I learn about exploration and exploitation from Quit: The Power of Knowing When to Walk Away by Annie Duke (my summary of the book here) with the observation of how ants look for food and forced quitting. The concept is very applicable in investing together with the other concepts from the book.
Also, Edward De Bono’s concept of farmer and fisherman in his book, Opportunities: A Handbook of Business Opportunity Search, add more perspectives.
Investing is about exploring and exploiting where we look for opportunities and taking advantage of opportunities.
Explore
Explore can be viewed in two main aspects:
- Explore and learn the various investing and tradings approaches to improve
- Explore new investing and trading opportunities (different sectors, different markets)
The investing universe is a huge place to explore with many companies listed in our home market and major exchanges. There are also commodities, precious metals, futures, ETFs and cryptos.
There is also easy availability and access to knowledge and information (social, media, YouTube, podcasts, library books and magazines, blogs) that can help us improve our investing skills.
However, many tend to limit and stick to what they have learned and are familiar with. They limit what they have learned and their usual watchlist and stop exploring. On the other hand, some are more interested in exploring to find the mystical holy grails and hot stocks.
When we limit our exploring, the approaches and opportunities may not offer good returns. There can be better approaches and opportunities in the stock market, in other countries and sectors that we can find.
In 1993, Warren Buffett sat down for an interview with Supermoney author Adam Smith, and the conversation began like this:
Smith: “If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?”
Buffett: “Well, if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.”
Smith: “But there’s 27,000 public companies.”
Buffett: “Well, start with the A’s.”
Be open-minded and curious to explore. Don’t stop exploring and exploit too early and dig a deep hole.
Farmer versus fisherman
Farmer is content to stay within his own patch. With his patch, he may be open to innovation and change for opportunities to increase productivity and yield. The “farmer” is willing to search out for opportunities but only in a defined direction.
The fisherman is a risk-taker. He owns no farm. He cannot guarantee that when he ventures out he will return with a catch. He puts down his nets and hopes for the best. He is a pure opportunist. He has invested in skill, experience and equipment. Through such investment he reduces the uncertainty and increases the chance of substantial pay-offs. The ‘fisherman’ approach leads to an investment in management skills and techniques that can be transferred to any field or used to follow up opportunities wherever they arise.
The farmer and fisherman view opportunity differently.
Exploit
Exploit can also be viewed in two dimensions: the expected returns (%) and portfolio allocation ($).
We have to be conscious of why we hold more and/or longer than to explore new opportunities.
Comfort zones and the status quo bias in investment decision making
Investors tend to invest in what they are familiar with. Being vested, they may have status quo bias, identity bias, confirmation bias and sunk cost fallacy that they prefer to stick to their knitting. They are less comfortable being adventurous and exploring something less familiar and different. At times, even when they underperform the market; they continue to hold.
Most people prefer to stick with the status quo.
It represents a mental account that we already have open, which has sunk costs (capital, time and efforts) associated with it. We are more tolerant of bad outcomes that come from sticking with what we are already holding than bad outcomes that come from switching to something new. We are warier of “causing” a bad outcome by acting than “letting it happen” through inaction. This phenomenon is part of omission-commission bias. Do note that to keep holding and not do anything is itself a decision as to where we stay put; status quo.
Identity bias and investment: The painful challenge of quitting
Sometimes, we give ourselves an identity and keep pounding the merits of the investments: macro investor, tech investor, dividend investor, Tesla bull, Bitcoin maximalist, crypto hodler, crypto laser eyes, etc. On the same token, we may give ourselves an “anti” identity on the demerits of some investments: anti-Bitcoin, anti-Tesla, anti-China, etc.
When it comes to quitting, the most painful thing to quit is who we are. When new information conflicts with a belief, we experience cognitive dissonance. Whether it is our actions or new and disconfirming information, when it comes to a battle between facts and changing our beliefs, the facts too often lose out. We identified ourselves so strongly that the identity becomes hard to abandon.
It becomes much harder to quit when we are worried about being judged by others. We are too strongly identified with the “themes” of the investments that we are very convinced and confident with. We get it in our heads that if we do not stick to our original choice, that will reflect negatively on us. We worry that if others see the inconsistency between our present and past decisions, beliefs or actions, they will judge us as being wrong, irrational, capricious and prone to mistakes. The irony is that this desire to be viewed as rational and consistent causes us to become less rational and consistent in the decisions we make. External validity increases the escalation of commitment. The tragedy of all this is that the way we imagine other people view us is often wrong. Those worries we projected onto others are just head trash we are carrying around.
This is like being an ardent fan of our favourite sports team. However, having such an identity in investing can hit our profitability when our investing thesis goes awry and we refuse to quit. We lose our rationality to profitability. We can see such investors in social media with their strongly identified investments. We are worried in more things than the important objective of making money.
There is a huge difference between having a strong identity and having conviction with a large allocation. The latter would not mind changing their views and selling the position when they think there is a mistake or the investing thesis is less valid and there are better opportunities.
When the facts change, I change my mind – what do you do, sir?
John Maynard Keynes
The best investors do not strongly identify themselves with their investment ideas. They remain rational and establish their understanding based on their due diligence.
Keep exploring and wait
Explore and exploit do not mean we have to jump from one opportunity to another better opportunity to exploit. Explore allows us to come up with a list of high-quality companies to invest in while we wait for the opportunity to buy.
We can always explore but there is no need to keep exploiting.
Balancing between exploration and exploitation
We need to be mindful of the balance between exploring and exploiting to achieve good returns.
- Is the operating environment benefit or affect our investments?
- Are there opportunities we have been exploiting still good?
- Are there any new opportunities we have been exploring to be better than existing ones?
Concentrated versus diversified
There is nothing wrong with having a well-diversified portfolio. It is a personal preference and a balance between the extent of exploring and exploiting to achieve profitability. It is good to start small, learn and perhaps, concentrate. The decision of what to concentrate on needs not to be made at the beginning; some investors just let the share price appreciate the portfolio concentrate by itself over time.
A related article: The great investing myth (5): Concentration versus diversification
