Friday, 27 September 2013

Musings on Investor Psychology

After spending a few years in the investment game, I now have a firsthand appreciation for the difficultly in completely filtering out the impact that share price fluctuations and other market noise have on your decision making, which can also be inherently flawed on its own. More and more I realise that having an awareness of, and being able to control cognitive biases is just as important as understanding business. Many great investors have warned against the psychological challenges involved - Charlie Munger says: Above all, never fool yourself, and remember that you are the easiest person to fool - and I would second that. It would be very interesting to see some experts in psychology try their hands at investing. 

If you can spare 10 minutes or so, I would highly recommend you read this extensive list of cognitive biases on Wikipedia. While many are clearly applicable to investing, such as loss aversion and outcome bias, there are many other social and memory biases that it would be useful to be aware of for day-to-day life. But be careful that you don't pick up one or two extra biases in reading that list - 'bias blind spot' is 'the tendency to see oneself as less biased than other people, or to be able to identify more cognitive biases in others than in oneself.'  

As it relates to investing, misjudgements due to these biases can be very costly mistakes, which is a factor that is often overlooked. While nobody is completely immune to these cognitive biases, I believe they can be reduced by continuously scrutinising one's decisions and thought processes, and having an understanding of what the various types of biases are. On the latter front, I intend to read some books on psychology after my higher school certificate exams are over, which I expect will prove fascinating and rewarding. I think that the best thing about this blog is that it has forced me to clearly argue why I have done what I have, and since it is all there in black and white, I can look back to assess why I bought or sold something without any fear of memory bias. Both of these have helped expose psychological biases in my own thinking. 

Perhaps the stock that I have had to be the most careful with in terms of cognitive biases is Delta SBD (ASX:DSB), an underground coal mining services company I bought in late February this year. While I'll try to outline my thinking, I must first warn you that my judgement of the situation is likely to be quite biased since I still hold shares in it, so as always, I encourage you to be critical of my thinking.

I initially bought in DSB late February this year at $0.76, however it has since dropped to a low of $0.33 a couple of months ago, and is now back up to $0.53. Incidentally, the day I bought was the very peak, and ever since it has been a rather painful trip down. I knew going in that this was a fairly mediocre business (current normalised return on equity of 14%, net debt to equity of 32%, and a net profit margin of 5.5%), and anticipated a less than impressive earnings outlook, but the price looked cheap enough to offer a significant margin of safety - less than 5 times FY2013 earnings. In addition, I liked that the founders of SBD and Delta were still managing the company, and held a majority stake.

Unfortunately, I underestimated the speed and extent of the downturn in the coal sector, with news day after day reporting hundreds or thousands of job losses due to declining coal prices that made many mines uneconomical. Perhaps the widespread and sudden change in sentiment towards the sector is explained by the 'availability cascade', which is 'a self-reinforcing process in which a collective belief gains more and more plausibility through its increasing repetition in public discourse'. 

I will admit that in response to this outlook, I probably fell into the trap of confirmation bias - tending to read more articles that had positive views on China and the coal sector in an attempt to justify my initial investment. After losing 31.5% in a couple of months, I decided to double my initial investment by purchasing more shares at $0.52 since I believed that the market was being unnecessarily pessimistic and thus DSB had become cheaper. Eventually I recognised my confirmation bias mistake and started listening more to the bearish arguments (although I still have a healthy scepticism for any macroeconomic forecasts). In combination with the falling share price, it soon became hard to decide on what course of action to take - should I sell, buy more or wait for more information in the annual report? My value investing framework told me that despite the poor outlook, a share price in the 30 cent region was most likely too low so I ruled out selling at that price. However, neither did I have enough confidence to buy a third time, so in the end I opted to wait more information from the company, which had been deafeningly silent in its announcements.

Eventually, the annual report came which was largely as I expected, with a great FY2013 but with an expected drop in revenues and compression of profit margin in 2014 onwards. While there is now considerable uncertainty over the future earnings of DSB, they certain to be substantially lower, with a greater than 50% drop in earnings next year looking quite likely to me. That would take DSB from a bargain basement P/E of 3.1 currently to a still quite cheap P/E of 6-7, but there is considerable downside risk to that if China well and truly blows up sometime soon, which is a risk that makes me uncomfortable holding DSB for the long term.

To break-even on my two parcels, I would need a share price of around $0.59 (including fully franked dividends and brokerage). While it is tempting to hope to sell at a break-even price, this is another psychological pitfall known as 'anchoring' that inhibits rational decision making. As Phillip Fisher put it: More money has probably been lost by investors holding a stock they really did not want until they could "at least come out even" than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realised, the cost of self-indulgence becomes truly tremendous. Instead of calculating whether you will come out even, what needs to be asked is - 'where is current share price in relation to its intrinsic value?' If the answer is 'lower' then it usually makes sense to hold, unless as Fisher reminds us, you have found a better opportunity that you require funds for. While I am aware that my judgement may still be clouded somewhat by owning shares in DSB, for now my valuation work suggests the answer is 'a little lower' and so I continue to hold for the time being. 

The verdict is still out on what the future of DSB, the coal sector and China is, but regardless of the outcome, I hope that I will have at least taken away some valuable lessons about investor psychology that will improve my decision making going forward.

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