Skill v/s luck in investing - the eternal debate

I am very sure that we all have been part of this debate at one time or another in our investing lives. In my experience, the more drunk the participants, the more lively is the debate! :-)

There are some who really believe in their own prowess and opine that skill is the only factor which dictates success in investing. Well, perhaps these people have been fooled by randomness or have never been hit by a black swan event. These people should really read Taleb. :-)
There are others who say that investing is as good as (or as bad as) gambling. They opine that performance in investing is a matter of sheer luck. Believers in the Efficient Market Theory would surely say that if you are outperforming the market, it is only because you have been lucky. Well, these people should read Buffett! :-)

In my view, the answer lies somewhere in between and is a combination of luck and skill. Its like marriage. One would be lucky to get a good wife, but one has to be skillful so that she remains good to you! :-) Success in investing is a matter of luck as well as skill. However, the percentage of both differs in different situations.
E.g. There is skill involved in earning money as well as in not losing money. So if you avoided something bad, thats skill too. On the other hand, many times, one earns money by luck too.

But in my experience, here is what most people do. If they make money, its all skill, but if they lose money, its all bad luck!! I don't think thats a very great way of approaching things. Crediting skill when we make money leads to overconfidence and stupid decisions in future. Blaming luck when you lose money does not let us introspect and correct our mistakes since we think that we did not make a mistake, it was just bad luck!

Let me share a couple of my experiences with you.

1) Albright Chemicals (now, Rhodia Specialty Chemicals)
Albright was not an extraordinary business. But still, I had bought it for a specific reason. The company was available at a market cap of about Rs.50 cr. (Today its Rs.126 cr). The company had also published an advertisement for selling their land in Ambernath. The 26 acre piece of land would be worth about Rs.50 cr. Now, since it was very clear that they wanted to sell this land, its value becomes material. I thought the business to be worth Rs.45-50 cr plus the land worth Rs.50 cr more, giving a valuation of Rs.80 cr, after deducting Rs.20 cr if debt. So, something worth Rs.80 cr was available for Rs.50 cr. Decent logic, I felt, and I bought the stock.
After some time, suddenly, Solvay acquired Albright's parent, triggering an open offer. The stock price reacted and I sold at a decent profit.
Now, the question is, was this skill or luck? I believe the end result was a matter of pure luck. I had bought it primarily because of expectation of land sale, leading to increased valuation for the stock. The price did increase, but for a different reason. The land still remains unsold!! So, even though the end result was as per expectation, the reason for the end result were not as per expectation. Now, thats luck, wont you say?

So, in my view, if you bought something with certain expectations, and in future, the expectations materialised just as per your view, due to which you earned the desired profit, then its skill. Otherwise, even if you earned the profit, its all luck!

2) Provogue Ltd.
Boy, was that an adventure or what! :-) Although, I must say that it was not a very comfortable adventure! I did earn decent returns here, but it was all pure dumb luck. Absolutely no doubt about it!
The reasons why I bought the stock can be found here.
After some time, due to some changes which occurred in the situation, I decided to sell it before ex-date.
Now, all that I had thought would happen, did not happen!
- I had thought that on ex-date, the stock price wont fall much. Maaan, it fell huge!
- The reason I sold, was that relisting of Provogue could take lot of time..but it got relisted pretty fast.
- Creating free shares of Prozone was the main reason for getting into Provogue. That, it seems, would not have happened! :-)
So, absolute dumb luck it is!

There are other cases where I think I applied decent amount of skill..but there is no fun in talking about success stories, right? :-)

So all in all, we should always remain grounded, with understanding of the reality that luck does play a role in investing. Luck is something we cannot control, but skill is something we can develop. Let us all concentrate on that but not consider ourselves to be exceptionally skilled just because we earned money. If we do that, there would be no room for self-improvement.

On the same topic, me and my friend Ninad often discuss about the idea of positioning yourself for luck. If you can get yourself in situations where multiple lucky things can happen to you or no un-lucky thing can happen, that would be really something! But, that would be a topic for a separate post, I hope!

Till then,

Cheers and happy-go-lucky investing! :-)

Investing and Magic!

