Why Negative Thinking Makes You A Better Investor — Musing Zebra

What does going into space and investing in the stock market have in common? Both activities engaged in a high risk, high uncertainty environment. Whereas astronauts have to deal with the risk of 526,000 gallons of propellant blowing up beside them during takeoff or the shuttle disintegrating during re-entry into Earth’s atmosphere at 7.8 km per second, investors have to deal with the risk of changes in the business competitive landscape, permanent loss of capital, psychological misjudgment, and the unknown-unknown. If that is the case, is there something we can learn from astronauts on how to deal with risk and being ready? Plenty.

Staying in the game

It is easy to picture astronauts as cowboys and risk-takers like Bruce Willis blowing up asteroids in the Armageddon movie. In reality, it is the opposite. Chris Hadfield, a Canadian retired astronaut, wrote in An Astronaut’s Guide to Life on Earth that one of the most common questions astronauts ask themselves is, “Okay, what’s the next thing that will kill me?” When astronauts are not on a space mission, they’re training in deep pool, simulators and mission planning. They prepare for all kind of eventualities on what can possibly go wrong so they know what to do in those high risk situations.

Similarly, investing is first and foremost about managing risk (not making money). Just as astronauts don’t go into space with a hope that everything will turn out as planned, you don’t go into a position only to ask “Should I hold or sell?” after the share price has fallen by 50%. You have to pre-empt it. In other words, you need a plan.

Preemptive strike

Whenever you buy a stock, you’re making a forecast. You’re thinking there’s a good chance to earn a satisfactory return (from dividends and share price increase) based on certain assumptions about the business. But that’s not investing. Investing is being ready to deal with a whole range of negative possibilities as they arise. The emphasis here is about avoiding the downside of not having a plan. When you have a plan, or an exit plan, you can perceive the market more objectively and reduce the likelihood of personalizing your position through confirmation bias. You’re also less likely to get surprised and panic when something goes wrong. What happens when you panic? You make stupid mistakes. Being prepared is more than knowing what to do in a bad situation; it prevents you from making things worse.

Rushing to sell everything during a market turmoil is a classic example of unwittingly adding more risk to a bad situation. This is the reason why knowing what not to do is far more important than knowing what to do. If you can identify 20% of your mistakes that contribute to 80% of the losses and stop doing them, your return will improve exponentially.

Now, you might think all these negative thinking is depressing. At this rate, we are probably not going to end up buying any stocks. But it is actually the opposite. Instead of being paralyzed by fear, negative thinking is liberating. It makes you more productive by becoming a better thinker.

Thinking backward

Negative thinking is a form of premortem. Whereas postmortem is an examination carried out by coroners to identify the cause of death, premortem study an incident before it occurs. In a premortem, you start with a hypothetical bad scenario (i.e collapse in sales volume or revenue) and you work your way backward from the future to the present by identifying a series of minor events that lead to the major event. Do you know why some people are more vigilant than others and able to act swiftly in a dangerous situation? That’s because they have spent their time thinking through how to handle every conceivable situation. They’ve done the drill in their head, “Okay, if this happens, this is what I’m going to do. But if that comes up, I’ll do this instead.” Along the way, they pick up subtle cues that improve their situational awareness. So when the shit hits the fan, they don’t think, they just act.

Another important source of negative thinking comes from seeking out contradictory opinion.

You’d be toast as well in investing if you see your own opinion as a trophy to be cherished instead of something to be destroyed as fast as possible. It is about cultivating a “What if I’m wrong?” mindset. When you take into account both supporting and opposing evidence and weigh them accordingly, your judgment is going to be more accurate. You reduce the probability of being wrong and increase the probability of being right.

Open-mindeness

Negative thinking is part of having the humility to acknowledge that things are harder than it looks. Many things are going to turn out differently from what we expected so it’s better to over prepare than under prepare. You want to always think about “What is the characteristic of the business?” What can hurt the business or my investment thesis? At what point will the advantage of the business become its Achilles’ heel? You want to kill your ideas first. A good rule of thumb to find out if you’re well prepared is whether your list of ‘what can go wrong’ is longer than ‘what can go well’. Humble yourself before the market humbles you.

Notes

Hadfield, C. (2015). An Astronaut’s Guide to Life on Earth: What Going to Space Taught Me About Ingenuity, Determination, and Being Prepared for Anything.

Originally published at https://musingzebra.com on April 25, 2019.

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