to rise in the coming days, and
then you read on Bloomberg that analysts from Goldman Sachs, J.P. Morgan,
and Credit Suisse say that this stock will be trading at $300 in a year from now.
Let’s pretend that these big banks’ recommendation have an influence on
market participants’ estimated value of the stock, and a substantial group of
investors also start to believe that the stock is worth a lot more and will trade
about $300, or at least, $250 in a year from now.

Hence, estimates don’t fulfill the independence nor diversity requirements of

wise crowds. You think this is the case, and see the stock is trading at $130
now. If a large group think it’s worth $250-300, why not buy the stock, hold it
for a while and then sell it at a higher price later to those guys? Yes exactly,
why not?!

Just Avoid Being the Greater Fool

Your estimate of the true value is still $100, but you can buy it for $130 now,
and you are confident that there is a large group of investors that believe it’s
worth even more, at least $200. Easy money! You buy it for $130 and 6
months later it trades at $200 and you sell it again. This kind of game can go
on for a long time and with most of the stocks in a market, it is what is
commonly referred to as a bull market.

As you can see the true value of the stock (assuming that it can be
determined) or your estimate of it, don’t really matter, the only thing that
matters to make money is if you’re on the right side of the market. You only
need to avoid being the greater fool; there are always buyers at a higher price
and you’ll make money irrespective of the true value or your estimated value
of the stock.

The Market is More Like a Beauty Contest

There is something in the economics and finance world referred to as the
Keynesian beauty contest, it is an analogy created by Keynes; a fictional
newspaper beauty contest about the stock market and its participants.

The newspaper contest was to select the six most beautiful people from
among 100 photos, and the participants choosing the most voted for would
win a prize. The point here is that the best strategy to win the contest is not to
pick the six photos that you find most attractive, but rather to guess and pick
the ones that the majority of the other participants would find most attractive.
I’ll leave you with this, and hope I have woken some questions in your
mind about the rationality and efficiency of markets. To me, the stock
market looks more like a beauty contest, and a place where people play
the game of not being the greater fool. Rather than, as it should be; an
efficient pricing mechanism that with the help of wise crowds can
identify the true value of an asset.
 The Value of
Information
"Overoptimism and overconfidence tend to stem
from the illusion of control and the illusion of
knowledge."

— James Montier
Does More Information
= More Money?
Alexander Wetterling, CIPM (@BkkBanker)

Information is a central concept in investing. It’s central in the sense that an

investor’s informational advantage can be the sole reason he or she makes
money in the market, and might even be able to do so continuously.

Whether you believe that there exist, skilled managers that can persistently
beat the market or not, you most certainly will have learned that there are
people making money from insider trading. Insider trading is about using an
informational advantage to make money, and though it’s both unethical and
illegal, we know that it happens.
Nobel laureate Eugene Fama said:

Again, it’s about information. Fama says it in the context of market efficiency,
but the value of information is central to all parts of investing. But is it that
simple? That the more information you’ve got the more money you’ll make?

Cognitive flaws reduce the value of

information
We humans have some cognitive issues you’ll need to consider when it comes
to information and processing information; biases and heuristics that might
not give you the informational advantage you’d expect to make good
investment decisions.

One issue is that we often tend to try to confirm our own beliefs. We do also
many times give more weight to recent information and information that is
more easily available. Hence, we don’t objectively acquire and process the
information that we get.

Confirmation bias, recency bias and overconfidence work in tandem to create

what Shefrin (2000) refers to as the illusion of validity . The issue with the
illusion of validity is it makes you hold invalid beliefs as they’re not acquired
through a rational and objective process.
According to Montier (2007) we suffer from two more illusions; the illusion of
control that makes you believe we can affect the outcomes of uncontrollable
events and the illusion of knowledge that you think your forecasts become
more accurate solely due to considering more information.

Dr. Andrew Stotz previously said in a blog post: “In the trade-off between
simplicity and precision, I choose simplicity”; referring to that more
information doesn’t always add an equal amount of value when it comes to,
for example, precision in forecasts.

