I recently read a wonderful book called “The Art of Thinking Clearly” by Rolf Dobelli. The book is a collection of 100 different human biases and tendencies that impair us from making rational decisions. I HIGHLY recommend you check it out.
As I read the book, I tried to convert many of the 100 psychological tendencies into short investment-related examples that would help me remember each specific psychological tendency.
The collection of psychological tendencies is the work of Rolf Dobelli, and should be properly credited to him. The adaptations, in the form of Mr. Irrational, and his portfolio of fictitious businesses, are of my own creation.
Social Proof/Groupthink – Mr. Irrational attends a cocktail party. He learns that many of the attendees have bought shares of a popular yoga clothing maker called Gugugrape Athletica, Inc (GUGU) and have made a TON of money on it in the past year. The next morning, as soon as the market opens, Mr. Irrational puts in an order for 100 shares of Gugugrape.
Sunk Cost Fallacy - A few years back Mr. Irrational bought some stock in struggling retailer called K.D. Benny’s (KDB) believing it would turnaround. The stock is down 50% since he bought it. Even worse, Mr. Irrational believes his initial thesis for the buy was based on flawed turnaround assumptions. Although Mr. Irrational now believes K.D. Benny’s intrinsic value will actually decline rather than rise, and that the stock is actually selling well above that declining intrinsic value, he holds onto the shares anyway, in the hope he might get lucky and be able to sell at a higher price.
Confirmation Bias 1 – Mr. Irrational owns shares of a very controversial tech company called Macrohard, (MHRD). Mr. Irrational reads LOTS of articles about Macrohard on the Motley Fool. When he reads articles highlighting what makes Macrohard such a screaming buy, he is sure to comment on such articles, and tell the author how wonderful the article is. However, when Mr. Irrational reads Motley Fool articles with that argue that Macrohard is actually a value trap, he ignores the articles.
Confirmation Bias 2 - When massive internet retailer Congo.com, Inc (CNGO) surges over 40% after earnings, Mr. Irrational pats himself on the back, having confirmed that his superior investment strategies have earned him a 40% gain, and that luck played no role. A few months later, Mr. Irrational uses the exact same investing strategy to buy military contractor Universal Forces (UF). Universal Forces then plummets 40% and Mr. Irrational sells his stake. He chalks the loss up to bad luck, and believes the loss had nothing to do with his investment strategy.
Authority Bias – Mr Irrational buys shares of a natural gas play called Navajo, Inc, a company that he doesn’t really understand, because Jim Cramer said it was a good idea.
Outcome Bias – (never judge a decision purely on its result) – Mr. Irrational spends 12 hours analyzing a major heavy machinery company called Worm, Inc (WOR) and buys the stock. He later buys an agricultural machinery business called Elke & Company (EL), known for their famous Jon Elke brand tractors. Mr. Irrational did zero research before buying Elke. 12 months later, Elke is up 30% and Worm, Inc is down 20%. Based on the outcome, Mr. Irrational concludes that he should not do any research before buying stocks in the future.
Liking Bias – Mr. Irrational disregards earnings predictability and valuation and buys a technology company called Orange, Inc simply because he likes their flashy products. To make the purchase he sells Trash Administration, Inc (TA) a company with a better valuation and much more predictable growth.
Endowment Effect – Mr. Irrational has owned shares of Kool-Kola (CO) for decades and made a lot of money off them. Even though Kool-Kola is now overvalued, and Mr. Irrational has found a number of companies in which he has just as much confidence in as Kool-Kola AND are at much cheaper valuations than Kool-Kola. However, Mr. Irrational just doesn’t have the heart to sell Kool-Kola after all these years. He decides to hold on to them and ignore his new, better ideas.
News Bias – Mr. Irrational sells his shares of Scottish Petroleum, plc (SP) after seeing on the news that one of SP’s drills in the gulf coast blew.
Action Bias - Mr. Irrational’s portfolio badly underperformed the market last quarter. As a result, Mr. Irrational feels compelled to take action and sells some of his stocks and replaces them with other companies. Mr. Irrational never read Pascal’s quote, “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”
Thanks for reading, and please let me know if any of my examples are irrational in their own right!