How Investing Can Turn Into Gambling

There are psychological biases and neurological factors that turn rational investors into gamblers

This was it. My first true “value” investment.

After years of studying generations of great value investors from Benjamin Graham, to Warren Buffett, Charlie Munger, and Monish Pabrai, I had finally decided to give the craft a try myself. Considering that my portfolio consisted of low-cost index funds, this was a big jump.

Regardless, off I went.

I spent weeks researching one company. Diving through years of annual statements, studying their management team, and attempting to perform a valuation of their stock. I had a sound investment thesis and long investment horizon. I was ready.

Or, so I thought.

Not long after I invested in what I believed to be an undervalued company, the stock dropped 10%!

“But I did all this research”.

“But they have best-in-class operations”.

“How could this be?”

I started getting anxious. I second guessed my thought process and all the years I spent studying.

Then, I remembered a Buffett quote that Jeremy C. Miller highlighted in his book, Warren Buffett’s Ground Rules,

“While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance”.

If Warren Buffett prefers to evaluate the performance of his investment decisions over a five-year period, why was I freaking out over one bad week?

The answer lies in behavioural finance and the roulette table.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” — Benjamin Graham

Shut-out the Noise

As investors, we have a tendency to watch the market. With such a vast array of media outlets at our disposal, it’s hard not too. However, watching the daily market headlines and stock charts does not make you a more informed investor, it simply makes you more myopic.

Daily stock price fluctuations are known as market noise and they can cloud your judgment, making you question your investment decision in the first place. It’s not that all of our investment decisions are winners, but rather that a down or uptick in a stock price does not change the intrinsic value of the business.

“Price is what you pay. Value is what you get” — Warren Buffett

Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago (1995) refer to our predisposition to hate losses more than we appreciate gains as loss aversion. Naturally, they also refer to the combination of our desire to avoid losses and our habit of watching daily market fluctuations as myopic loss aversion.

If we thought we were making a rational, long-term investment decision after spending weeks, months, or even years researching a given company, why would an intra-day down-tick in the stock price change that mindset? Has any material change occurred in the company’s business model?

If not, stay the course. 

Block-out the noise of daily market fluctuations

To avoid reacting to daily market fluctuations you could try following the path of Monish Pabrai, Managing Partner of Pabrai Investment Funds, who chooses not to place trades while the market is open. This helps him ensure that daily price movements don’t force him to make rash decisions.

“The stock market is not there to instruct us. It is there to serve us. Where we can buy at times when it is offering a bargain, and we can sell at times when it’s euphoric” — Monish Pabrai

Walk Away From the Table

When we have a myopic view of the market it is easy for investing to resemble gambling.

Alex Blaszczynski of the University of Sydney, and Lia Nower of the University of Missouri-St. Louis (2002), dive into the ecological, emotional, and biological factors surrounding pathological gambling. They note the role that dopamine, a hormone associated with reward recognition, plays in gambling behaviour.

When we participate in pleasurable activities, such as watching our stocks go up or winning a bet at a roulette table, neurons in our brain release dopamine, which makes us feel great and yearning for more. Soon, watching stock charts feels a lot like the anticipation of spinning a roulette wheel.

This can lead to overconfidence and irrational decision-making. Similar to how people chase the rush of winning in a casino (or the effect of dopamine), we can also irrationally chase the rush associated with returns in the market. In their paper on gambling, Blaszczynski and Nower discussed “behaviourally conditioned problem gamblers” and how excessive gambling can stem from:

“…the effects of conditioning, distorted cognitions surrounding probability of winning, and/or a series of bad judgements or poor decision-making…”

A few short-term gains can condition us into believing we have some sort of edge in the market. As highlighted by Brian O’Reilly in his 1998 Fortune article, this is known in behavioural finance as the hot hands” fallacy, similar to assuming that a basketball player who has made his last 5 baskets will continue on and drain his 6th.

An example of this was the irrational exuberance that swept the market during the tech bubble of the late 90’s. People were convinced that market prices would continue to rise, but in their overconfidence, they forgot about the value of the underlying businesses. As a result, the historic climb in market prices came crashing down.

Remember, a rise in a stock’s price doesn’t necessarily reflect an increase in the intrinsic value of the business.

Source: Yahoo! Finance

On the other hand, abnormal levels of serotonin in the brain, which helps regulate mood, can make a down-tick in a stock-price feel overwhelming. We try to mask this effect psychologically by framing the performance of our stock picks in a positive light.

Ever listen to a gambler brag about how much they won at a casino on a given day? They likely didn’t discuss their lifetime losses. This is an example of framing. We do the same with our investment portfolios when we say “I’m up 10% this quarter”.

Whether you are talking about your portfolio’s performance over the course of a day, a quarter, or a year, it is all arbitrary if you are a long-term investor. Take Warren Buffett’s advice and measure your performance in the market on a 5-year basis, or longer.

Continuously watching stock prices can give you a dopamine kick, similar to gambling, but it leads to myopic decision-making

By paying less attention to daily market swings, we can successfully walk away from the roulette table and begin taking a more rational approach to our investments.

We are never perfectly rational. That’s what makes us human. However, we can do ourselves a big favour by recognizing and mitigating behaviour that cultivates irrational decision-making.

As for me, I try to always remember why I made a particular investment. Whenever a significant price change occurs I ask myself if my investment thesis still holds. If so, I take the change for exactly what it is: a price change, not a change in value. With regards to the case of my first true value investment, I am glad that I shut-out the noise and took the long-view.

 

Brandon Belding

Connect with me on Twitter and Medium

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