Human or Pigeon, Which is the Better Long-Term Investor?

In Thinking, Fast and Slow we learn that we have two systems of thinking. System 1, a quick thinking system built on heuristics and patterns. System 2, which is our deeper thinking rational system.

Because system 1 has to be quick it sees patterns when they aren’t there. As The Psy-Fi Blog explains.

The reason our pattern matching systems go wrong isn’t hard to figure out. In evolutionary terms the downside of missing something which is there – like a snake – is far higher than the downside of seeing something which isn’t. Reacting to 99 fake snakes is fine as long as you also react to the one real one. By and large it’s better to have a system that’s overly sensitive and makes mistakes than one that’s unresponsive to potential threats.

So seeing patterns where there aren’t any isn’t surprising. However, when you attach this tendency to a brain that’s evolved to seek meaning and explanations for everything, even where events are completely random, you get all sorts of unexpected consequences, like superstitious behavior, religious beliefs and stock market crashes.

Technical analysis is all about pattern recognition. But as the Psy-Fi blog goes on to point out through the research paper Noise Trading and Illusory Correlations in U.S. Equity Markets that the most popular chart patterns are just noise. They provide no real value. But humans are pattern seekers. We look for clues and patterns in the randomness.

Worse Than Rats & Pigeons

Jason Zweig points this out in his book Your Money & Your Brain. An experiment pits people against rats and pigeons. In the experiment, two lights could be flashed; one green the other red. The red light flashes 20% of the time. The green light flashes 80% of the time. The order of the flashing is completely random and the human test subjects are told this. The object of the experiment is to guess which colored light will flash next.

The optimal strategy is to guess green every time. You will be right 80% of the time. Rats and pigeons learn quickly to select green all the time. People, not so much. People still try to guess when the red light will flash. On average people guess green 4/5 times and red 1/5 times. Trying to guess when the red light will flash drops people’s accuracy down to 68%. People also tend to get worse at guessing the longer they play.

Unlike other animals, humans believe we’re smart enough to forecast the future even when we been explicitly told that it is unpredictable. In a profound evolutionary paradox, it’s precisely our higher intelligence that leads us to score lower on this kind of task than rats and pigeons. – Jason Zweig, Your Money & Your Brain

Play the Odds

The rats and pigeons learned to use the odds to their favor. They’ll guess wrong many times but in the long run, they learn to maximize their rewards by guessing green all the time. A similar situation pops up with investing.

People spend an extraordinary amount of time trying to guess the day-to-day fluctuations of individual stocks and indices. It is why triple leverage ETFs are able to exist. Guessing the day-to-day moves is close to a 50/50 bet. It is when you start looking at longer-term returns that the odds tilt heavily in your favor.

From A Wealth of Common Sense.
From A Wealth of Common Sense.

This is the pattern that individual investors should be seeing. It is the 80% green light. All that extra effort trying to guess daily, monthly, or yearly moves is the same as trying to guess when the red light will flash. It will only diminish your ability to maximize your long-term rewards.


Behavioral Bias 101: #1 Illusory Pattern Recognition (The Psy-Fi Blog)

Playing the Probabilities (A Wealth of Common Sense)

Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich by Jason Zweig

What I Wish I Wrote ~ Feb. 26, 2016

The Jewelry Effect. “there is a dizzying array of bass lures in variations of blues and purples even though bass cannot see those colors as anything other than gray”. (Above the Market)

Trading is hazardous to your wealth. (SSRN)

Why bear markets and corrections are good and why you should want them. (Newfound Research)

A look into Ken Fisher’s performance. (Meb Faber)

Why Gilead Sciences’ (GILD) is a bargain. (Institutional Investor)

How to become a successful dividend growth investor. (Dividend Mantra)

What you can learn from Bernie Madoff as an anti-model. (25iq)

A good story can always trump good research. (A Wealth of Common Sense)

Buybacks are not a cure all. Especially, if your main business is a melting ice cube like Outerwall’s (OUTR). (Base Hit Investing)

A big obstacle to saving more for retirement is lifestyle creep. How can you avoid it? (Castlebar Asset Management)

James Cash Penney’s (yes, that J.C. Penney) his thoughts on the golden rule after taking over the Golden Rule Stores and turning them into J.C. Penney. (Farnam Street)

A lot of time and human potential is wasted during commutes and our commutes keep getting longer. (Washington Post)

A little motivation for saving more and investing in dividend growth stocks. A full year traveling 9,275 miles, 4 provinces, 15 states,  and 7 countries. (The Dividend Guy Blog)


The 27 (Really 28) Stocks That Fit Buffett’s High-Quality Buy Criteria

From Barron’s and according to Credit Suisse these are the 27 companies (although the list is 28) that fit Warren Buffett’s high-quality investment criteria right now.

  • Hanesbrands (HBI )
  • Hasbro (HAS)
  • Carter’s (CRI)
  • Ross Stores (ROST)
  • Dollar General (DG)
  • Wal-Mart Stores (WMT)
  • CVS Health (CVS)
  • Walgreens Boots Alliance (WBA)
  • Aon (AON)
  • UnitedHealth Group (UNH)
  • Aetna (AET)
  • Cigna (CI)
  • Universal Health Services (UHS)
  • Johnson & Johnson (JNJ)
  • Bristol-Myers Squibb (BMY)
  • General Electric (GE)
  • Honeywell (HON)
  • General Dynamics (GD)
  • Snap-On (SNA)
  • Acuity Brands (AYI)
  • Carlisle Cos. (CSL)
  • MSC Industrial Direct (MSM)
  • Toro (TTC)
  • C.H. Robinson Worldwide (CHRW)
  • International Flavors & Fragrances (IFF)

The next three stand out because they are technology companies and Warren has repeatedly said tech companies are not in his circle of competency.

