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To be a great investor, don't 'stay positive'

Good investing isn't about being an optimist, it's about running experiments.

We all like to think of ourselves as perfect realists, but the truth is we often suffer from what psychologists call optimism bias: the tendency to overestimate the probability that good things will happen and underestimate the risk of adverse events.  

This is a really, really unproductive bias to have. For one thing, it's fuel for the millions of people who buy lottery tickets on the basis that 'someone has to win'. In our mental models of the world we're all special, allowing us to imagine we can beat the odds - but in the brutal world of probabilities, we're just statistics. If you need aching proof of this, check out 'parkour fails' on YouTube.

Optimism bias can have an even more pernicious effect: it stops us from learning. In 2011, psychologists at University College London published a study that suggests we are biased towards forming memories based on positive information. We tend to remember things that turned out better than expected and quietly sweep anything unpleasant under the rug. That makes it especially difficult to learn from our mistakes.

The researchers asked participants to estimate the probability that they would suffer 80 different adverse life events, such as robbery, Alzheimer's disease, or getting cancer. They were then told the real-world probability of those events. Finally, in a later session, they were asked to recall the probabilities from memory.

It turns out that the participants' recall attempts were more accurate when their first guess was overly pessimistic. That is, they were more likely to learn from information that let them adopt a more positive outlook than data that went against their optimistic expectations.

What's your hypothesis

When an investment doubles, we take note and try to figure out what we did right to find the next opportunity. But when one of our stocks halves in value, we either look for someone to blame or simply sell the stock and put the whole messy experience behind us. Very few investors track the subsequent return of stocks they've sold to know whether it was a good idea. On some level, we just don't want to know.    

The antidote is to reframe how you think about investing. It's natural to think of your portfolio in terms of financial gains and losses - things to get excited or disappointed about - but this could be holding you back from learning from mistakes.

Instead, try thinking about your portfolio as running a series of scientific experiments based on asking questions and getting feedback. Rather than thinking 'I hope XYZ happens', reframe it as 'I wonder if XYZ will happen'. At the time of purchase and sale of any stock, make a quick note of your hypothesis in an investment journal for later reflection ... and force yourself to re-read that reasoning if the investment doesn't work out.

We did this recently for the IVF industry. We've been long-term optimists and our original Buy case four years ago rested on the premise that cycle growth would be in the 3-4% range. This seemed reasonable at the time and we had plenty of historical data to support the idea. However, it just hasn't worked out that way. Since our original recommendation, growth has slowed to 1.5% and the stocks have languished. It was only by questioning each of our initial forecasts that we realised our expectation for cycle growth was out of whack with the reality that developed. Modifying our hypothesis knocked a good 20% from our valuations.

Also pay attention to your emotions. How do you tend to respond when a stock dives? Do you feel compelled to cut your losses or do you double down? If you come across a 'short case' for a beloved stock, do you turn the other way or try to understand why people have a different view? By analysing your own emotional reactions and recognising when you're prone to irrational thinking, you'll be more equipped to spot when it's happening and then take a different course.

Graham Witcomb is a senior analyst at InvestSMART. To access more share research from InvestSMART, start a 15-day free trial.