Hammer and Nail Cognitive Bias In Investing: DCF

Psychology Bias in Investing: Hammer and Nail. DCF
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Some traders and investors sometimes fall into the same trap: hammer and nail cognitive bias. As a stock market trader seeks the best indicator, so does a fundamental1 investor search for the best valuation ratio.

Preface

I often see an (or a group of) investors who really proud of his fundamental analysis, mocking the day trader who relies on a chart and indicator. They (the investor) argue how could someone believe a mathematical calculation could predict the price movement2. But, ridiculously, the investor has the same mentality: They seek the best single valuation ratio to make a decision.

Single indicator for the trader. Single valuation ratio for investors.3. This brings us to a discussion about the hammer and nails cognitive bias.

Hammer and Nail Cognitive Bias. In This Issue.

  1. Human Search
  2. Cognitive Bias in every aspect
  3. Discounted Cash Flow
  4. The Educated Investor
  5. Key Takeaway

For readers that not familiar, a cognitive bias is a deviation of how we should interpret the information. Let’s take a look

Mankind Search

Mankind long the best form of their body and wellness. They want to be Chris Herria or Jessica Smith’s version for themselves. Try to search for the best workout on Google and you will find some. Cardio, HIIT4, Calisthenics, Resistance Training, Tabata. All of these methods have popularity among some people and become a hype in some period.

Problem is, like Jeff Jeff Cavaliere from Athleanx.com said, you can’t out-train a bad diet. Having a great body is a combination of many things. It is genetics, diet – you are what you eat – workout, daily habits, sleep. Why do people love to rely on exercise alone instead of having a good diet?

Because doing burpee 10 x 4 is easier than prepare our healthy meal in the morning. Because running 5 miles is easier than throw away sugary drinks and fries. That’s why you still see a workout active person with bellies.

Investing is similar. It needs multiple aspects and multi-discipline to take an approach. For instance, if you want to buy ConocoPhillips stock it is better for you to understand financial, petroleum production, macroeconomics, company business advantages. It doesn’t have to be very deep, but there is a minimum threshold.

Hammer and Nail Cognitive Bias in every aspect

When you have only a hammer, you will see everything need to be nailed

Familiarity plays an important factor in decision-making. Once we get used to relying on a certain method, we tend to solve everything with that method. I’m an electrical power engineer, at the beginning of my investing journey, I tend to invest5 based on my engineer expertise. I used to believe that advanced mathematic could solve all investing6 problem.

I use all indicators and not satisfy with the result. Then I move to the more sophisticated method, using Laplace and Fourier transformation and….doesn’t help, but make me look cool. Tired, I try something else. Reading Buffett material, I begin to realize, all indicator is crap, I began seeking something that I’m familiar with, as Warren Buffett suggests, “Invest in a business that you understand”. My watchlist is heavily on the utility sector, energy, microchip, and technology – due to the influence of my academic background.

I remember, the most weighted factor to make a decision is a technical area, for instance, in the utility sector, I think about the diversity of power source, renewable or fossil fuel? Today I realize, this approach leaves me with some blind-spot7

I believe some of us make this mistake. This is the hammer and Nail cognitive bias, or formally called “the law of the instrument”. When all I have is electrical engineering, everything seems to have a galvanic relationship.

When all you have is X degree, everything looks like X related field.

Law of Instrument Cognitive Bias in “Discounted Cash Flow” Case

Discounted Cash Flow sums all Cash Flow in future into present value

DCF or Discounted Cash Flow has been worshipped as the best valuation formula. The idea is simple, bring the future free cash flow (or similar matrices) into present value. Even with this definition, we could guess the flaws immediately, but let’s go on, we will take care of that in another post.

Once investors finished calculating Discounted Cash Flow (DCF) for a certain company, they feel their task is complete. Unfortunately, the world doesn’t work like this. DCF application for Exxon or Bank of America will not bring you an accurate valuation. Honestly, every single formula is meaningless without business understanding – we won’t deploy DCF for ExxonMobil due to its cyclical nature. Come on – we all know this – we have to understand something first before making a judgment or assessment.

The Educated Investor

One of the main problems is our education system. Since at the school we used to solve the problem with a single and simple solution. Who did discover America? Christoper Columbus. If I have 10 dollars and each pencil costs 2 dollars, how many pencils we could get?

There is only single, simple and exact solution.

We tend to solve the problem like this. we think everything will be much more relaxing once we graduated and get a job. Or when we think that marrying our dream girl makes us happy after ever like Shrek or princess story. Oh, it’s not that simple. Investing is the same, it is not finished once we understand DCF or P/E or any other folly formula.

Know what

We often forget that life is a never-ending lesson. It is a game with no final boss – and updated regularly.

Trading Investor, Investing Trader

Why technical analysis so popular? Because it seizes the complexity of the stock market – which is a representation of human emotion – into a much smaller package: price. Buy if the price breaks the resistance and sell if the price falls from its support line. See how simple it is? Investors may fall into the same trap, zipping the business aspect of a certain company into a compact form: whether it is DCF, P/E, or PBV.

This why DCF or PE is so popular. Because it is easy to perform.

Hammer and Nail Cognitive Bias: Key Takeaway

Life requires more than one solution. It needs careful thought in many aspects. Simultaneously. No simple rule – not even a complicated one – always works. You only control a tiny fraction of the environment, you have no control over the outcomes. History rhymes but not exactly repeats. This makes life is not easy. So does investing.

Valuation need more than that.

More about this topic:

  1. Investing should not be easy, if anyone tells you that you can beat the market in 5 minutes – that is right, but you can’t beat it five minutes for years.

  1. not true fundamental investor actually []
  2. ouch, the trader will answer, we not predict, we react, but actually it is the same, they buy because the indicator tells to buy! []
  3. Ok, let make two for each []
  4. High-Intensity Interval Training []
  5. actually it could not be defined as invest []
  6. trading at my case []
  7. Doesn’t say that the method is wrong, all of them is important []

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