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¡@ The IQ: Investment Quotient ¡@ ¡@ ¡§A psychologist is a man who watches everyone else when a beautiful girl enters the room." ¡V Unknown ¡@ The degree of one's emotion varies inversely with one's knowledge of the facts ¡V the less you know the hotter you get. ¡V Bertrand Russell ¡@ As investors, how well do we understand understanding, causality and correlation, and our psychology? ¡@ Understanding Do we understand ourselves? Who are we? It is still crucial to understand why we do things in certain ways. First of all, it is important to realize that there are five categories of understanding : Category 1: We understand that
we don't understand something.
Category 2: We don't understand that
we don't understand something. That is, we think we understand something,
but in fact, we don't.
Category 3: We pretend to understand
something. That is, we don't understand something but we pretend to be experts
before peers.
Category 4: We understand something
but we pretend we don't. (This is an usual practice during political power
struggle or in office politics.) Category 5: We indeed understand something and we can communicate clearly our understanding to laymen and experts. In the investment industry, lots of retail investors are in Categories 2 and 3. Causality and Correlation Do we understand the differences between a fact and a reason? In ancient time, farmers thought that roosters caused sunrise. It was because before dawn, roosters crowed and then the sun came up. Roosters crow before dawn is a fact. But it is not a reason for sunrise. The mixing up of facts and reasons for some events are not uncommon in retail investors. Even professionals fall into that kind of trap sometimes. Psychology ¡@ Let us discuss the investment psychology briefly. ¡@ 1. We prefer complication instead of simplicity. During the civil wars between the Communists and Nationalists in Mainland China from 1946 to 1949, military experts around the globe were hard to believe that, with just "millet plus rifles", the communists defeated the nationalists' "aircraft plus cannons." It was because communists went back to the basic ( B2B): Communists fulfill the desire of people. ¡@ Today people think that success in stock investment must involve complicated equations and software to manipulate a host of variables correctly, and it is beyond the scope of even the well-educated. It is an unforgettable experience for a Ph.D. holder in physics, engineering or mathematics to play with partial differential equations (PDE), neural networks, chaos theory, Monte Carlo simulation, stochastic calculus and software. It is something to be proud of. Retail investors think that they are the god of investment. ¡@ The late
Chairman Mao
said, "If the troops with advanced weapons ignore the desire of people,
all advanced weapons will become just paper tigers." It is also true in investment.
If we ignore the fundamentals of companies,
we may win in short term but lose in long term. ¡@ 2. We prefer personal judgment more than simple rules People prefer personal judgment a lot. The phrase, "I think", is frequently
over used today. Everyone seems to be an expert in some fields. When looking
at a stock chart of a company, five different analysts can have five different
interpretations. No one cares a lot about the simple rule: value and price
of the company. Simple rules are universal. But they are also too simple
to be ignored.
There are two ways to make predictions. One way is for a person to run through a variety of possible outcomes mentally, relying on personal knowledge, personal experience, and personal common sense to reach a decision. This is known as clinical or intuitive approach. ¡@ The second way to reach a decision is the actuarial, or quantitative, approach. Here the forecaster makes no subjective judgments. Empirical relationships between and the data and the desired outcome are used to reach conclusions. This method relies solely on proven relationships, using large samples of data. We prefer the former instead of latter, although the latter often provides more accurate forecast. Human beings prefer subjective experience and feelings more than boring but objective quantitative data. ¡@
Mark six is a sure win business, since it can give people instant excitement. If Mark Six were to require its client to check their numbers five years later, it would lose all its clients. Many of them will even lose their tickets within a year! We are impatient to be rich even just after five years! ¡@ We are even more impatient to check the fundamentals of a company. Those
fundamentals are boring facts. But we are much more excited to keep track
of the daily fluctuation of its stock price. Then we plug the fluctuations
into software and equations to update its return and risk. It is fun and
sophisticated. It offers instant excitement.
This one is classic. Greed causes a lot of over-priced stocks. Fear makes stock prices below their intrinsic values. ¡@ ¡@ 6. We are driven by our feelings, not understanding. People know that smoking cause cancer but they still do it. It is because smoking gives them a special feeling: freedom, accomplishment, taste, and a sense of strong identity, and even a sense of friendship. We are driven by emotions instead of reason thinking. It is the same with investment. ¡@ ¡@ 7. We pay attention to individual trees, but ignoring the whole forest. Some people will give a handful of stocks as examples, demonstrating how well they went on to perform. Unfortunately, these people conveniently ignore the many other stocks that also possessed the preferred characters but failed. ¡@ Some people would tell others how their stock picking strategies bring them a nice return of a particular stock during the past year. But they blindly avoid the fact they lost much money with the same strategies in the past several years. ¡@ Pasture Investment Corporation Limited |