Unconventional wisdom: Why ‘trust your gut’ is the most dangerous phrase in investing
I tried to apply the same lesson that worked with Microsoft and Apple to CSL - so far I’ve been very wrong.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Why ‘trust your gut’ is the most dangerous phrase in investing
The confidence that individuals have in their beliefs depends mostly on the quality of the story they can tell about what they see, even if they see little.
- Daniel Kahneman
Investors craft narratives to paper over the randomness of markets. Invariably we are the hero of our own narratives. Good results stem from skill and foresight. Poor results are chalked up to bad luck.
Seeing the factors that shape your outcomes in this bifurcated manner leads to a common conclusion – ‘trust your gut’.
I bought Microsoft in 2012. I bought Apple in 2016. In retrospect both decisions were very good ones. Am I an investing savant? Hardly.
Both companies had fallen out of favour with investors and the share price drops had led to higher dividend yields. They met my criteria as an income investor. I’m as surprised as the investor who sold me the shares at what has happened since.
I used similar logic to purchase CSL in 2023. That didn’t work out well.
Hindsight is just as likely to create a misleading myth as a valuable lesson.
For investors the problem with narratives is how our perception of the past can distort the decision-making framework we use in the present.
Developing too much confidence in your intuition is a false lesson from past successes. When you apply that lesson to guide future decisions ‘trust your gut’ can become the most dangerous phrase in investing.
How narratives can lead to mispriced markets
Narratives don’t just shape the way we interpret our past actions. They also distort our perception of markets.
There are countless studies showing the impact of common investor and media narratives.
Barber & Odean wrote about how investors gravitate to attention grabbing shares. Engleberg & Parsons demonstrated the influence that media coverage has on trading patterns.
Perhaps the best-known work is by Nobel Prize winning economist Robert Shiller. Among other studies, his 2017 paper and subsequent book Irrational Exuberance argued that market narratives spread like epidemics and cause stock prices to change far more than fundamentals justify.
Just like the narratives about our own lives, market narratives become self-reinforcing. As the price of a share goes up more people buy into the underlying argument that caused the initial rise. At a certain point prices no longer reflect fundamentals.
Why I bought Microsoft and Apple
I’m naturally drawn to parts of the market that have underperformed. This was how Microsoft and Apple found their way into my portfolio.
In late 2012 Microsoft had a yield of over 3.50% and was trading at around 12 times earnings. Today the yield is 0.70% and the price to earnings is 27.
My experience was similar with Apple in 2016 with a yield of approximately 2.20% and a price to earnings of around 12.50. Today the yield is 0.30% and the shares are trading close to 40 times earnings.
At the time I purchased both shares the investor sentiment was remarkably similar. Both companies were large and investors didn’t think they had growth prospects.
Windows was dominant and a cash cow but investors thought Microsoft missed the boat on the two biggest technology trends of the day - search and mobile.
In 2016 for the first time in fifteen years Apple experienced a revenue and profit drop from the previous year. Investors were worried that iPhone sales were stagnating because of increased smartphone competition and didn’t see evidence that new products could fill the void.
Microsoft’s price to earning had dropped from around 20 in the prior five years to when I bought the shares and Apple’s had declined from around 15. Along with this multiple compression the yield jumped.
I thought both companies would continue to generate cash and grow the dividend even if earnings growth was tepid. This scenario aligned with my goal of growing my passive income.
I did think there was some potential upside to the share price and dividend growth if either company could exceed low investor expectations.
How hindsight bias influences future decision making
There are two very different lessons I could take away from my experience with Microsoft and Apple.
The first is that I bought shares that met my dividend growth criteria with a chance of upside given low investor expectations.
The second potential lesson is the market was wrong and I was right about the future growth prospects of both companies. The evidence to support this conclusion is how much the shares have appreciated – my Apple position is up 1,264% and Microsoft 1,639%.
A red flag for any lesson is presuming to know something you couldn’t possibly know at the time you bought a share.
This sounds obvious but it can be surprisingly easy to go down this harmful path.
