The Best Investment Ideas Should Be Easy

Following on from my last post (Second-Level Thinking: What Is It And Why You Need It) I wanted to take another look at investing psychology, specifically, the emotional bias associated with investment research.

Investment ideas should not require a lot of work

Researching a stock is a critical part of the investment process, but if you’re not careful, you’ll end up convincing yourself to buy the stock, rather than buying based on fundamental research.

To explain further, I’m going to use a quote from Mohnish Pabrai, one of the most interesting and thoughtful investors of all time.

“A few years back, I had dinner at Charlie Munger’s house with a small group of people. He posed the question to the group; he said that the Capital Group, a few years back, had set up a best ideas fund. They had asked each of their portfolio managers to give one stock, their highest-conviction idea, and then they created a best ideas fund, which was taking one pick from each of the managers. Charlie went on to say that this fund did not do well, it underperformed its benchmark and the S&P 500. He was asking the group why this was.

They tried setting up the best ideas fund multiple times, and each time it failed. He said, ‘Before I answer the question why it failed, I want to give you a story from my days at Harvard Law School.’ He said that sometimes when they had classes at Harvard Law, the professor would bring up a case where the facts were such where it wasn’t obvious which side was in the right. Then they would divide the class into two halves randomly. One half would argue for the defendant, and the other would argue against the defendant. The two sides went off and studied the facts and made their arguments. After all of that was done, when they surveyed the entire class, overwhelmingly the students who had argued for the motion believed strongly that they were right, and the people who had argued against the motion believe strongly that they were right. Before they had studied the facts, they did not have a leaning one way or the other. Charlie said the best ideas fund was simply a fund full of ideas which managers had spent the most time on, the ideas they were most excited about.”

This quote is taken from a speech Pabrai gave at Google (link) the critical takeaway of which is that it’s better to invest in only the ideas where the value is apparent immediately.

The more work you need to do, the more likely it is that you’ll convince yourself that the idea is worth following when it’s probably not. Your highest-conviction plays are your highest conviction ideas purely for the reason you know more about them than anything else, but that does not keep you from being wrong.

How do you get around this bias? Well, a checklist (as mentioned in my previous article) helps. Pabrai also recommends putting together an argument for why you’d short the stock:

“The first hack is being aware. Just being aware of these facts is a huge advantage. So being aware of the fact that we have a lot of biases, and our mind can play games and tricks on us. Being aware of that and being rational. Charlie Munger often says that he isn’t successful because he’s smart, he’s successful because he’s rational. Another approach is to be fluent in the other side of the argument. If you are going to be long a stock, it’s probably worth putting together a thesis of why you should go short. That will force your brain to think about things that it does not normally want to think about.”

 

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