Behavioral missteps are an investor’s biggest challenge – Jeremy Zhou

Jeremy ZhouAuthor: Jeremy Zhou

Covestor model: Biotech and Medtech

Disclosures: Long VNDA, MAXY, LXRX

I’ve long recognized an intriguing phenomenon whereby the amount of questions from friends regarding their investments is inversely related to the percentage gain of major market indices.  Usually the questions can be grouped into two categories: “Do I sell now?” or “Is it too late to sell?”  Ultimately what they really want to know is will the market go down further or will it rebound. I wish I knew.

While I believe there are many investment styles that could lead to long term success, most of them don’t involve making an accurate prediction about the future direction of the market.  On the contrary, a great majority of them consciously avoid making such a prediction.  Instead, the focus is on what we as human beings can control: investment selection, portfolio construction, risk management, holding time horizon, buy/sell discipline and intellectual independence and honesty.  By obsessively sticking to these controllable variables, the odds of favorable outcome improve.

The main reason for improving odds is due to the avoidance or reduction of behavioral missteps, such as loss aversion, overconfidence, confirming bias, herding, etc.  These common behavioral traits can be found in all amateur or professional investors, and those who can persistently suppress their influence tend to come out ahead.  But the act of always overriding our own emotions and biases is extremely difficult, if not close to impossible.  That is why we need to focus on the controllable variables of the investment process and formulate a concrete plan to execute them, no matter what.

Since the beginning of June, the market has headed into the negatives. The bears beat their drums and the bulls begin to doubt. Yet the most prudent course of action is to keep our emotions in check and carry on what has worked in your experience. In my experience, some of the things that have always worked are staying away from the herd, making buy/sell decisions based on preconceived reasons, admitting to mistakes and correcting them in a timely manner, looking for evidence that falsify your views, and guarding the lure of great returns from overriding the discipline of risk management.

Getting back to the questions from my friends, my usual answers are “I don’t know” and “It depends”.  But mostly, my preference is “I don’t know”.

Before I end this piece, I’d like to put in a sentence or two about my recent portfolio activities.  However, the most important thing isn’t what I sell or buy; the most important thing is to understand what drives my buying and selling, which I attempted to describe in the previous paragraphs.

Recently I sold Optimer Pharmaceuticals, Inc. (NASDAQ: OPTR), Delcath Systems, Inc. (NASDAQ: DCTH), Biodel Inc (NASDAQ: BIOD) and bought more Vanda Pharmaceuticals Inc. (NASDAQ: VNDA), Maxygen, Inc. (NASDAQ: MAXY), and Lexicon Pharmaceuticals, Inc. (NASDAQ: LXRX).  I sold those companies because either they had reached valuations where the risk/reward ratios were no longer favorable or they failed to perform according to the original theses that led me into them.  For the stocks that I bought, the reasons were simply the opposite of why I sold: favorable odds and/or the expectation of price appreciations due to upcoming catalysts.