The value of information

So far, I’ve mainly focused on why more information doesn’t necessarily lead
to increased accuracy or better performance, but as I mentioned earlier, there
certainly is value in information, and clear evidence of this, is that insider
trading seems to be lucrative. If there wasn’t value in this informational
advantage, there wouldn’t be any money to be made off insider trading, and I
doubt it would then occur at all.

Years ago, back at university studying behavioral finance, I had a visiting

professor, Michael Kirchler (great guy FYI), who ran some interesting
experiments with his colleagues to understand the value of information
better. As it seems that sometimes more information is adding value and
sometimes not.
Trading “coin-flip assets”
What Prof. Kirchler and his colleagues did was to set up an experiment based
on a “coin flip model”. First of all, they set up a scale of information ranging
from weakly informed participants (e.g. private investors), to average
informed (e.g. institutional investors, fund managers), to the most informed—
the insiders.

The “asset” that the participants in this experiment can buy or sell is the value
of the outcome of 10 coin flips. Let’s say a coin flip that return Heads is worth
$1 and Tails $0. If the outcome of the coin flip series then is 5 Heads and 5
Tails, the value of the “asset” would be $5 (as $5x1 = $5), and if it was 10 Heads
and 0 Tails the value would be $10. What the heck have coin flips got to do
with information though, it’s just random outcomes?

Indeed, it is, but how they constructed the experiment was to give the
participants different information at the point when they were making their
decision to buy or sell the asset and at what price. The least informed investor
didn’t know any of the outcomes of the 10 coin flips, while the average
informed one had seen 5 out of 10 outcomes, and the most informed (the
insider) knew 9 out of 10 outcomes.

The insiders, therefore, already know 9 out of the 10 outcomes, and so if all of
those were Heads, they know that the asset is worth $9 for certain. According
then to expected utility theory, the insider will assign a $9.50 value to the asset
as there is a 50% chance that the last coin flip will return Heads (as $9 + 50% x
$1 = $9.50).

It matters where you are on the information food chain

Prof. Kirchler and his colleagues ran many experiments adding in different
conditions, and their conclusions from these experiments are very interesting.
They show that the only ones beating the market, in this case making a
positive return, are the participants with above-average information. In the
coin flip model, it meant that only the participants who had seen 6 or more
out of the 10 outcomes were informed enough to make money.
Another interesting find was that the least informed investor who knew no
outcomes in advance and therefore most likely valued the asset at $5 (as (50%
x $1) x 10 = $5), performed better than the participants that already knew
between 1 to 5 out of the 10 outcomes.

This research implies that to be informed but not informed enough damages
your returns; it’s actually better to have no information at all than being less or
averagely informed.

Conclusively, we can see that the amount of information matters as well

as how we then process this information. More information doesn’t
necessarily translate into increased accuracy or enhanced returns, hence
More Information ≠ More Money.
 Learn To Not Be
Your Own Worst
Enemy
“The investor’s chief problem—and even his worst
enemy—is likely to be himself.”

— Benjamin Graham
5 Behavioral Biases You
Should Be Aware of Now
Alexander Wetterling, CIPM (@BkkBanker)

When the markets seem a bit more uncertain than usual, and you are
bombarded on all sides with cascades of information—whether it’s
negative, positive or conflicting news—about what’s going to happen
next; it is important to trust yourself and your own judgment. To achieve
this means that you must know yourself; as Benjamin Graham said, “The
investor’s chief problem—and even his worst enemy—is likely to be
himself.”

In this chapter we will focus on the 5 behavioral biases you should be aware of
that you, and every investor, most likely suffer from. At many times in our lives
—and especially in investing—we are our own worst enemies. But, awareness
and admittance can help you out in times like this, in order to make better
investment decisions.
Despite whether we want to admit it or not, we are emotional creatures and
as such, our emotions affect our behavior and decision making. Furthermore,
research has proven that we each have our own set of heuristics (those ‘rules
of thumb’ we follow) that are either learned or hard-wired into our brains or
genes according to neuroscience and evolutionary psychology.

