How To Keep Your Brain From Ruining Your Returns

In his latest column for Seeking Alpha, Validea CEO John Reese says that all investors — even Warren Buffett — are going to make mistakes and pick losing stocks. The real key to success, he says, is whether you can adopt the right mindset to get you through the inevitable ups and downs.

“That Buffett has made big mistakes shouldn’t be a big surprise,” writes Reese, who details some of Buffett’s biggest misfires. “The stock market, investing world, and economy have far too many moving parts for anyone to be right 100% of the time. To me, the key to good investing thus isn’t to obsess about avoiding mistakes on every single pick you make. Instead, it’s to avoid mistakes of mindset — to not fall prey to the self-destructive tendencies and biases to which all investors, being human, are predisposed.”

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What sorts of biases? Here’s a sampling:

Myopic Loss Aversion: This is when investors, not wanting to lock in losses, hold onto losing stocks well after they’re no longer attractive. The phenomenon has a biological basis: Studies show that the pain of locking in a loss is about twice as great in magnitude as the good feelings we experience when we lock in a winner.

Anchoring: This is when one bases one’s expectations on facts or figures that are no longer relevant. When a stock falls from, say, $50 to $30, investors will often automatically “anchor” their expectations to that $50 price. They think the stock could well bounce back to that level, even if its fundamentals have changed for the worse.

Recency Bias: People are predisposed to extrapolating the recent past into the future. If consumer stocks do well one year, many investors will keep piling into them. They simply expect more of the same, when they should be basing their decisions on things like valuations and balance sheets.

Hindsight Bias: This is more than just realizing how you could have made money (or not lost money) after the fact. It’s when we incorrectly think that what we should have done was obvious or easily predictable — and allow that misconception to color our future decisions.

Contra-positive investing: This is when investors allow previous experience with a particular stock to influence whether they invest in it again later on, rather than sticking to the facts and data.

Expectation Bias: Studies show that people are more likely to look for facts and data that support their initial thesis than they are to find evidence to refute it. If you have a good feeling about a stock, you’re likely to focus on information that supports that feeling.

The Antidotes

These biases are all hardwired into our brains. How do we get past them? A few suggestions:

· Stick to the numbers: Unlike humans, numbers aren’t impacted by emotions; they don’t fear losses, and they don’t follow the crowd at the expense of reason. By focusing on quantitative analysis, you let reason and cold, hard data drive your decisions.

· Buy and sell only at regularly schedule intervals: Many of the biases listed above are particularly strong when it comes to deciding when to sell a stock. But if you use a quantitative system in which you update your portfolio only at regularly scheduled intervals, you remove day-to-day emotions from the equation.

· Have an understanding of history: Not knowing your history makes you particularly prone to recency bias. For example, in 2009 we saw scary headlines about the supposed “death” of equities. But if you knew that, back in 1979, BusinessWeek ran a cover story heralding “The Death of Equities”, and that just three years later stocks took off and returned almost 20% per year for the rest of the century, you’d have been more likely to focus on the facts, not the hyperbole, in ’09. That would have made you less likely to bail on stocks, and your portfolio would’ve benefited greatly.

· Follow strategies with proven track records: While the investing world is consumed by new fads, the fundamentals of good investing don’t change. My Benjamin Graham-inspired portfolio is based on an approach Graham outlined more than 60 years ago. By targeting financially sound companies with steady growth and cheap shares, it has averaged annual returns of 12.4% since its mid-2003 inception, while the S&P 500 has gained 6.6% per year.

Following these tips doesn’t guarantee that you’ll be right on every stock pick. Nothing can do that. But what it does do is stack the odds of success in your favor. That’s why I stick with my unemotional Guru Strategies in good times and bad. Here’s a handful of stocks that these strategies are high on right now.

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