A couple of weeks ago I wrote a post on why one should avoid unforced errors (a situation you are completely in control and you make a mistake). So I thought about the unforced errors I made in just one aspect – stock picking. And boy there are a ton of them. But before we get to those mistakes, I had also finished reading (or rather listening to) The art of thinking clearly. An excellent book on all the biases we fall prey to. So I thought I should give a name to my biases and delusions as I tried my hand at stock picking. If you don’t know, I performed very poorly at picking a stock and the story is available on one of my previous posts if you are interested.
Charlie Munger, the famous investment partner of Warren Buffet said that one should always operate with in their circle of competence. A circle of competence is the subject area which matches a person’s skills or expertise. So as a software engineer, my circle of expertise is coding and everything related to software. I cannot jump into stock picking with the same expertise because it is outside of my circle of competence.
He further said that you can increase your circle of competence by learning new things. However, it is more important to know the boundaries of circle of competence than the size of that circle. I worked on the first part i.e. started reading about all the fundamentals of stock picking. I learned how to read balance sheets, profit & loss statements and cash flows. Taught myself DCF (discounted cash flow) and how to analyze securities. In the end I felt that stock picking was within my circle of competence and picked a stock. This is the first mistake. Going out of circle of competence without knowing for sure if I am really an expect. This was known as chauffeur knowledge (not exactly this, but similar) in the book.
After picking up the said stock, I went about looking for information that favors the stock. This is the second mistake. Looking for supporting evidence does not prove anything. It is like saying “all swans are white”. No matter how many white swans you see, you can never say for sure that there doesn’t exist a black swan. All you can say is that there is a good possibility that there are more white swans than black ones. But if you see at least one black swan, your theory that “all swans are white” goes for a toss. Which is why you should always look for disconfirming evidence.
Charles Darwin, who developed the theory of evolution based on natural selection was always looking for disconfirming evidence. I should have been looking for signs which did not support my point of view. Yet I did not. This was my confirmation bias at play.
Charles Darwin trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one.Charlie Munger
Another mistake I did was to give too much value to the opinion of experts also known as authority bias. Authority bias is the tendency to attribute greater value or irrational trust in the judgement of experts. When I was looking for evidence to support my hypothesis that the stock I picked was good one, I came across two authority figures who had similar opinion. One of them is an expert in the field of value investing. The other was a value investor too, someone whose opinions I regard highly. When they too approved that the stock was a good one, I blindly agreed with them instead of looking for disconfirming evidence.
There were equal if not more experts who were against the stock that I picked. All their arguments were equally strong too. Yet I was not looking for them. Eventually I invested in the stock that I prided myself and lost money on it.
Regression to mean delusion
Alright, after having fallen for all the biases above, I decided to invest in the stock that I picked. For a few months that stock went up and I was feeling like a great stock picker. But things changed quickly. The stock started falling, and yet I poured in more money in the hope that the stock will revert back to mean. It never happened and I kept on losing money.
Sunk cost fallacy
After having lost so much value, I still did not sell. I lost so much money in the stock, I can’t sell it now, can I? This is irrational behavior. Anyway, eventually I came out of this behavior and sold the stock for a huge loss.
There are a few more biases and fallacies that are still associated with this one decision of investing in a stock. Imagine how many mistakes I must have done in various other aspects of life. It all started after reading the book and I thought of reflecting on my mistakes. I would encourage you too to read the book and reflect back on things where you might have fallen prey to biases or other fallacies.
There is nothing wrong in making mistakes. That is how we learn. But if we don’t reflect back on the mistakes and learn something, that would be a mistake and a wasted opportunity.