Excellent article Pablo. Just to add to the comments below it, I watched the following video this morning:
http://www.livewiremarkets.com/wires/profiting-and-protecting-from-investor-psychology
When you play the video, if it asks for a password, just type "password" and hit the [Enter] key - that worked for me.
The psychology aspect is vital to master in the realm of microcap stocks I believe. Steve Johnson talks about the many biases that affect our decision making process, and our research efforts, including narrative bias, anchoring, and confirmation bias. Examples include when people have already decided they want to buy a stock, they start gathering all the evidence they can to support that decision, and tend to ignore most of the evidence against it. Sometimes it may not be so much ignoring contrary evidence as giving that evidence less weight if it doesn't support our pre-conceived ideas. And we can spend less time looking for that evidence (the evidence that does NOT support our pre-determined end-point) in contrast to the time we spend looking for evidence that supports our original view.
That information-weighting bias is often subtle I think, and sometimes we may not be consciously aware of it. An example would be finding out something negative about a high conviction company that you already hold. The default position might be to look for other evidence that undermines the credibility of this new (negative) information, rather than examine the new information without emotion or bias to see if it affects your investment thesis significantly. The trick then is to remove emotion from it and not feel you need to defend a past decision to invest in a company that you now may have good reason to view in a slightly different light.
What Steve says about how much the average person hates losses is very interesting. Steve believes that loss-aversion is a big driver in some of this unhelpful behaviour that most of us exhibit. Steve admits that he is a fairly emotionless person and that he doesn't have a problem with losses. He grew up on a farm, and says that he learned that losses are just part of life. The ability to take losses in your stride is a big advantage in this game. Loss-aversion can lead to poor decision making, in that we can be desperately trying to prop up our original thesis ("I know I'm right and the market is wrong") in the face of mounting evidence that we may have got this one wrong.
Tenacity and strong confidence in ourselves and our own opinions can also be a great attribute. You don't want to panic and sell out of a great idea every time somebody says something negative about it. However, the ability to dispassionately analyse information on its merits - without emotion - and without letting biases creep in and skew your process one way or the other - is important - and also very hard to achieve.
What a great piece. Thanks Pablo.
Story driven stocks can really test an investor's nerve, with prices soaring and diving on even the smallest bits of news. And if that story starts to come apart, the losses can be brutal.
For me, this is why it is absolutely critical to clearly layout your expectations. Putting these in black & white helps prevent "thesis creep" and allows an investor to more objectively evaluate how well a company is delivering.
Further, it's why determining an estimate of 'fair value' is so helpful. You'll never be able to know exactly what a company is really worth, and you'll be able to come up with vastly different estimates with only the smallest of changes to your assumptions -- but it is incredibly instructive in terms of helping you to understand what variables are important, and to give you a sense of what the business needs to deliver -- in cold hard cash -- and when that needs to come in.
You also need to approach this space with an expectation that you will be wrong more often than right. But, as with venture capital, that's fine if you make enough 'bets', and understand that you only need a few big winners to more than offset the inevitable losers. And, importantly, you need the proper resolve to sell when the thesis is clearly broken (no matter the loss), and the conviction to increase your holding as the story gains credibility -- even if you are buying in at progressively higher prices.
So, evaluate the story objectively. Understand what success looks like. Spread your money across a basket of microcaps. Be prepared to change your mind as the facts change. Understand that price and value are two very different things, and that volatility can provide good opportunity.
For me, MSL Solutions (ASX:MPW), Envirosuite (ASX:EVS) and Fluence (ASX:FLC) are all interesting prospects in this category.
Happy hunting!