Recent Musings 9 October 2014

On risks versus returns, and how some psychology of misjudgment impact on the investment process.

Investing involves estimating risks and returns. Success or failure in investing over long periods of time (5 years and above) is a byproduct of average returns per unit of risk taken. The process involves an estimation of both the probability and consequences of each possible outcome, both good and bad. Once that is done, the overall result is compared with an alternative choice of investment.

That sounds like a lot of work. It is. Unfortunately, our human brain is not wired to automatically work this way. We prefer stories which progress in a linear fashion, rather than grasping with multiple timelines with different outcomes. In areas of complexity, we are wired to make simplifying assumptions.

There is also an asymmetry of incentive involved. Dreaming about returns is much easier. Assessing risks is unpleasant. Therefore the human brain, being risk/pain adverse, does not automatically engage in risk assessment.

The brain also suffers from a recency bias. This leads to the brain over-emphasising recent events, which can lead to extreme pessimism in bear markets and extreme optimism in bull markets. Both result in mispricings which can be systematically exploited, provided one is patient and not succumb to the Action Man bias. The difficulty in staying calm and patient must also be understood in light of our natural human tendency towards collective madness, especially in moments of stress and uncertainty.

Altogether, it is much easier to dream than work. Being aware of this will give one an automatic edge over the general market.

How do we apply the above learnings to our opportunity set in the current market?