The classic, though now dated, ‘right answer’ to the job interview question, “what is your biggest weakness?” is to say that you are a perfectionist. The thinly-veiled subtext is that perfectionism is actually a strength, though perhaps one that has been taken a bit too far: “I’m just so focused on making sure I get everything right all the time that sometimes I work too hard (sigh).”
Of course, attempting to achieve the unachievable can lead to harmful outcomes for you and those around you. But there is more to it than that. The underlying drivers of perfectionism affect pretty much everyone and can interfere with your ability to make rational decisions. In investing, where so much is about maintaining Spock-like rationality, this is probably one of the most common and important psychological issues investors face.
There is a difference between simply ‘striving for excellence’ and perfectionism. In principle it is possible to strive for excellence and take any bumps along the way in your stride. Perfectionism is what happens when you strive for excellence but your ego gets in the way. It implies a degree of neuroticism – neuroticism that comes from a fear of flaws, mistakes or the negative judgments of others. In the extreme, perfectionism can lead to all sorts of unhappy thoughts and counterproductive behaviours.
I readily admit to being a bit of a perfectionist myself. While I am generally fairly laid-back and agreeable, I’m also prone to take myself too seriously at times and suffer some of the insecurities that come with this. I have a low tolerance for mistakes and can beat myself over trivial errors days after they have happened. I’m often overly reluctant to take actions that might expose weakness or naivety.
I think it’s better not to see perfectionism as black or white – a character flaw that you either have or you don’t. It’s more of a natural tendency that is likely to affect everyone from time to time. The drivers of perfectionism are ingredients inherent to being human: an innate need to protect your ego, a highly-evolved ability to spot potential threats and a subconscious that is actually in control of much of your behaviour, despite your better judgment.
The quest for perfection can lead you to try to control the uncontrollable, to take overly drastic measures to avoid losses or to dwell on past mistakes. All pretty unhelpful if you want to do well as an investor.
Controlling the uncontrollable
It is easy to underestimate the extent of uncertainty you face when making an investment.
You can make an educated guess that a business is likely to be successful, say if it is profitable, well-managed and providing a unique service that its customers value highly. But even then there are countless things that can go wrong, a lot of them outside of the business’s control. The reality is that the future prospects of a business are determined by such complex processes and interactions that the range of possible outcomes investors face is huge.
If you don’t fully acknowledge the extent of this uncertainty, it can be difficult to accept all the investments that inevitably turn out badly. This may make you strive to control the outcomes of your investments to a greater extent than is possible. This typically only makes these outcomes worse.
For example, one way you can attempt to reduce uncertainty is to seek out as much information on an investment as you can. In principle more information should allow for better decision-making, as you can disregard anything that is not relevant when ultimately making a decision. However, a lot of research has found that in practice too much information often has the opposite effect. The way information is presented, the time when you receive it and the effort you put in to find it can all affect your decision-making very materially, even though it should not. This can lead to all sorts of biases as I set out in this previous post. The biggest problems I think come from excessive conviction and confirmation bias, making it more difficult for you to accept when the odds are no longer in your favour.
This is only part of the story. Layered on top of the uncertainty about the prospects of an investment is the uncertainty about what will happen to its share price. While the two should be closely related over the longer term, over the short to medium term the relationship can be much less clear.
In fact the efficient market hypothesis (EMH) posits that as prices should reflect all the information about prospects available to investors, share price movements should follow a ‘random walk’. Of course, EMH doesn’t entirely stack up or else I wouldn’t be writing this blog! Price movements are not entirely random and it is perfectly sensible to have a strategy that attempts to exploit that part which is predictable (eg from undervalued shares converging to their true values).
However, there is still a lot of randomness that can manifest itself in the form of share price volatility. It’s easy to lose sight of just how much price volatility is essentially random, caused by short term shifts in the balance between supply and demand for the shares. This is especially the case for more thinly-traded illiquid shares. This means that you need to be able to tolerate a degree of price volatility. Disentangling the signal from the noise of price movements can be hard.
This is a problem for everyone, but especially for investors who rely on information on price movements to make decisions, for example through buying breakouts or using stop losses. These kinds of strategies can be effective in exploiting momentum. However, they can also leave you exposed to the danger of being ‘whipsawed’ in volatile conditions, as you buy on temporary highs and sell on temporary lows. It can also be a problem even if you know you ought to tolerate some volatility, but allow yourself make buy and sell decisions on the fly. My experience is that resisting the urge to expunge your portfolio of a misbehaving share prematurely in a moment of weakness is easier said than done.