Yesterday, I watched (again!) one of my all time favourite movies The Prestige, a masterpiece by Nolan. Hence this post!
Think about it, investing is indeed like magic. We make money out of virtually nothing, there are a lot of things about investing we do not understand/cannot logically reason.. and its so much fun..everything just like magic! :-) 
So lets try and see how investing is like magic!

Every great magic trick consists of 3 parts or acts: (no prizes for guessing where these lines come from!)
The first part is known as The Pledge. Here, the magician shows you something ordinary like a 'normal' deck of cards, etc. He might ask you to inspect it and ensure that is just an ordinary piece.
The second part is known as The Turn. Here, the magician takes the ordinary something and makes it do something extraordinary. Now you are stunned and are thinking 'how did that happen'. But you still wont be clapping. Making something disappear is not enough. You have to bring it back.
Thats why every magic trick has the third and hardest part, called The Prestige. What disappeared now appears back in the most unlikely place! Thats where the applause starts! 
Every great investment consists of 3 parts too:
The first part is The Research. A thorough and comprehensive research to determine the true value of something. Something which might look like an ordinary company, but may, actually, be extraordinary.
The second part is The Buying. Proper research and proper conviction results in proper buying! Buying and tracking its performance and various other developments is most important. Keep tabs on it patiently as the ordinary starts becoming the extraordinary. Stock price goes through the roof. However, that is not enough. Applauding notional profits is just like explaining the importance of capitalism to communists. Its useless!
Thats why every great investment has the third and the hardest part, The Selling. Its not until you have sold have you made profits!
See, just like magic! :-)


Every magician takes advantage of the obvious. The most complex illusion is based on the most simplest of 'tricks'. Like a trap-door in the stage to make the magician 'disappear'. If you learn how that trick was performed, you will say 'o that should have been so obvious'. But while watching the trick, you never realised it!

An investor does the same thing. He tries to catch the obvious, which others have missed. The market misprices stocks; an intelligent investor recognises and grabs it. After some time, the market starts valuing in properly, resulting in increase in price. And other people say..o that was so obvious..why didnt we buy that time?

Magic indeed!

Magic is fun! Sad magician..or boring magician..just doesn't sound right huh! When a magician performs his tricks, he too seems to have as much fun as his audience. The best part is..its fun even when a trick fails and a magic act becomes a comedy act.

Investing is fun too, believe me! Its a constant circus happening all around us 24x7. And just like magic, its fun whenever it fails too.. its hard to admit mistakes and laugh at one's own stupidity, but believe me, its fun! And most importantly, you get to learn sooo much from the mistakes.

Magical eh!

Magic is dangerous. Magicians have died trying to do the impossible. Trying to take unwarranted risks. Trying to do illusions without having proper checks and controls in place. Magic can become suicidal very fast if the magician does not know what he is doing.

Investing is dangerous too. People lose their money, their house, their happiness and peace of mind. It happens when they take unwarranted risks. When they speculate and punt without having proper checks and controls in place. The stock market is the best and surest place to incur losses if the investor does not know what he is doing.

Be careful with magic!

So, what say? Investing and magic go hand in hand huh! Hope you had fun reading, coz I had real good fun writing!


Abracadabra!!


Cheers and happy investing!




P.S. This is meant to be a light, fun read. If you think I am going bonkers, thats quite ok! Relating diverse disciplines is something I honestly enjoy doing. But if you liked reading this, you might also like reading another post of mine. 

That left out feeling!

A warm hello to all! I think the title of this post summarises the state of the majority of investors (not all!). Its the feeling which the only married guy in a group gets, when all his bachelor buddies go drinking!
The world was so beautifully going to the dogs. The PIGS were being cute and wonderful, China bubble was supposed to pop anytime, US was supposed to have never recovered, the Iran guys were upto something which would take oil prices through the roof, our Government policy and decision making was in shambles, inflation was still not comfortably low, interest rates looked like they would stay high for some more time, our deficit was ballooning out of control, with growth being hit simultaneously and most importantly, everyone around was also not investing. We all were waiting for the inevitable fall so that we could deploy the safely kept cash and dance around merrily. Hell, that didn't happen! Instead, the market (index) rallied, with a huge number of well known small and midcaps going up 50-100% within a couple of months. Investors were left just sitting on their behinds! So what went wrong (or should I say, what went right, for everything to rally?) What to do now? Lets try and answer these questions..