As you will notice behavioral biases don’t usually show themselves in isolation
but feed off each other or become a combination of many that lead you to act
the way you do. Listed below are the 5 behavioral biases that we all suffer
from and how you can deal with them.

Anchoring
Anchoring is when we fixate on some past information and then base our
future investment decisions on this. One way is to anchor to the price you
bought a stock for, and another to anchor to the price target you expect it to
achieve (based on your valuation and expectations) and then stick to your
anchor even when new information suggests you should do otherwise. The
world around us changes, and so do the fundamentals of the company you
have invested in; there are all sorts of information that can affect its share
price.

By just being aware of your anchor and that it can become irrelevant
due to new information, you should be able to deal with this bias.

Confirmation
Confirmation bias is the tendency to search for, focus and put weight on
information that confirms beliefs you have already. You purchase a stock
because you spent a month researching the company and think the business
has great growth potential and a revolutionizing product.

You then seek to reinforce and confirm this belief by reading and allowing any
company announcements and news to add weight and support your point of
view. You may also actively choose to ignore news about a possible
competitor launching something that will make your investment company’s
product obsolete.
Always be open to opposing views and strive for objectivity. Play devil’s
advocate with yourself or ask a friend to challenge your opinion.

Recency
Recency bias is the way in which we overweight future decisions based on
recent events and information. With the market in a downward trend now, as
it has been for some time, we tend to assume that it will continue to go down
—and vice versa in the alternative of that situation.

Again, increasing your awareness of recency bias will help you to deal
with it. Be sure to put everything in a larger perspective and expand
your time horizon when making decisions about your investments. See
the bigger picture.

Herding
Herding is displayed when we decide to follow the crowd—being the social
animals we are—rather than acting contrarian and running by ourselves—not
with the herd. Keynes said, “…it is better for reputation to fail conventionally
than to succeed unconventionally.” This one is a bit tricky as you can indeed
make money by following trends, and so too you can lose money by going
against the crowd.

Herding behavior by others can make you doubt your contrarian view or force
you out of your contrarian position. Financial and economic bubbles have
shown throughout history though that the herd can run in the wrong direction
for a long time, so being a contrarian will require strength and stamina—but it
can be profitable too.

My advice here would be to seek information and then create an

informed opinion and to always have a rationale for your investment
decision. Don’t just do it because everyone else is.
Overconfidence
There are a wealth of academic papers, books, articles, blog posts, speeches—
this could go on forever—already out there about overconfidence, so I will
keep it short: YOU ARE OVERCONFIDENT.

This may come across as an overconfident statement to make, but it’s highly
likely that you are, and even if you aren’t you will learn from this. Admit that
you are overconfident, be humble, do your research, and at least, know
that you don’t know it all.

I recommend that you spend time getting to know yourself better, and
learn to not be your own worst enemy. Be aware of your flaws; whatever
they may be and for whatever reason you have them.

Be humble and admit your shortcomings; that you don’t know it all and
are not always right. Keep on learning and strive to Become a Better
Investor each day and soon, you will!
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About The Author
Alexander Wetterling, CIPM is a Portfolio Strategist at A. Stotz
Investment Research; selecting stocks and creating portfolios for
institutional investors around the globe.

He is also the Head of Content at Become a Better Investor and has

a deep passion for Behavioral Finance as well as human and
market behavior in general.

At A. Stotz Investment Research we developed our unique FVMR methodology

as framework for selecting stocks in any market. We create portfolios of stocks
that aim to beat the benchmark.

We love to do research to become better investors and share our ndings in

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Disclaimer

This content is for information purposes only. It is not intended to be

investment advice. Readers should not consider statements made by the
author(s) as formal recommendations and should consult their nancial
advisor before making any investment decisions. While the information
provided is believed to be accurate, it may include errors or inaccuracies. The
author(s) cannot be held liable for any actions taken as a result of reading this
article.