  • Oracle (ORCL)
  • CA (CA)
  • Amdocs (DOX)

Warren did buy IBM so maybe an investment in Oracle and its recurring revenue streams and high switching costs could be attractive. I still say it’s a stretch.


27 High-Quality Stocks Warren Buffett Might Buy (Barron’s)

What Warren Buffett Wouldn’t Do

When looking for guidance from our role models we often ask “what would they do”? Maybe we should invert the question and ask, “what wouldn’t they do”?

Bloomberg does and asks what wouldn’t Warren Buffett do?


Don’t be too fixated on daily moves in the stock market: “Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.” (from letter published in 2014)

Don’t get excited about your investment gains when the market is climbing: “There’s no reason to do handsprings over 1995’s gains. This was a year in which any fool could make a bundle in the stock market. And we did.” (1996)

Don’t be distracted by macroeconomic forecasts: “The cemetery for seers has a huge section set aside for macro forecasters. We have in fact made few macro forecasts at Berkshire, and we have seldom seen others make them with sustained success.” (2004)

Don’t limit yourself to just one industry: “There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.” (2008)

Don’t get taken by formulas: “Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.” (2009)

Don’t be short on cash when you need it most: “We will never become dependent on the kindness of strangers… We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity.” (2010)

Don’t wager against the U.S. and its economic potential: “Who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder… We will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.” (2015)

Read the rest of the article by following the link below for what Warren wouldn’t do as a manager in a business.


Here’s What Buffett Wouldn’t Do, and Maybe You Shouldn’t Either (Bloomberg)

Wolves, 13Fs, Cognitive Ease, and Getting Trapped Along the Well-Worn Path

Wolves fail more often on their hunts than they succeed. As Nick Jans states in his book A Wolf Called Romeo,

Survival hinges on a brutal imperative: more energy must be gained than lost, across endless hard miles. To fail is to die.

When there is a lot of snow on the ground hunting packs travel in single file with different animals taking the taxing lead position. A well-worn path through the snow is a very attractive option for the pack. Less energy is spent forging their own path, leaving more energy to survive until the next meal.

The well-worn path through the snow can get wolves into trouble. Nick Jans goes on to tell how some of his Inupiaq trapper friends will drive a snowmobile, packing down the snow, and setting traps just off the newly made pathway.

If you’ve done any backpacking or hiking you know the appeal of the well-worn trail. When you’re out in the middle of nowhere the well-worn trail is mentally soothing. You don’t have to constantly check your map. You don’t have to constantly wonder if you’re going the right way. You don’t have to constantly keep a distant object fixed to your bearing. You just have to walk. You know many people have walked this trail before. You know that they made it safely. And you know you will too. Your mind is free to think about other things. You are in a state of cognitive ease.

Following a well-worn path also puts the wolves into a state of cognitive ease. Trappers take advantage of this. And like wolves, when we’re in a state of cognitive ease we can get into trouble. Especially with investing.

The Well-Worn Path of 13Fs

It’s 13F season. That time of year when all the large asset managers file with the SEC on what they own in their portfolio during the previous quarter. I have my list of people and funds that I follow. I use their filings as an idea generator and a study tool. When a manager I follow adds a new position and it fits into my dividend growth universe, I try to reverse engineer why it is an attractive investment. If I can reverse engineer the investment thesis, and I’m confident in my work, and the company is still cheap I may buy it.

This process takes a lot of work and produces cognitive strain.

It is far too easy to substitute the research work with the rationale that manager X bought it and manager X is a billionaire with a great track record. Therefore, I should buy this company too.

This line of thinking, the search for cognitive ease, can get investors into trouble. The most recent example is Valeant (VRX). The image below is from Whale Wisdom and it shows which asset managers held Valeant (VRX) as a large position in their fund during the quarter ending December 31, 2015. It includes some very impressive names.

From Whale Wisdom. Click image to enlarge.
From Whale Wisdom. Click image to enlarge.

All the names on that list did their homework. I hope.

The problem is the average investor or the average portfolio manager seeing all these famous names holding Valeant and then investing in Valeant too. Because how could all these famous money managers be wrong? They can when Valeant’s management is playing fast and loose with their accounting. Resulting in a restatement of earnings.

This is not to say that the average investor or average portfolio manager would’ve caught the accounting irregularities. But did they do the necessary research to build the necessary confidence in Valeant’s business strategy to invest? Probably not. And when you don’t do your own work, what do you do when you when you get caught in a trap?

Image courtesy of Click image to enlarge.
Image courtesy of Click image to enlarge.

When investing in a company you saw in a 13F, are you buying it because you did the research and the company is a compelling bargain? Or did you substitute it with the much easier question, “does manager X have a great track record?”

If you want to learn more about 13Fs and how to use them, Market Folly is having a sale on its newsletter dedicated to 13Fs Hedge Fund Wisdom.