What caused this rally?
Answer: Really doesn't matter! The rally has happened, its done! No point in brooding over past events, which will add zero value to you. No point in looking at the stock prices and saying this available at half the price a few weeks ago etc etc. Lets be in the present and not dwell upon the past.

What to do now?
Well, everyone has different approaches to doing things. So i will talk a bit about what not to do too, coz that is most important..
1. Absolutely avoid panic buying. There is no point in buying just for the heck of it. This is the time when one will become most susceptible to 'tips' because the mind will be looking for support from someone to help you earn some money and not be left behind. When everything around is rallying and someone tells you that xyz stock is the next in line, it is but natural to get tempted. But, don't!! Control temptation, keep logic and common sense alive.
2. Don't instinctively buy stocks that haven't gone up in this rally. Typically, our mind will search out stocks whose price hasn't gone up, thinking that they are next in line to go up. Well, there could be very good reasons why the price hasn't moved and these reasons could very well take the price even lower! So, no buying without proper investigation.
3. Don't justify your failure to deploy cash. Do not say to yourself that I knew this rally was going to come but this is just a one-off. It will fall soon and then I will buy! Admit your mistake. Its the first step towards not making it again!
4. Don't be afraid to sell. If you think that the price of some stocks in your portfolio has undeservedly gone up, do sell them. Don't wait for a higher and higher price to sell, like most people recently waited for lower and lower price to buy!
5. This is a good time to get the crap out of your portfolio. Well, any time is a good time to do that actually! But now, if the crap has moved up, it will be less heart-wrenching to let it go! Use the opportunity! Also, remove small and marginal positions in your portfolio, which you don't intend to add to. Make the portfolio leaner.
6. Opportunities still exist. They always do, wherever the index may be. But now, it will require much hard work to find them out. So, lets work harder. Of course, now is the time to be ultra careful, not because the market has rallied, but because our mind will be eager to buy something and not be left behind. Lets watch ourselves and not get sucked in.

What should we learn from this?
This is most important. We learn from history, that we don't learn from history. Let history not repeat itself! Let us all learn that timing the market is impossible!

So wasup with me?
I am sooo very tempted to look smart and say that I deployed all my cash (which was a rather large %). Well, I couldn't. I managed to build some positions in a couple of special situations and deploy some cash in few stocks I liked, but full cash could not be deployed. Though the rally did not surprise me, to be honest, the speed of it did. Typically, I tend to take a step back when prices of my stocks start shooting suddenly (uncorrected behavioural flaw!), hence, I could not complete my full buying in a majority of my intended purchases. I am so very left out! And I am quite ok with it, as of now! :-) I am continuing to look at some stocks to see if there is something to buy out there. I am sure there is, it just needs to be found out. Guess we will have to work harder and smarter now! Equally important is whether any of my holdings need to be sold. But I am not still finding any compulsive 'sells' yet.

So all in all, if you could not 'participate in the rally', don't fret. Just keep a calm and cool mind and control the very natural urge to buy something, anything, just for the heck of it! Buying/selling should not be dictated by the market direction. Buy only if makes sense and if it does make sense, buy without fear! If you just cannot control the urge to buy something merely for the heck of it, do go out and buy a few good books! They will always be a great investment! :-)
Let it all be 'routine as usual'.

Cheers and happy investing...

Why investing is unnatural!

Nature has bestowed all living organisms with certain instincts. Its hard-wired into the very being of organisms. We humans are no exception. And since we have turned out to be the alpha organisms on this planet, we have a bit more instincts than others, some smarter, some dumber!
Well, instincts are natural. They are like reflex actions and we are, by our very nature, slaves to them. Imagine that you have your face against a strong glass cage, housing a snake. Now, if the snake strikes, you will instinctively recoil back, inspite of knowing that the cage is pretty strong and there is no real danger to you.
Let us try to relate some of our instincts to the discipline of investing. I find that most of our natural instincts are quite useless in investing. Investing is a slow, deliberate, disciplined and a well thought out process, not an instinctive one. I am talking strictly about investing here and not 'trading'. (You know what I mean!)

