Try to Avoid Minsky Moments

Hyman Minsky was an economist whose theories were largely ignored during his lifetime and forgotten since his death in the mid 1990’s. They were forgotten until they became glaringly relevant during the financial crisis of 2008.

Even today, his work on financial cycles and fragility hasn’t found its way into economics textbooks, but it’s starting to. His work might have been ignored because of his argumentative personality or maybe his ethnicity excluded him from being fully accepted among the elite of economics theorists. I suspect the real reason was that his work went against the thinking of the time, which imagined prosperity without end and demanded freeing the banks and other financial institutions from any restraint.

From what I’ve been able to learn, Minsky’s big idea was that banks and other lenders become increasingly reckless until asset prices eventually collapse. We saw this in the early 2000s when a boom in the US property market was perpetuated by so-called NINJA loans where the applicant had no income, no job and no assets. But immediately the crisis started, getting a bank to lend money was like pulling teeth.

One lesson from this, for any financial system, is that banks should be more conservative when the market is hot, but more liberal in the aftermath of a crisis. That’s not happening in Australia, where the banks have had to increase their capital following the Murray Inquiry. This means they will have to be even more careful about lending money than they are now. So it’s going to be a longer recession here in Australia than it needs to be.

The lesson for me is to take notice when the banks start making it easier to get home loans. Australian banks never offered NINJA loans but there were low doc and no doc loans offered (requiring little or no documentation from the borrower to prove their ability to pay). Next time round they will use different names for these easy loans, it’s a sign the market is topping.

Of course, Minsky wasn’t the first person to notice market cycles. The ancient Romans knew about and documented several. Before the Romans, the ancient Egyptians and Babylonians institutionalised market cycles with their ‘jubilee’ system. A jubilee occurs every 50 years. To mark the jubilee, the Pharoah forgave all debt. If you owed someone money, they could no longer collect it. In this way the market cycles were controlled and predictable.

So Minsky didn’t invent the market cycle, his big idea was fragility. He noticed that the longer the cycle continued and the looser lending practices became, the more fragile the overall market became. So, the longer the cycle and the more stable the system appears to be, the worse it will be when it collapses. Have you ever seen a big tree that got blown over in a storm revealing the termites and fungus that have eaten it out from inside? Me either, but there’s an analogy for you.

How can I apply this idea to trading? What about a company that has long been considered a ‘blue chip’? The share price has risen steadily over many years with a stable board drawn from the elite business circles. Perhaps they’re a bit lazy about defending their interests from disruptors who want to eat their lunch? Perhaps their systems are a bit calcified? Perhaps they’re hiding a few embarassing problems from their shareholders? I think it’s better to buy a good company a little while after it’s started to rise than a famous company many years into its dominance.

For the longest time, Australian banks have been seen as the safe stock market investment. They’re the anchor of any superannuation portfolio, promising a guaranteed dividend. But since Murray is demanding tighter capital adequacy, miners and retailers are doing it tough and the Sydney housing market is looking a bit toppy – maybe now isn’t the time to be buying banks. I hope I’m wrong about that, I bought a fair slice of bank shares just before I came across Minsky’s theories.

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002 Cognitive Bias: Mental Accounting

Notes from Think Like the Great Investors by Colin Nicholson:

New investors are always looking for a guru or a perfect system to tell them what to invest in. This is flawed because no system is perfect all the time and nobody knows their investment needs better than themselves. The path to successful investing lies within us.

The world is hugely complicated. One way of dealing with the complexity is to put things into categories. This simplifies things by breaking them down into simpler parts. We do this with budgetting, but putting money into categories or accounts makes us see it differently, even though one dollar is the same as any other.

Some people identify some of their funds as “money I can afford to lose” in fact, it is no less valuable than money they can’t afford to lose, but they treat it differently to rationalise bad investment behaviour. When we are up, we consider it ‘the market’s money’ and use that as an excuse not to sell, taking more risk than we would if the stock fell straight after buying. An example is where an investor has bought a stock at $1 and it rises to $2. He will say that he has made $1 profit. If the stock later falls by 20c, he will say that he made 80c profit. In fact he has lost the 20c he would have made if he sold the stock when it was trading at $2.

Your paper profits are real money and you need to protect them as much as if it is money in the bank.

Some strategies to overcome mental accounting are:

  • Revalue each stock at its current price, forget about the price you paid for it.
  • Restart your records each year.
  • Plot the value of your portfolio on a chart so you can see what level it has reached.
  • Take some profit off the table.
  • Write a six monthly report on your portfolio’s performance.
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001 Cognitive Bias: Overconfidence

Notes from Think Like the Great Investors by Colin Nicholson:

Studies have shown that we are more likely to be confident when we try to estimate something when that thing is difficult to estimate than when it is comparatively easy. An example of this is the fair value of a stock. The reason for this is because our brains simplify the task by focussing only on one or two things and not taking account of the many factors which drive a share’s price.

