The Silent Killer

Today’s article was supposed to be about Cash Flow Statements, keeping the order flow somewhat harmonic. However, on Tuesday I listened to a podcast that made me realize the importance of a topic I involuntarily omitted throughout this series. In this podcast, Annie Duke, a professional poker player and author of best sellers, exposes a very helpful mindset investors can adopt to increase their chances at this game.

Annie has an academic background on psychology, cognitive psychology and psycho linguistics, at a PhD level. The scientifical knowledge makes her understand how the human brain works and how unconsciously vulnerable are we as human. Leveraging it allowed her to recognize and properly break down concepts/fields/areas that play a huge role in the world of investing, perhaps without one even realizing them.

Embracing Uncertainty

The world is an unpredictable complex system. The infinity of agents affecting all thing’s course of action turns impossible the task of developing a model to predict events with higher chances than a coin flip. In hindsight, everything makes sense and it’s understandable, yet we have to live looking forward. We, as investors, have to make decisions based on what we expect the future could look like but knowing we’ll be wrong. Once we realize that’s the way it is, we can start embracing this unavoidable uncertainty and begin taking it into consideration.

Thinking probabilistically can mitigate a lot of the damage done by this factor of imperfect information. Evaluating the likelihood of different events occurring could help us increase the rationality implied in our buying/selling/holding shotcalls. The purpose being not only addressing the issue, but minimizing the room of randomness in our future performance. Consequently, when unluck strikes us, we can go back to our decision process and assess the occurred event’s actual probabilities at that moment. If it can truly be determined as unluckiness, we can fairly de-estimate the possibility of us having made a wrong call.

The key relies in playing odds the best you can with the hand you are dealt, so that when the Law of Large Numbers appears, it will favor you. More explicitly, if you made a call estimated to be correct in 60% of future paths, of course you’ll be wrong in the other 40%. But, as times goes by, your success rate should tend to its intrinsic expected value, 60%.

Biases

Our underlying condition of human beings makes us susceptible to suffer from biases, which’s danger relies in their invisible presence. As the last topic, it is our job to acknowledge these hidden biases exist and play a major role in our decision making process. There are multiple of them, which could be the subject of a future article, Annie mentions two particular ones.

We are masters on validating prior opinions we had. That’s why it’s not at all difficult to convince ourselves we are right once we are invested into something. We get particularly irrational to paying attention to the signals or the red flags that could appear once our money is allocated. It is important to realize this because it makes us unwilling to react appropriately when needed, negatively affecting our performance.

When we buy something, let’s say for fundamentals, we have the intuition that if those fundamentals shall move against us, we would take risk off. Well, “Decades and decades of science tells us that is not what we do.”

There are personal states in which we, as humans, behave sub-optimally like when we are tired, hungry, sick, but there’s one particular cognitive one that strongly affects investors, when we ‘are in the losses’. This state is triggered either by an actual unrealized loss, or even by a stock we bought at 50, went to a 100 and it’s now trading at 75. Once we are in this state, we are heavily inclined to behave sub-optimally because we want our money back. We know that if we decide to sell, we turn that loss in paper into a real loss and we never want to experience real losses after the first time. Again, all of this is unconscious.

So, we are trying to protect ourselves from suffering the real losses. We tend to do this in spite of it being the wrong decision, even if fundamentals may have turned against us. It is important to acknowledge these different states in which we will not be propense to make good calls and try to develop a plan to avoid it.

Kill Criteria

Annie addressed the issue by creating a framework called the ‘Kill Criteria’. It implies an investor to try to model what could happen in the future and recognize which events could trigger a sell signal. If one of them happens in the future, then that’s a sell. Of course it’s not an easy thing to do, but it is something that helps us protect from our biggest threat, ourselves.

Personal Commentary

I have to admit that my research has been lacking this Kill Criteria and it is something I must correct. I thought this subject was extremely important to discuss given it’s overlooked by our own minds. Hope you enjoyed it!