Instinct to get away from danger
This is an omnipresent instinct in all organisms. Unless you yourself are the danger, you will try to run away from danger! Going against this instinct is quite something! Why do we admire our soldiers and firefighters? They fight every instinct in their body and mind while doing their work and actually run towards danger!
Now what happens in investing? History tells us that the best investment opportunities have been found when everything around is 'dangerous'. Recent memories of Mach 2009 are still fresh in our minds. That was the dangerous time when quite a lot of stocks were quoting at irrationally low prices. If investors run away from it, they lose some really good opportunities.

Instinct to avoid pain
This is a very pervasive instinct in humans. (Just ask all the pharma companies manufacturing pain-killers!) Rational humans will not deliberately do something which can cause themselves pain. The ones who do sometimes get locked up in mental institutions! Unless totally unavoidable (like, lets say, a medicine injection), we all would honestly like to avoid pain and would be willing to do anything for that.
In investing, people experience mental pain, seeing their portfolios in red. To avoid the same, they wait for the market to bottom, where they will buy truckloads and probably retire quick! Well, it just doesn't happen. You will know the bottom for sure, only after it has come and gone. Pain in investing is common. Your portfolio can give you anguish for short-medium periods of time, when things are irrational. If you have conviction and have done your homework, the short term pain is worth taking, for the long term gain.

Instinct to survive
The instinct to survive is probably the most prevalent of the base instincts. We have all heard the story of the monkey and her baby trapped in a well. We all will do whatever it takes to survive, however irrational or illogical it might be.
Does this work the same way in investing? Imagine a person who has lost a lot of money in the markets. He is close to losing everything. If you go and tell him a hot stock idea or some F&O strategy, which can 'recover his losses' fast, chances are he will jump into it without much thought or analysis. The desperation to come out, to survive is extremely prevalent. But here, he might end up hastening his death, instead of managing to survive. The instinctive brain needs to be given a rest sometimes!

Instinct of greed
Many of you will argue that this is no instinct! But I believe it is. We have an instinct to want more of what we like. Now, this 'more' may not be good/healthy for us later, but still it gives us the required pleasure at that moment and we are fine with it.
Well, we all know what greed can do to us in investing, so I will not talk much about that. Gordon Gekko famously said 'greed is good', but he also (infamously) went to jail! This is another instinct which needs to be controlled.

Instinct of instant gratification
Humans look for shortcuts! Our mentality is such that we get attracted to anything which has the potential of giving us fast results. Something which requires longer time and higher effort is something which does not appeal!
In investing, the same thing holds true. Why do people get attracted to the get-rich-quick MLMs, why are the 'hot stock tips' so popular? Instant gratification! Well, there is nothing instant about investing. Businesses take time to perform and so does your investment. Our 'instant' instinct needs to be strictly controlled!

Instinct to form groups
Since ages, humans have lived in groups for a variety of reasons. And it has worked fine. We have a natural tendency to not be alone, if we can help it. Sometimes, any company is good company. (No pun intended!)
This same instinct may not necessarily work in investing. Investing is quite a lonely exercise! If we do what the crowd is doing, the decision may not be correct. The best opportunities to buy have been when the crowd is selling and vice-versa. Always going with the consensus may not be great for your investing health! Mauboussin famously equated fund managers with zebras and is something worth reading.

Instinct of aggression - the alpha male!
The instinct to show that you are the aggressive, happening guy is ever pervasive. The dopamine kick that aggression gives is quite an experience.
Imagine an intraday trader talking about his exploits. How he had the nerves of steel and the aggression to fight the market and come out on top. This aggression may, of course, not work every time. Undue aggression at a wrong moment may be enough to wipe you out for ever! Now imagine a longer term investor talking. :-) It may of course sound boring compared with the flamboyance of  the aggressive trader! Investing is not about being aggressive just for the heck of it. The investor will let loose this instinct of aggression at rare, opportune moments. Rest of the times, this instinct needs to be carefully controlled!