Let me demonstrate. With the high returns as the foundation of my argument I can weave a narrative about how ‘trusting my gut’ paid off.
I can give myself credit for things I didn’t know or forsee at the time. Maybe just giving myself credit for seeing a ‘strong culture" or a ‘robust R&D function’.
This doesn’t have to be a deliberate manipulation of the facts. It can just be a subtle reinterpretation of history that gives me more credit for the outcome. These internal narratives guide future decision making and can morph into misleading lessons.
Economists Simon Gervais and Terrance Odean wrote a paper Learning to Be Overconfident which shows how investors that give themselves too much credit for past success go on to take more risk.
That is the final dangerous shift this lesson can take. All of a sudden the lesson becomes: take bigger positions when your gut tells you something is a good opportunity.
The truth is I got lucky with both companies. I didn’t know or foresee that Microsoft would transform from a leader in personal computer software to a cloud computing power. I didn’t anticipate Apple would pivot to services and introduce new successful products.
Applying the wrong lesson to CSL
I tried to apply this lesson three years ago. In the middle of 2023 CSL was trading close to an all-time high at over $300 a share. The company issued a profit warning because of the weak Australian dollar and margin compression due to higher plasma collection costs.
By late 2023 the shares had dropped to $250. This is when I jumped in. I equated CSL to Microsoft and Apple. A very successful company with a history of strong dividend growth was temporarily out of favour.
Once again, I thought my core goal of growing passive income had a high probability of occurring. I also thought there was upside in the shares.
So far I’ve been wrong. The dividend was recently cut and by May of this year the shares were trading at $124. They’ve since rebounded to over $200. But even with the rebound it is clear the first profit warning was not an aberration and instead a harbinger of things to come.
I’ve been reflecting on what went wrong. I didn’t think deeply enough about the right lesson from Microsoft and Apple. With CSL I wasn’t patient enough to let the fundamentals get to a point where the probability of success was high enough.
I purchased CSL after the initial drop. In retrospect that drop was just the volatility that comes when a high valuation growth share runs into a little bit of trouble. The valuation was not cheap enough to insulate the share price when more bad news came – and it kept coming.
I couldn’t have predicted the future struggles of CSL. But when I bought the shares there wasn’t enough of a margin of safety to offer downside protection. I made an asymmetrical bet that wasn’t in my favour. The valuation levels didn’t offer protection against bad news and my upside was limited.
This all happened relatively quickly and the true lesson may only become clear in the future. I still hold CSL shares and like all my investments I’m in it for the long-haul. If things don’t work out it won’t be the first time – nor last.
Final thoughts
If you buy individual shares like me the best you can hope for is to find opportunities where the probability of success is tilted in your favour. Not every investment will work out – and that’s ok.
But don’t let the ones that went well go to your head. A little humility goes a long way in investing.
A lifetime of investing requires making hundreds of decisions. It is easy to judge each of those decisions by their result.
It is harder to take a step back and evaluate the decision in a more holistic manner. This is what I try and do with varying levels of success.
I try and ask myself some questions. Was my decision-making process sound? Did I follow my investment criteria? Given what I knew at the time would I do it again?
I’m trying to learn the right lessons from my successes and failures while looking in areas outside the prevailing narrative driving the market. I prefer to fish in less crowded seas.
Academic musings on markets and investor behaviour are interesting – at least to me. But what matters is how to apply them to your own portfolio to achieve your goals.
I will be doing that next week and walk through how I’m trying to thoughtfully apply the right lessons to the current market.
Questions, comments or restaurant recommendations? I can be reached at [email protected]
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What I’ve been eating
I’ve got a valuation dilemma for you. I know where you can get an amazing pie. That pie will cost you $14.
Pictured below is the bolognese pie from Lode Pies in Surry Hills. It is delicious. The crust is flaky and buttery and I wanted to dump the filling in a jar for the next time I make pasta. But you must admit - $14 is a lot to pay for a pie. I think it is worth it but my visits to Lode will be few and far between. Although they might increase in frequency if CSL keeps climbing.
