Revisit: Why do we often make fair but not excellent investment decisions

This article was first published on 21 Aug 2020

After coming across Dr Wealth's article https://www.drwealth.com/why-a-barbell-strategy-is-extremely-useful-in-this-age-of-disruption/ , I thought I would give this post a revisit with some additional points.

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Why is it that common folks often make fair investment decisions and end up with fair returns?  

Being afraid of the EXTREMES

We were taught in theory that everything should strike a balance. Don't go to the extremes... and we will be pretty safe, isn't it?

That's right and you might even thank yourself for it. Anything with ratios that are too extreme may smell like trouble. For instance, price /NAV of Eagle hospitality trust is at a record low of 0.17, Lippo Malls is 0.44, but will one dare to buy? 

Certainly not! It's for obvious reasons.

Then...

Afraid of buying into the All Time High Over-valued stocks

This is another subset of fearing extremes. Many times we missed catching growth stocks until their share prices go to the moon and so do their P/Es. 

As though a lack in foresight is not enough, there comes Price Anchor Bias, which I can't deny I have also fallen prey to.

Remember this famous quote? "It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” - Warren Buffett

Then we would wait... and wait... and wait some more. Or just buy the fair company at "better pricing" cos too fed-up from waiting!

This is not saying that everyone should go and buy shares at ATH prices. That's FOMO-ing. We need to understand that decisions should be based on data that are forward-looking and not backward-looking, which involves certain degree of prediction and conviction.

Price Anchor Bias also led to the problem of believing that fallen stocks will come back once again to their glory (backward looking once again). On one hand, we recognized that not buying into the extremes is a wise thing to do. But on the other, we are holding on to the "extremes" and, worse still, average down on them. See paragraph on Endowment Effect below.

Some time ago, I mentioned Barbell strategy. This strategy advocates going extreme. It's something that I have wanted to try but eventually did not.

The gist of Barbell strategy is allocating money for investments into two extremes - the very stable, almost capital-protective investments and the risky but very high-return investments. So the high-return investment (which should only constitute a small portion of the portfolio) can give substantial gains to compensate for the opportunity cost of the stable but low-return investments. There will be almost nothing in the middle "fair return" zone. Simple as it may sound but difficult to execute.

First, it is NOT easy at all to dig for gems, aka high-return investments. Just how many people have foreseen the exponential growth of Apple, Amazon, Google more than 10 years ago and stay invested in them till now? (Not withstanding the possibility that many rotten apples might have been mistakenly picked along the way.) Many times "high return" are non-guaranteed and could even be luck-dependent. The Barbell strategy might have worked out if we managed to catch those ATH growth stocks at their ATL. (Perhaps the closest that we can get was the March 2020's sell-down. Those who scooped up a fistful of US stocks would be sitting on some handsome gains since there seems to be no dead cat bounce, as of now.)

Second, the other end of "low risk" investments are giving almost zero return in the current low-interest rate environment. It's a huge opportunity cost incurred there.

Thus, in the long run, we would have a tendency towards making fair choices, and end up with a basket of investments that give us just fair returns.

And we naturally blame it on...

Diversification

Diversification, although a sound strategy, dilutes our returns. (Yeah, it's a freakin double-edge sword.)

There's actually one more purpose of diversification (besides spreading out risks), which is to help us in uncovering gems. Think of it this way - we have to get our skin in the game and get our hands dirty sieving out countless stones to uncover gems. We know majority of stones won't be gems, so we need to spread our finite resources over a number of stones in order to find the gems.

Peter Lynch has said it:

"All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don't work out."

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One method is to simply an allocate equal sum of money to each of our hand-picked stock or vehicle of investment, which naturally allows dilution factor to come into play. 

Another way is to skew our holdings to the winners by allocating more money into them over the years. Also, do your position sizing carefully.

"Don't grow your losers. Grow your winners."

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In the end, it is not about buying into the ATL, ATH or dabbling in high-risk instruments; it is about who is a step ahead in finding gems and getting rid of useless stones by closely observing the ever-changing macro and micro economic environments.

The Endowment Effect

Endowment effect indicates that people are more likely to retain something that they own than acquire that same thing when they don't own it. It is a psychological phenomenon that was well illustrated in the book Thinking Fast and Slow. 

We tend to hold on to our losers due to this and refrain from acquiring gems with prices trending high, which could have prevented us from making good trade gains. On the other end, it is rather conflicting as to why we would readily sell winners to reap even small amount of profits.

To overcome this barrier, we need to set in place methodology for our investment and trade decisions.

Short-sighted panic vs Long-sighted calmness

Selling into the lows during market crashes and in the winter of a bear market, that is short-sighted panic.

When one takes solace that the market will eventually rebound and have the conviction to hold / DCA into the gems, that is long-sighted calmness.

"Millions of people are competing for each available dollar of investment gain. Who will get it? 

The person who's a step ahead of the rest."

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Disclaimer: Contents of this blog are personal opinions and NOT financial advice to buy or sell any mentioned securities, commodities or assets.