We tend to be overconfident when the confidence of the general community is high, such as at the peak of a bull market. One way you know that you are at the peak of a bull market is that it’s hard to find someone who isn’t bullish, or when those who aren’t bullish are ridiculed or ignored.

Lack of expertise – Students leaving an exam centre were asked to predict their results. Those who said they didn’t study (and therefore scored badly) expected higher grades than they were actually awarded. Those who said they studied did better at predicting what their final score would be.

Hubris – Those who become experts in a particular field quickly get used to the situation where the people they mostly deal with don’t know as much as them. This causes them to become arrogant about their abilities, not only in their field of expertise, but in other areas in general.

Confirmation bias – Humans tend to seek out information that supports their decisions and ignore that which doesn’t. If you can’t find any reasons against an investment decision then you haven’t searched hard enough to find them. The best decisions are usually the ones you have agonised over the most to get right. There is little profit in easy decisions that are obvious to all.

Selective memory – It is more pleasant to remember and talk about our successes than our failures. So we develop an unbalanced view of how good an investor we are. This reinforces our feelings of superiority and hubris. Keeping good records can help with this.

The notion that more information is better is an illusion. What helps us is not how much information we have but identifying which of it is useful and valid.

Availability bias – We most strongly recall and are influenced by those situations which:

  • happened to us personally or to people close to us;
  • are very shocking; and
  • happened most recently.

These influences lead to poor judgement because of:

  • small sample size;
  • lack of proportion; and
  • we are blinded to what the true probability is.

Some strategies to overcome overconfidence:

  • Seek out contrary views.
  • Concentrate on the critical information, not all the information.
  • Focus on a few stocks rather than many.
  • Keep good records and an investment journal listing reasons why you bought and why you sold and any lessons.
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Women are Better Traders Than Men

In Think Like the Great Investors, Colin Nicholson points out that studies have shown women tend to be better traders. Some of the advantages women have include are they:

  • are less confident;
  • take less personal credit for their success;
  • spend more time analysing their trades;
  • take more notice of expert advice;
  • make fewer transactions;
  • don’t expect consistently high returns; and
  • buy less small, volatile stocks than men do.

 

For all that, when I think of the famous investors, I can’t think of a single one. Though there must surely be many. Where are the female Soros/Buffett/Tudor-Jones’s? Even female finance writers are thin on the ground. Perhaps that’s due to the second point in the list above.

The key takeaway is that overconfidence leads us into bad trades.

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Think Like the Great Investors: Colin Nicholson

Colin Nicholson is a finance academic on the finance speakers’ circuit in Australia and this is not his first book on investment. In this book he looks at aspects of the psychology of investing.

The book is in three parts. The first part covers various mistakes in our thought processes which serve us well in our daily lives but make us terrible investors if we don’t find ways to overcome them. They are many and most of them apply to me. My worst fault is cognitive dissonance, but I also discovered mental accounting, which I also suffer from. I will write more about these in future articles.

The second part is a few essays on crowd thinking, which is helpful for understanding market booms. The third part is a collection of essays on investment psychology in general. I found these essays to be less interesting than the content in the first part of the book.

A useful feature is strategies to overcome the problems Nicholson raises at the end of each essay.
Overall, I think the book is worth reading, whether you are an Australian investor or not. I borrowed my copy from the public library and have taken notes from it, so I don’t need to buy it.

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Context Adds Value 03

Pepsi has often tried to prove that its cola tastes better than Coca Cola. It tried to prove it by conducting blind taste tests which showed people preferred the taste of Pepsi when they didn’t know what they were drinking. Eventually, in 2003, their claim was proven to be a fact when an MRI scan was used to show how the ventral putamen (the part of the brain which processes reward) becomes more active when someone drinks Pepsi than when they drink Coke.

 

So why does Coke continue to outsell Pepsi?

 

The study also showed that if the participant was told they were drinking Coke, their ventral putamen lit up even more than when they were drinking Pepsi without knowing what it was. The researcher concluded we attach so much value to the childhood experience of drinking Coke (and the many years of successful Coca Cola advertising that we’ve been subjected to) that our brain attaches extra value to the brand. So much that it overrides our sense of pleasure derived from taste.

 

My conclusion is, if you are selling an item you will be more successful if you can somehow appeal to the buyer’s positive memories, more than relying only on the superiority of your product.

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Context Adds Value 02

An experiment conducted in 1985 asked people to imagine they were sitting on a beach, feeling a bit thirsty and a friend offered to fetch one for them. They were then asked how much they would allow their friend to pay if he was buying it from a fancy hotel, and how much if he was buying it at a “small, run-down grocery store.”

 

Beer tastes the same, wherever it is bought from. So, logically, you would expect them to be willing to pay the same, whether from a fancy hotel or from a little shop. In fact, the participants said they would be willing to pay $2.65 for a beer from the hotel, but only $1.50 from the shop.

 

The participant’s willingness to pay 75% more depending on where it is bought is caused by people’s expectation that a big hotel will charge a premium for drinks, but people would feel ripped off if they paid the same price at a small shop.