Instinct to justify
I honestly think that this is one instinct prevalent only in humans. Imagine this: a cheetah is running after an antelope but he doesn't catch it. He blames it on a small pebble that tripped him while he was running! Seems very funny even to imagine right? Now imagine yourself trying to finish work before a deadline. If you can't, you will have a hundred ready excuses, which prove that 'it was not my fault'. Happens to us all! Its instinctive.
Justifying is perhaps the most dangerous thing in investing. Why did I make a loss? Coz the market itself collapsed. So my stock, which is an amazing company, also collapsed for no reason. Why did I make profit? Coz I am goddam smart! Not coz the market rose! Justifying ourselves in our brain does not help us learn from our mistakes, coz it tells us that we are not making any! Something to be avoided at all costs!

Instinct to do activity
This is another instinct hardwired into all of us. We all have the constant need to keep on doing something. Why is meditation so difficult? Its because its unnatural to sit quietly, with a blank mind!
This is prevalent in investing too. The need to 'do something' is so pervasive. Of course, its not the best of ideas to keep on doing something all the time. There are times to do nothing and there are other times to do everything! Majority of the times, the need to do activity needs to be controlled.


So what can we infer and learn from all this? 

1. I can write really long articles!
2. We have certain instincts hardwired into our brain.
3. These instincts may not work in the process of investing. Relying on these instincts may prove disastrous.
4. There is no such thing as a 'born investor'. (in my view)
5. We need to train our brain to control our instincts while investing. Investing has to be a thought out and logical process and not an instinctive one. Controlling instincts is very hard, I agree, but no-one said investing is easy!

Hope you did not instinctively ignore this article, seeing its length! :-)

Cheers and happy investing!

The biases of value investors..

Value investors are considered to be a class apart. They do things differently, they have their emotions under control and they make fantastic returns over longer periods of time. We have n number of examples to substantiate the same. Listen to Buffett's interview vis-a-vis a broker or an analyst or a hedge fund manager's interview and you will agree!
On the blog, I have discussed quite a few examples of biases and mental screw-ups that investors face. (The articles can be found under the 'behavioural finance' label on the right hand side of the blog). Well, value investors are supposed to be well aware of these biases and generally avoid them. But they are humans after all and it got me thinking as to what other biases specifically affect the value guys?
My thoughts on this topic are based on observations of my own behaviour/thought process and that of others whom I consider to be value-oriented investors and with whom I interact. I agree that a specific value investor may not be prone to all the biases listed and also that there may be other biases out there affecting value investors. I would like to add that I am (and probably will be) very much a victim of some of the biases listed below. So lets try and take the mask off the value investors eh? :-D

The 'absolute cheapness' bias
Followers of Graham will especially understand what I am saying. Typically, value investors run screeners to find stocks that are quoting at absolute cheap valuations; e.g. PE ratio of less than 8 times etc. Of course, it is just a starting point, but I have rarely seen investors of this breed being comfortable with valuations of 30-40 times. Even value investors who take investing decisions exclusively based on a company's business model and not just numbers like PE ratio will flinch at the thought of a stock quoting 40 times trailing earnings. The flip side of this bias? Focus on absolute cheapness might lead to missing the bigger picture or ignoring hidden assets of a company which are currently not earning anything.

The 'under-researched stock' bias
A large number of hard core value investors I know enjoy the process (of finding an opportunity) more than the result (profit/loss). Everybody loves profit, of course! :-) But because of this inclination towards the process, lot of value oriented people are obsessed with trying to discover something new, trying to catch something that the market has not understood. There lies their 'kick'. How many value investors will try to discover value in an Infosys or a Tata Steel? As a result, value investors enjoy digging into unknown companies' ARs and trying to find value. The flip side of this bias? Such value investors will miss a 'well covered' stock, like a large-cap, which sometimes becomes a 'sitter' due to Mr.Market going bonkers!

The 'conservatism' bias
Value investors have a licence to be conservative! :-) Lots of them can be also classified as pessimists too! Of course, when a pessimistic guy finds an attractive idea and loads up on it, results can be fabulous. Of course, this wont happen very often, but thats ok! I feel 1 or 2 ideas in an year, in which you can load up is quite ok! The flip side of this bias? Lotsa opportunity losses because the 'conservative' value investor let it go; and selling the stock too early, because the 'conservative' value investor thought the stock has become 'overvalued' too early.