Danny Kahneman, the Nobel prize winning economist, described the concept of loss aversion, the idea that people feel the pain of losses much more acutely than the benefit of gains, as “certainly the most important contribution from psychology to behavioural economics”. Empirical research has consistently found that the vast majority of people suffer from loss aversion. It is obviously highly relevant to investing.
Motivated by a desire to avoid errors, investors tend to care disproportionately about whether they are ‘correct’, rather than how much they make when they are correct. Rather than solely considering an investment’s future prospects, investors allow their decisions to be influenced by the price they originally paid and whether or not the current share price represents ‘success’ or ‘failure’. This leads a tendency to want to chalk up small wins quickly rather than letting winners run, or conversely to hold on to losing investments for too long in the hope that they turn around. This in turn means that it takes longer for undervalued shares to appreciate to their true value or conversely for overvalued shares to decline. This is one of the main reasons behind the consistent outperformance of the momentum factor.
Excessive fear of losses also affects how investors view the prospects of the stock market as a whole. There tends to be a bias towards excessive pessimism, where the fear of an upcoming market correction leads investors to want to crystallise their profits and raise cash far too often. In the famous words of Peter Lynch:
Far more money has been lost by investors trying to anticipate corrections than in the corrections themselves.
Severe market crashes don’t happen very often and even when they do it doesn’t take the market very long to recover. The fear investors have of market crashes (myself included) seems overblown. Correctly anticipating a market top, selling out to raise cash and then reinvesting at the bottom seems a pretty unrealistic goal, unless you have some special insight. Yet the fear of getting caught out leads many investors to persistently try to time the market anyway.
Dwelling on the past
As well as worrying too much about mistakes you may make in the future, perfectionism can make you dwell too much on the mistakes you have made in the past. Excessive regret can often lead to further mistakes.
‘Revenge trading’, the investing equivalent of poker’s going ‘on tilt’, is a common phenomenon where investors may try to quickly make back losses they have suffered, often due to perceived bad luck. It sounds like something that should be easy to avoid if you are clear-headed, but a run of bad luck can screw with the psychology of even the most level-headed investor. Comparing your performance to other investors, something difficult to avoid on social media, can also contribute to you going ‘on tilt’. It can lead to unrealistic ambition where you feel compelled to try to consistently match the best (or perhaps luckiest!) investors you follow.
Another example of irrational behaviour I’ve observed amongst many investors is a reluctance to buy back into an investment that has previously been sold. Perhaps emotionally scarred from having incorrectly sold too soon, investors want to avoid the scene of their previous mistakes. It certainly often seems that way.
Anticipation of this reluctance to reinvest can also make you reluctant to let go of your investments in the first place. For example, in the quest for big winners (the fabled ‘100 bagger’) investors are often encouraged to hold great businesses through the inevitable big drawdowns that can occur from time to time. Share prices of even major long term winners often fall by more than 50% on some temporary bad news and can take a year or two to resume their upwards trajectory once it becomes clear the story is intact. You would often be better off avoiding much of this drawdown, investing in something else for a while and buying back later if progress does indeed resume. It is the compound return that matters at the end of the day, not the number of 100 baggers you have the tenacity to hold on to!
Investing without conviction
I’ve argued above that a whole host of common mistakes stem from perfectionist tendencies and ultimately the fragility of our egos. This is the root of many of the best-known behavioural biases. As Buddhist philosophy teaches, your ego can leave you trapped by your past decisions, when ideally you want to live in the present. So how can you avoid this?
I think the answer is to try to put less of your ego on the line every time you make an investment. You can do this by having less conviction. Do not focus on individual investments too much. Diversify. It’s an alluring thought, but this investment is not ‘the one’ that will make you rich. Avoid thinking that your outcomes are solely a function of the skill and research you put in. Focus on your process and on controlling your behaviour rather than on your outcomes.
I think an inherent flaw with the traditional valuation-based approach to investing is that it encourages excessive conviction. It encourages us to run concentrated portfolios and hold on to ‘great’ businesses through temporary difficulties and despite falling share prices. This can be fine in principle, if you have the mental flexibility to promptly change your mind when the story changes. But it disregards the challenges your ego can pose in doing so in practice.
There are considerable benefits to more systematic approaches that actively manage the risk of behavioural mistakes through clear rules that must be consistently applied. As small private investors it does not cost much for us to have less conviction. Why not take advantage of this?