My Investment Strategy : 3 Ts 3 Ms ( part 3)

孟子曰：天时不如地利，地利不如人和。

According to Mencius studies, the “人和 “ (or People’s Harmonization ) is the most important part of any war game or the battle, same apply for investment, I think this is the most difficult and challenging part, yet the most vital to ensure the success of our investing in stocks.

The Art of War (孙子兵法), Sun Tzu, a Chinese military philosopher and the strategist in the 6th century BC, he mentioned :

知己知彼,百战百胜

image credit to baike.com

“知彼知己者，百战不殆；不知彼而知己，一胜一负；不知彼，不知己，每战必殆。

” He who has a thorough knowledge of the enemy and himself is bound to win in all battles. He who knows himself but not the enemy has only an even chance of winning. He who knows not the enemy and himself is bound to perish in all battles.  

 No matter you buy, sell or hold, you should have full understanding of the target in which you invest and your own abilities. Otherwise, investment is more like gambling.

In investing, we treat the “market “ as an enemy and we fight for a better return than the market (or so-called Alpha ), as such, we need to understand ourselves and market in order to win the “War”. If you know neither yourself nor your enemy, you will always endanger yourself. 

Is beating the market a mind game or myth?

So you have studied the best investment strategies out there, attending the best and most prominent investment courses and you spend hours analyzing stocks. Still, you are unable to beat the market. Why?

We have all heard the tales of  "experts" who perform worse than monkeys when it comes to picking stocks that will outperform the broader market index and the average individual investor performs even worse. However, monkeys have an unfair advantage: they do not have a business degree, they do not follow the news, and they do not care about money!

While it seems logical that having more financial knowledge would lead to better results in the stock market, nothing seems further from the truth. But with all the knowledge (Fundamental Analysis) and tools (Technical Analysis), most of the retail investors fail to beat the market.

Invest in your head and not with your heart is an often repeated phrase but it's easier said than done, even for the professionals, not to mentioned us as retail investors. But investors should not underestimate just how large a part their emotions play when it comes to money; from having the willpower to save to holding your nerve when stock markets are rough and volatile, all of your decisions will be affected by your emotions to some extent.

In the book “ Your Money and Your Brain “, Mr Zweig explains that we really have two brains. 

Our reflexive brain gets the first crack at decision making and is essentially based on intuition or how we feel. Our reflective brain, on the other hand, is more logical. The problem is that we usually don't know which part of the brain is at the switch when we make any decision. One key to maximizing wealth is to give the reflective brain some time to respond, and not to react immediately to our gut instinct.

In another book called: Mean Markets and Lizard Brains

George Dvorsky wrote:

“The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.“

Cognitive biases are anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money.  As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Does the current extension of the financial markets appear to be rational? Are individuals current assessing the “possibilities” or the “probabilities” in the markets?

The cognitive part of our brain which evolves million years ago is great for finding food and shelter but terrible at navigating the market. Our brain is also good in forming a “pattern “ but lacks the capabilities in “probabilities calculation “ and as well as full of “ cognitive biases “.

Below quoted from Investopedia are some of the “Common biases” which will affect our investment decision and the outcome ….

Anchoring refers to the tendency to become attached to something, even when it may not make sense. Examples include a piece of furniture that has outlived its usefulness, home or car that one can no longer afford, or a piece of information that is believed to be true but is in fact, false. In investing, it can refer to the tendency to either hold an investment too long or place too much reliance on a certain piece of data or information.

For instance, suppose that XYZ stock had very strong revenue in the last year, causing its share price to shoot up from $25 to $80. Unfortunately, one of the company's major customers, who contributed to 50% of XYZ's revenue, had decided not to renew its purchasing agreement with XYZ. This change of events causes a drop in XYZ's share price from $80 to $40. 

By anchoring to the previous high of $80 and the current price of $40, the investor erroneously believes that XYZ is undervalued. Keep in mind that XYZ is not being sold at a discount, instead, the drop in share value is attributed to a change to XYZ's fundamentals (loss of revenue from a big customer). In this example, the investor has fallen prey to the dangers of anchoring. 

Loss-aversion bias is the term used to describe the tendency to fear losses more than celebrate equivalent gains. For example, you may experience joy at the thought of finding yourself $5,000 richer, but the thought of losing $5,000 might provoke a far greater fear. Similar to anchoring, loss aversion could cause you to hold onto a losing investment too long, with the fear of turning a paper loss into a real loss.

Endowment bias is also similar to loss-aversion bias and anchoring in that it encourages investors to "endow" greater value in what they currently own over other possibilities. You may presume the investments in your portfolio are of higher quality than other available alternatives, simply because you own them. People who inherit shares of stock from deceased relatives exhibit the endowment effect by refusing to divest those shares even if they do not fit with that individual's risk tolerance or investment goals, and may negatively impact a portfolio's diversification.

image credit to illusionsindex.org

Overconfidence is simply having so much confidence in your own ability to select investments for your portfolio that you might ignore warning signals. We tend to overestimate our own abilities, thinking we know more than we actually do. You see this trait often in people who believe they have some sort of secret sauce for outsmarting market. Overconfidence may lead to “overtrading “ of stocks and increased the cost in the long run.

Confirmation bias is the tendency to latch onto and assign more authority to, opinions that agree with your own. For example, you might give more credence to an analyst report that favours a stock you recently purchased, in spite of several other reports indicating a neutral or negative outlook.

Home Country Bias, Investors' natural tendency to be most attracted to investments in domestic markets. Investors tend to focus more on their home markets and the companies that do business within these markets because they are familiar with them. One may miss-out the diversification effect of venturing into other global markets.