The 'sometimes the best thing to do is to do nothing at all' bias
I feel this is one bias behind which value investors hide when they are actually scared and afraid! It becomes nothing but a mental justification. E.g. a value investor might be actually scared that the market will fall because of debt in Europe, unemployment in US, interest rates in India, real estate in Middle East, fudged data in China and coz there are too many craters on the moon. So, he might not buy a stock he thinks is really cheap, so that he can buy it lower when the market falls! What he is actually doing is trying to time the market but the mental justification to this is 'sometimes inaction is the best action'! This is a very very dangerous bias and will surely lead to confusion, incorrect decisions and overall misery!

The 'bad management' bias
Without taking any names (for my protection), there are certain families or groups which are considered to be 'bad managements' due to their past activities and history. Now I have to mention something, which happens lotsa times: someone says that ignore this company, its a bad management. I ask why is it bad? And the answer usually is 'someone told them' or 'its generally said that they are bad'. Very few times, people give sensible reasons as to why is a particular management bad. Usually, they just 'think' that its bad, thats all! Value investors are usually ethical people and they wont want to earn money in a 'wrong' way. Well I also agree with this and while there are certain groups whose companies I wont touch, having this in-toto mindblock may sometimes lead to some really good opportunities being lost. Managements might change, new generation might take over which is radically different. Keeping an open mind (but an alert brain) helps!


The 'ignore macro stuff' bias

A lot of value investors I know take investing decisions based purely on valuations and not based on macro scenario. This has its pitfalls too. e.g. interest rates affect own discounting rates, industry scenario will change our growth assumptions. I personally am not very great at analysing macro stuff, but totally ignoring macro happenings will lead to incorrect decisions. I think that a fine line is to be maintained here as per one's inclination as well as ability to understand and analyse macro economic data.


The 'circle of competence' bias
We all have heard Buffett and Munger talk about the circle of competence n number of times. It essentially means; identify what you are good at and what you know, identify what you are not good at and what you dont know and then just stick to the former! But some lazy value investors escape taking efforts by saying that something is 'out of my circle of competence'. e.g. I give the very same answer when someone asks me about any pharma company, saying that I do not understand pharma. Now what stops me to get off my behind, read read read and understand pharma? Nothing! But I still havnt done it! So this is a good justification for my laziness right?! Btw, this also raises the debatable topic of should one be comfortable with a COC or should one go about expanding it?! This topic probably deserves an independent post! :-)

The 'we have to do things differently' bias
I have experienced some value investors having this kida and compulsion of doing things differently. They have this OCD to be different all the time. I agree that being different is a good trait of a value investor, but bring different, thinking differently and acting differently just for the heck of it doesn't make sense! The flip side of this bias? You will frustrate people you talk with and they might probably hit you on the head with something. On a serious note, such investors will make a simple straight forward decision complicated and make a mess of things!



Well there you have it! Some biases that I think value investors face. I do not claim that all of these biases are undesirable and should be avoided. Some of them are very much desirable, depending on the kind of investor you are. But what is important is to recognise these biases, identify whether a bias exists in yourself and to watch and monitor it carefully. See to it that it doesn't cloud your decision making process.

Cheers and happy (value) investing!!

Regret Aversion Bias and investing...

People exhibiting regret aversion bias avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the pain of regret associated with poor decision making.

Regret aversion bias and the decision to sell...

Investor A: Wasup buddy? Howz the market treating you?
Investor B: I am completely out of it. Sensex fell from 18000 to 16000. Same thing happened in 2008 also. I thought it will bounce back again, so I didn’t get out at that time. And I regretted it heavily.

Investor A: But weren’t you bullish when the market was 18000? So at 16000, you should be more bullish right?

Investor B: Noooo man..I don’t want 2008 repeating. Better to get out now. I will see what to do when things stabilise.

Sounds familiar? Investor B sold his holdings, not because they were overvalued, but because he had experienced huge regret when he didn’t sell in 2008 and he did not want to have the same experience again. In order to avoid regret, Investor B has taken a blanket sell decision, which is not a ‘studied’ decision and may prove to be very wrong. Then why did he take this decision?

His thought process..

Please click to enlarge

So basically, what Investor B says is that an opportunity loss is preferable to an actual loss! Hence, the decision to sell will cause him minimum regret. That’s why the decision to sell is the best decision to take. But was that the best decision? He may have sold some really undervalued stocks too, just to avoid regret!

