This article on Best Deep Value Book was written by Colin Richardson. Colin is a private investor based in Alberta, Canada. He focuses on applying a quantitative strategy to eliminate behavioral biases in his personal account. Article image (Creative Commons) by Michael D Beckwith, edited by Broken Leg Investing.
When you’re on the hunt for the best deep value book, who ya gonna call…?
No, not Ghostbusters. Call Daniel Kahneman. In his best-selling book Thinking, Fast and Slow, Kahneman provides us with valuable lessons that are crucial to effective deep value investing.
Did you know our minds play tricks on us? Kahneman calls them psychological biases and reminds us that every human is susceptible to them. For example, if you answered the first question with Ghostbusters, you have fallen for one of the many biases. Although rehearsing a simple tag line is harmless, the same bias could actually affect your ability to pick deep value stocks. If you’re not aware of the trap you’ve fallen into, your portfolio may be riskier than you thought. More on that later!
Published in 2011, Thinking, Fast and Slow is commonly found in the psychology genre section of bookstores and libraries. You may be wondering, why isn’t the best deep value book something more dedicated to teaching the strategy? What could Kahneman possibly teach us to improve our portfolios? Let's find out!
Table of Contents
The Two Systems
The general concept of Thinking, Fast and Slow is that our minds operate through two different systems. At least one of them affects every decision and judgement we make in a day.
System 1—the fast mode—works automatically without voluntary control. It generates all of our impressions, intuitions, and feelings. Answer the following math problem: 2 + 2. Your System 1 just got put to work without any cognitive strain. As deep value investors, we use System 1 to quickly analyse a balance sheet or scan through a stock screener looking for specific criteria.
System 2—the slow mode—uses slower processing to develop the criteria with as minimal effort as possible. However, it is also responsible for handling the more arduous mental activities. You answered the first math problem easily but now consider: 17 x 24. Unless you’re a math whiz, your System 2 just helped to solve the equation. Comparing two companies for overall value and reading a 10-K are both examples of when deep value investors use System 2.
Kahneman has discovered System 1 and System 2 work very closely together.
“System 1 continuously generates suggestions for System 2: impressions, intuitions, intentions, and feelings. If endorsed by System 2, impressions and intuitions turn into beliefs, and impulses turn into voluntary actions. When all goes smoothly, which is most of the time, System 2 adopts the suggestions of System 1 with little or no modification.”
The harmonious relationship between the two systems is often a very good thing. System 2 is lazy, so having System 1 making the majority of the decisions allows the former to rest until it is really needed. However, this can also cause problems and get deep value investors into trouble.
Have you ever read a stock analysis that highly recommends purchasing a certain stock? It is likely that System 1 read the article and once finished, assigned the company to a positive feeling. Now, imagine you run a stock screen and the same company appears on the short list. You can imagine that System 1 will send positive feelings and lead you to favouring that company over the others. This might be a good thing—the stock analysis could be right, and it is a great purchase. However, the stock analysis could be very wrong. Maybe the analyst used outdated data or miscalculated a ratio. Also, maybe it is a good investment, but the stock screen revealed even better opportunities.
Our System 1 causes us to fall for many psychological biases. The best deep value book—Thinking, Fast and Slow—highlights the three biases that investors are most susceptible to. Let’s analyse them and learn just how important it is to use System 2 when investing our money.
What’s Your Criteria?
Multiple published studies highlight the success of deep value investing. Most of them reveal specific criteria used to find the most successful companies. Examples include share buybacks, significant insider ownership, and potential for a catalyst. Although the criteria has been tested and proven, Kahneman found this may not be enough to convince investors.
“Several studies have shown that human decision makers are inferior to a prediction formula even when they are given the score suggested by the formula! They feel that they can overrule the formula because they have additional information about the care, but they are wrong more often than not.”
Most investors likely fall into this trap. Although there is a common denominator among the studies, we like to make exceptions. We feel that under certain circumstances, the formula needs to be modified. This is an illusion created by System 1’s impressions. Trust the process! Base your system on solid criteria.
How Far Are You Jumping?
Remember the Ghostbusters mishap we experienced earlier? The answer made no sense in regards to the best deep value book. What happened was our System 1 jumped to the conclusion without consulting System 2. Kahneman discovered this is a common occurrence for humans.
“Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves much time and effort. Jumping to conclusions is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information. These are the circumstances in which intuitive errors are probable, which may be prevented by a deliberate intervention of System 2.”
Investing your money in stocks is definitely a high-stakes situation. However, many investors still jump to conclusions when analysing companies. A common example would be that management has the best interests of shareholders in mind. There are many dishonest CEOs who will tell us only the good news and withhold the bad. Our System 1 makes the interpretation when System 2 should analyse the situation further. Always be aware of the conclusions you make and don’t avoid questioning their validity.
Are You Planning Far Enough Ahead?
It doesn’t take an expert statistician to know that a large sample size will be more accurate than a small sample size. However, Kahneman realized that people frequently ignore this fact in everyday life. Humans love to provide explanations for events—even when the event was completely random. This creates a dangerous illusion in our minds.
“The strong bias toward believing that small samples closely resemble the population from which they are drawn is also part of a larger story: we are prone to exaggerate the consistency and coherence of what we see.”
Ever wonder why more people don't invest using deep value techniques? Although it’s known for market-beating returns, most investors suffer from short-term bias. It is not unheard of for deep value portfolios to underperform for three years in a row. Most investors will explain the loss by believing deep value is no longer effective. They abort the strategy before it even has a chance to work. Stick to the long term and don't take any one-year stock result too seriously.
Conclusion to the Best Deep Value Book
It should now be clear why Thinking, Fast and Slow is the best deep value book. You can be an expert on how to find deep value, but if your mind isn’t under control, you will fail. That is why understanding Kahneman’s lessons in Thinking, Fast and Slow is crucial to our success.
As it was pointed out, deep value investors are not immune to psychological biases. Fortunately, Kahneman ends the book with some advice on how to fight back.
“The way to block errors that originate in System 1 is simple in principle: recognize the signs that you are in a cognitive minefield, slow down, and ask for reinforcement from System 2.”
If you are (or are considering) deep value investing, read the best deep value book. Highlight and take notes—this will involve your System 2 thinking and better the chances of remembering the concepts. Use solid criteria, don’t jump to conclusions, and focus on the long term!
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