The bandwagon effect, also known as herd behaviour, happens when decisions are made simply because "everyone else is doing it." For an example of this, one might look no further than a fairly recent and much-hyped social media company's initial public offering (IPO). Many a discouraged investor jumped at that IPO only to sell at a significant loss a few months later. (Some of these investors may have also suffered from overconfidence bias.)

image credit to thesun.co.uk

Recency bias refers to the fact that recent events can have a stronger influence on your decisions than other, more distant events. For example, if you were severely burned by the market downturn in 2008, you may have been hesitant about continuing or increasing your investments once the markets settled down. Conversely, if you were encouraged by the stock market's subsequent bull run, you may have increased the money you put into equities, hoping to take advantage of any further gains. Consider that neither of these perspectives may be entirely rational given that investment decisions should be based on your individual goals, time horizon, and risk tolerance.

A negativity bias indicates the tendency to give more importance to negative news than positive news, which can cause you to be more risk-averse than appropriate for your situation.

“Sunk cost effect“  is when you continue to put time, energy or money into something simply because you've already made an investment in it—and refuse to cut your losses and acknowledge that you can't get back those "sunk costs."

Even if we can successfully identify the faulty thinking behind an investment decision, it’s hard to know how to change it.  Can "behavioural finance" give some clues or a solution ?

“ Behavioral Finance “

Nicholas Barberis, a professor of behavioural finance at Yale University, wrote that “Simply acknowledging that investors have preferences and biases can help them better understand their own trading and asset allocation decisions”.

Prof Barberis pointed out that behavioural finance is still a young field, and so far the research has focused mainly on understanding the psychological drivers of investing behaviour — specifically investing mistakes.

Even though the “behavioural finance “ is still a very new and young field, the practicability might be overrated, but the understanding of our “biases “ and emotional control would avoid many mistakes made in investing which is considered as halfway to success, I think.

Quote Of The Day:

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or insider information. What is needed is a sound intellectual framework for decision and the ability to keep emotions from corroding that framework.” Warren Buffett

Money Management ( Flow ) :

Managing cash flow effectively is essential to any financial planning. Whether you are seeking to actively grow your wealth through investment strategies, or planning for retirement, an effective cash flow management is important in order to meet your financial goals.

Before we talk about investing or wealth accumulation for retirement, we need to understand a very basic concept of maintaining “healthy personal cash flow “.

One can earn millions a year, but a poor cash flow management will lead to personal financial disaster or catastrophe which happened to many celebrities. Cash flow is like “blood “in our circulation system, having negative cash flow in our personal finance is like letting our blood dripping day by days, which may end up in bankruptcy or financial disaster.

If you currently have a negative cash flow or you want to increase positive net cash flow, the only way to do it is to assess your spending habits and adjust them as necessary or increase your economic value in “human capital “.

Maintaining a “harmonize and optimize “ personal lifestyle is important for us to “ live a rich life “! But again, lifestyle is a “choice “ and “rich “ is very subjective for individuals, be it in immaterial or monetary term.

Lifestyle is a choice and everyone have “freedom to choose “on what kind of lifestyle they would like to live, same apply to lifestyle after retirement.

One may need to work harder or let their money “work harder” for them, if he or she would like to maintain a more comfortable and above average lifestyle. Again, some may think that house ( condominium ) is more important but some may think a car is rather important, but for me, “holidays “ is much more important than these two ..  :P

The most important thing is to work within your budget and means, do not overstretch your debts which might have problems if we face any unforeseen financial difficulties.

The danger of Lifestyle inflation  

Concept explained: by Investopedia

DEFINITION of 'Lifestyle Inflation'

Increasing your spending when your income goes up. Lifestyle inflation tends to continue each time someone gets a raise, making it perpetually difficult to get out of debt, save for retirement or meet other big-picture financial goals. Lifestyle inflation is what causes people to get stuck in the rat race of working just to pay the bills.

Lifestyle inflation may cause us to live paycheck to paycheck, make the minimum payments on our credit cards, and not have any cash to fall back on when an unforeseen setback like a medical bill or job loss arises.

People tend to increase their spending each time their income increases, because they believe that the additional goods and services they are purchasing will make them happier. Often those purchases don’t make them happier, and a better option would be to work toward financial independence by saving more.                            

People have a strong tendency to spend more if they have more. A couple factors are at work here. One is the "keeping-up-with-the-Joneses" mentality. It’s not uncommon for people to feel like they have to keep up with their friends’ and business associates’ buying habits. If everyone drives a BMW to the office, for example, you might feel compelled or pressured to buy one as well, even if your old Honda Accord gets the job done just fine.

Likewise, your house on one side of the city may have been your dream home when you moved in, but with so many of your colleagues talking up life on the other side of the city, suddenly you may feel the need for a new address. 

Lifestyle inflation creeps into more areas than cars and homes – you can also end up spending more money than you need to (or should) on vacations, dining out, entertainment, private school tuition and wardrobes, just to keep up with the Joneses. Keep in mind that the Joneses are typically servicing a lot of debt over a period of decades to maintain their wealthy appearance.

We can avoid lifestyle inflation by consciously establishing spending and saving amounts. An automated savings plan can be a good way to ensure that savings goals are met and spending is capped. 

Avoiding lifestyle inflation can mean achieving financial independence at a younger age, having the financial flexibility to choose a dream job over a higher-paying option, and retiring early.

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We have seen many celebrities failed or ended up in bankruptcy simply because of keeping a very high life-style.

Economics ( Life ) is about making choices within a limited amount of capital or resources. If we can’t afford to have Condominium, Car, Luxury items or Exotic holidays all at the same time, we need to choose.

I have made up my mind to go for exotic holidays destination, what about you?

Cheers !!.

< Sharing some of the photos I have taken during my holidays >