How does it affect investors: Regret aversion bias thus makes investors take irrational and panic selling decisions, which are not well thought out.

What should one do about it: I sincerely believe that, especially, decisions to sell should be taken solely on the merits (or demerits) of that particular stock. Trying to time the market is the worst possible way to take sell decisions.

The other side of the coin.. Regret aversion bias and the decision to buy

Scenario 1: You are looking to buy a stock. You bought it, but after buying it, suppose the price goes down. Will you regret your decision to buy?

Scenario 2: You are looking to buy a stock. But you decide not to buy it, and after that, the price goes up. Will you regret your decision not to buy?

Of course, you will experience regret in both scenarios. The question is, in which scenario will you experience more regret? Sooo, given a choice, which scenario will you prefer? Majority of us will prefer scenario 2 (come-on, be honest!), where there is no actual loss, hence lesser regret!

How does this affect investors: on this side of the coin, regret aversion bias makes investors numb. When the market falls and stock prices are going down, this bias stops investors from buying and lapping up the undervalued stocks, for fear that they may fall further! When the time comes to be aggressive, regret aversion sets in and causes indecisiveness in investors.

So what to do?

I too get affected by this bias and coupled with my ‘conservative’ (a.k.a. fattu) attitude, I incur lotssss of opportunity losses. But typically, here is what I do..

• Do not think about results of past actions while taking present decisions.
•  Study each company you are looking at very well. If possible, write down your reasons for buying/selling or not buying/not selling on a piece of paper. When you write things down, your mind will not cook up excuses later!
• Concentrate on the particular stock/company and ignore overall sentiment. If you think its undervalued, then buy. Period. If you think its crazily undervalued, then buy like crazy! Sureeee, the stock may (rather, will) go down after you buy. Accept it and make peace with it. Your portfolio will not show positive returns every day. So don’t be afraid to see paper losses, if your study has been in depth and you have the conviction.

The market gives us opportunities all the time. In bullish times, opportunities to sell are more than those to buy.. and vice versa during bearish times. Take advantage of these opportunities and be at peace!!

Cheers and happy investing...

P.S. For those of you writing in to know my views on 'where the market will go', please refer to this post.

Sugar Sector and Mind-maps!!!

Hello and happy AGM season to all!
Sometimes, it so happens that while taking an investment decision, one's thought process becomes more important than fundamental analysis, ratio analysis, etc etc.. (Most of the times, its because one is unable/incapable to do fundamental analysis, etc!!!)

For example, consider me and the sugar sector!! We just don't get along! I hate the sugar sector from the bottom of my bottom! I just cannot make any estimation or take a view on the future of the sector. Here's why..
- The price of raw material (sugarcane) is controlled by the Government.
- The price of the finished product (some of it) is controlled by the Government.
- Imports/exports can also be controlled by the Government.
- Government people aren't very rational lotsa times. One cannot even guess what they can do!!
- Soooo, what can happen to the sugar sector in between all this mess is anybody's guess.

However, it so happens that if one plays a commodity cycle (like sugar) right, the returns can be HUGE. Soooo now, we have a situation, where there could be an attractive opportunity, but we have absolutely no idea how to analyse it fundamentally, etc.

So here is where something called as mind-maps come in. When you want to arrive at a decision using a very structured thought process, mind-maps come in very handy. They are a flowchart kinda thing, where a logical flow of thoughts helps you arrive at a decision.

So I scribbled up a mind-map relating to something in the sugar sector, coz I had nothing better to do at the time! :-D Here it is...

Please click to enlarge

Some more points regarding the same:

• One can totally ignore the sector as such.. No harm in doing that at all. There is no compulsion. Huge number of other (but not comparable) opportunities are available out there.
• If one opts to go this way, one would be holding on to the stock for 2-3 years without having the faintest idea why!!! So it can get very very uncomfortable. 
• If one wants to take an exposure to the sector, one may also want to do a basket approach. Buy Balrampur, buy Renuka and also buy the worst company in the sector! 

Now for some idea killers (a.k.a. why all of the above sucks!)