 

The paper contains a number of other examples of counter-intuitive examples of pricing. One topic that seems to crop up from time to time is how prices are set for events and concerts, this paper gives some insights. It’s interesting but quite heavy reading.

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Unintended Consequences of Government Interference in the Rice Market

(710 words)

How many people have to die before governments stop manipulating markets? The answer is they will never stop. There have been two major rice crises this century, one international the other national. Both caused many needless deaths, both were caused by governments.

The first crisis
In early 2008, the price of rice increased 300% from $300 per tonne to $1200. This rise was initiated by an increase in the price of oil. Many rice exporting countries, such as India, Vietnam and Brazil, reacted by banning all rice exports, hoping to keep down prices in their own countries. This drove the international price up, making rice unaffordable in many importing nations, causing riots.

On 19 May 2008, the price of rice began to fall even faster than it had risen. This was because the Japanese government announced it would release 250,000 tons of rice to the Philippines. This was part of a 2.6 million ton rice mountain held in warehouses, enough to supply the Philippines for two years.

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On Contrarian Stock Picking

To be a successful investor requires us to take a contrarian position. We are able to fool ourselves into thinking we are contrarian investors when in fact we are just following the herd. These are my notes from an essay by Matthew M Stichnoth “The Psychology of Picking Stocks” from The Psychology of Investing.

The essay begins with the old joke of the drunk searching for his car keys under a street lamp. A policeman joins the search and after a while asks the drunk “where did you actually lose your keys?”

The drunk replies “around the next corner at the end of the street.”

“Why are you looking for them here instead of where you lost them?”

“I’d never find them there, there’s not enough light.”

This is how most investors pick stocks, they only look at the ones in the media now, they don’t hunt for them in the dark corners where the true bargains are.

Contrarianism
This is a very old concept, based on the fact that the markets go to extremes and must self correct over time.

  • First, a small group of investors come up with a conclusion (cabbage patch dolls will sell well this Xmas) and they invest in relevant stocks which stand to benefit.
  • Then as their conclusion shows early signs of being correct (shops sell lots of dolls), the stocks begin to rise and more investors show interest.
  • But the second wave of investors will need their stock to go higher than the first group’s in order to justify their profit expectations.
  • Next, these new, higher expectations are met.
  • Then more people become investors based on even higher expectations.
  • In the end, there is a horde of investors with wildly hopeful expectations, while the pool of new buyers dwindles.
  • Finally, the sky high consensus is shown to be too much and the market crashes.

An investor who can stand back while expectations are peaking, and who can buy when consensus is at its lowest point, can make a fortune.

Contrarianism is the basis for all investing. The momentum trader is betting that the consensus view isn’t bullish enough. Value buyers are implicitly saying the market has mispriced his company. Even the buy and hold investor believes that nothing terminal will happen to his stock, regardless of what the consensus thinks.

Avoiding contrarianism
It is against human nature to act in a contrarian way, even though we know that we must do so in order to be successful traders. So we justify our conformist choices by deluding ourselves into feeling as if we are contrarians by using stock picking methods such as astrology, ‘socially responsible’ investing and technical analysis. None of these are particlularly harmful investment methods, but none of them are particularly successful, either.

Screening
The worst avoidance device is to use the computer to screen for ‘cheap’ stocks. The problem is that everybody else is already doing this and they are doing it in the same way, using the same screening parameters (multiple of book value, % revenue growth, % debt etc). And they are using the same data, which is disclosed to everyone at exactly the same time.

Using screening methods, everyone comes up with the same investment decisions. That is not conrtraian investment.

Painless contrarianism
Stichnoth gives three tips for stock picking which do not rely on screening but which give you a chance to find stocks with good potential.

Insider buying
Heavy buying by company insiders (especially by a CEO) are a good indication the market has overdone its pessimism. But you should watch out for companies that make stock-purchase loans to their executives, or ones that require their executives to own shares.

Spinoffs
These are unloved by their very nature. They are spun off from their parent company only because no buyer could be found. So the stock is distributed to the owner’s shareholders. Many of the shareholders don’t want the stock they’ve been issued and they sell it as soon as possible. As they all exit the stock at the same time, the price is depressed regardless of its value.

Busted IPOs
Some stocks sink soon after floating. This is sometimes because of a single bad quarterly report or management may be struggling to adjust to operating as a public company. These stocks can stay low for ages. Once these (often simple) problems are fixed, the company may be re-rated.

I would only add that you should be careful with that last tip. Often an IPO sinks for very good reasons and never recovers its original price.

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How to Identify Gentrifying Localities

(710 words)

One property buying strategy that has been successful for the past thirty years is to buy near the center of big towns. Even though it’s a well established trend, there are plenty of opportunities. But it is still important to be selective when you find what looks like a cheap inner city property.

The trend
This trend is sometimes referred to as gentrification. Land values rise because wealthier people move in. Because of the higher prices, the poorer people are forced to move to places where rents are cheaper. Gentrification is often considered a negative thing because the neighborhood loses some of its original character but also the poor may become homeless or lose social connections.

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