Why I invest in watermelons - Perception vs Reality
When a good story trumps rationality
Despite our best efforts, human nature dictates that in life and in investing we often find ourselves making irrational decisions. That’s not to say that those decisions aren't reasonable, but instead that most people prefer to act ‘reasonably’ rather than rationally.
In the early 1900’s a doctor by the name of Julius Wagner-Lauregg began testing the premise that a fever as treatment for certain ailments could dramatically reduce mortality. He tested his theory on patients with neurosyphilis and discovered that his patients (with an induced fever) had twice the survival rate of patients left untreated.
Dr Wagner-Lauregg went on to win a Nobel Prize in 1927 for his discovery before Penicillin was discovered and made his treatments redundant.
The challenge is that what we know and how we feel are in direct conflict. We may recognise the benefits of the fever, but at the same time, we can’t stand the thought of our child suffering.
The Cost of Loss:
However, that is a concept far simpler in principle than in practice. You see, psychological studies have often found that the pain felt from an investment loss is considerably greater than the joy felt by a gain. In fact, that loss:gain coefficient is thought to be as high as 2.5x.
Consider a coin toss scenario (a 50/50 toss).
How much would you need to be offered to win in order to risk losing that $250,000?
- For some, the thrill of the speculation and the gamble means that they are happy to risk that money for less than the $250,000.
- For others, they would be willing to take that bet on even odds.
- Yet for the vast majority of betters, the payoff would need to be significantly greater, on average, close to a $500,000 potential payoff.
The psychology is very interesting, and within that psychology lies the vast majority of our opportunities as fund managers. Our role is quite simple: recognise those emotional drivers that push investors into irrational decision making, and when the difference between the reasonable and the rational is wide enough, to take advantage.
Keeping Things Simple:
We take a different approach. We don’t want to pick fruit at all. Why stretch and stress when there are wonderful ideas already lying on the floor. I’d rather pick up a watermelon (investment idea) off the floor than stretch to pick an apple any day of the week.
And there are plenty of ‘watermelon’ ideas available to those looking for them. They aren't necessarily as exciting as the more complex highly prospective ideas, but they are simple, they are profitable, and there is far less chance of falling off a ladder (getting oneself into financial trouble) if you aren't climbing one.
The fewer the steps between an idea and its success the better.
Imagine for a moment that we were investing geniuses. So good are we at investing that we could accurately predict outcomes at a rate of 70%. Now by most accounts, a 70% accuracy rating in investing terms would generate extraordinary outcomes. Simply by predicting earnings outcomes would mean that we are right 7 out of 10 times, and no doubt our results would be great. But what if, on top of having to accurately predict earnings, we also needed to predict market growth rates, or margins, or the outcome of a strategy adjustment?
Well, if we need to predict two factors accurately to generate a positive investment outcomes, our strike rate falls from 70% to (70%x70%) 49%! If we are required to accurately predict three factors to generate a positive outcomes, that rate falls all the way down to 34%.
It’s not just unnecessary to invest in complex ideas, its hubris to think that we as investors have the capacity to know the full impact of each variation and how it may play out in markets. Recognising the importance of keeping things simple truly is the ultimate indication of investing sophistication.
- For more reading on Reasonable > Rational see The Psychology of Money - Morgan Housel.
- For more information on the loss/gain coefficient see Thinking Fast and Slow - Daniel Kahneman
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Michael is the MD and one of the founding partners of the Collins St Value Fund. The Collins St Value Fund is one of the best performing Funds in Australia - having ranked among the top 10 performing funds across all Australian Equity mandates by...