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Opinions about opinions

Investing is all about opinions: every buy and sell is an expression of an opinion. But investors need more than these. We also need opinions about our opinions, because these can protect us from mistakes.

One opinion about opinions we need is: why do I believe this? We flatter ourselves that our opinions are rationally based upon facts. But this isn’t always so. They can be founded on other things.

One of these is our formative years. If you are worried by the threat of sustained inflation, is it because you’ve good evidence that today’s rising prices of gas and oil will lead to generalised inflation, via say higher inflation expectations or higher average wage inflation? Or is it instead because the high inflation of the 1970s had a big impact upon you in your formative years?

Similarly, if you think equities are a great long-term investment, is this because of the evidence or because you are overweighting youthful memories of the 1980s and 1990s? Remember that the All-Share index has fallen in real terms since 1998, and that its total returns have been only a percentage point more than bonds in this time. Which matters, because this is in line with what economic theory predicts, as Rajnish Mehra and Ed Prescott pointed out in a classic paper in 1985.

We know that our formative years matter. Ulrike Malmendier at the University of California at Berkeley has shown that people who experienced hard times in their youth own fewer equities even decades later than those who experienced good times.

A second dangerous influence upon our opinions is peer pressure. Ben Jacobsen at Tilburg University has shown that our asset allocation decisions are shaped by our friends, and Hans Hvide and Per Ostberg have shown that stock selections are unduly influenced by work colleagues. One channel through which such influence operates is our tendency to believe strong stories. Yale University’s Robert Shiller has shown that such narratives can spread exactly like a virus does, with some people being more susceptible than others. This, he says, is one reason why equities sometimes become egregiously mispriced. We must therefore ask: do I believe this because of actual evidence, or because I’m susceptible to the opinions of others?

Yet another mistaken origin of our opinions is our tendency to underreact. We know – thanks to work inspired by the 18th century clergyman Thomas Bayes – that our beliefs should be a mathematical function of our prior beliefs and new evidence. But we often deviate from this ideal by cleaving too closely to our prior ideas. One expensive way in which we do so is by holding onto losing stocks in the belief that we were right to buy them – a habit bolstered by wishful thinking.

We should therefore ask: if I didn’t own this stock, would I buy it now? And: do I believe this because of the evidence, or merely because I did so a few months ago?

This is also why we need some form of automatic selling rule. Such rules are error-correction devices: they save us from ourselves.

There’s another opinion we need about our opinions: how confident am I in this? The Nobel laureate Daniel Kahneman has said that overconfidence is the most damaging mistake we make: we underestimate the chances that we are wrong.

One way to guard against this is to find the strongest counter-argument you can to what you believe. If you can’t find somebody to make that argument, do so yourself. And there is always an argument: for every stock you buy there is somebody who thinks it’s a good idea to sell – and that somebody is not always a fool.

Another protection is to remember base probabilities. We know that most newly floated shares underperform in their first few years on the market; that Aim shares typically do badly; and that companies that buy others often don’t see the benefits they expect. This doesn’t mean that every flotation, or every Aim stock or every takeover is a dud. But it does mean you must set the bar high before investing in them: you need better-than-usual evidence before you reject the base rate probabilities.

Yet another opinion about opinions we need is: what happens if I’m wrong? What’s the worst-case scenario?

Herein lies one virtue of cash. Its worst-case return is simply the real interest rate. Even if inflation proves higher than most of us expect, this would imply smaller losses than we’d see in the worst-case scenarios for equities, bonds or gold.

Everybody makes mistakes all the time. The trick is to ensure that they aren’t ruinous.

There’s a common theme to all of this. It’s that good investors must stand back from themselves, and leave their egos out of things. This is difficult: it’s hard to mark your own homework accurately. And that’s the point. Successful investing doesn’t require great intellect or even hard work. What it requires are character skills such as self-awareness, discipline and detachment. These are rare – which is why there are so few very successful investors.