• Extended sugar cycle depression: You could have a situation where you are stuck in the position for a long looooong time without any decent returns. 
• Capital allocation: How much of your portfolio can one allocate to such a kind of position? Basically, you are taking a position without much 'actual' thought, right?
• Probable opportunity losses: Once capital gets allocated there, one may have to suffer the heartburn of suffering opportunity losses, at least for some time.
• Irrational decision making down the line: If one cannot control emotions here, there can be some irrational decision making one can get into. It wont be comfortable holding positions like this...
• When to sell? While taking the position, one has no idea about the 'value' of the company. So one will have no idea at what price it becomes overvalued, at what price to sell, etc. So it could cause real confusion later..

Anyways, it could very well be the case that you do not agree with me at all. And that's absolutely ok. We are different people, we will have different opinions! Investing is extremely relative. But even if you don't agree with this way of getting into the sugar sector, at least do give a thought to the concept of 'mind-maps'. Its a great way of taking decisions.

Cheers and happy investing!!

The 'Value' Mindblock

Each of us have got different views, different opinions and different mindsets when it comes to investing. Some of us like to 'play' in stocks, some like to get into under-researched stocks with good businesses and some are content investing in 'bluechips'.
However, as investors, each and every one of us should properly understand one thing; what do we properly understand?! We should know our circle of competence/our comfort zone and invest accordingly. This will ensure not only decent returns, but also a good night's sleep.
This brings us to the topic of the post - a mindblock that 'value' investors face. The value gang typically goes for stocks that are cheap vis-a-vis their future potential and which also offer a decent margin of safety in case things go a bit wrong. Personally, I also look for a 'trigger' which will help the discovery of value in such stocks. Otherwise, such stocks will remain perennially cheap. (Look at Ultramarine Pigments for example).
In this entire exercise of investing, I often face a certain mindblock. Let me tell you about it with an example. Look at the following companies.

The companies I have illustrated are all established, proven and robust businesses. They are not concept stocks like, lets say, Zee Learning or Delta Corp, which have interesting business, but have yet to 'prove' themselves.
Now the question is, will I buy any of the above companies at present market caps? The point is, I just cant!!! Why not? The valuations!! Look at just the PE Ratio to begin with. Such high PE Ratios tell us that Mr.Market expects a lot of growth from these companies in future (As the companies have delivered in the recent past). Mr.Market also likes the business models which could actually deliver the growth expected of them. And yes, these companies really could deliver.
My problem with such stocks is that there is no margin of safety for black-swan/unforseen events. The valuations already discount a high future growth. And as long as the growth comes in, the valuations continue to be high. But what if for some damn reason, the growth does not come in. What would happen to the valuations (and effectively the stock price) then?
Lets take Jubilant Food for example. Personally, I thought that it was expensive at 400 bucks. I thought the same when it became 500, then 600, 700 and now 800!!! Jubilant Food has been nicely growing for the past coupla years. They have recently expanded their products portfolio, which could help sustain and increase future growth. The valuations therefore continue to be high and the stock will give returns as long as the growth sustains.
The question is, what will happen to the valuations of such stocks, if the expected growth does not sustain or some unforeseen event screws up the basic business model? Crash in the stock price is an understatement.

There comes the mindblock:

• Should one buy into such 'high growth' stories, paying through the nose for the growth? Or
• Let them be and suffer opportunity losses (like I suffer all the time). Invest in the 'cheap' cheap stories and stick to what you understand and are comfortable with.

Views invited...

Cheers and happy investing!

Representativeness Heuristic and Delisting...

I have been following various delisting cases for quite some time now. Over the last few weeks, the market has taken a fancy to this theme, forcing me to take a step back. (One shouldn't do what the crowd does!) Anyways, I couldn't help but notice a high degree of 'representativeness heuristic' in the events of the past few weeks, hence this post...

What is representativeness heuristic?

A representativeness heuristic is a bias in which an individual categorises a situation based on a pattern of previous experiences or beliefs about the scenario.
Umm, if that was a bit heavy, visualise this:
You see a person on the road. He is wearing a starched extra-white shirt (shirt not tucked in). He has an expensive cellfone is his hand. There is a very visible thick gold chain in his neck and an equally thick gold bracelet in his wrist. He is also wearing numerous bejeweled gold rings in his fingers and has a big tika on his forehead. Got the picture in mind? Well, if you suck at visualising stuff, its someone like this:

Now I ask you; What do you think does a person like this do?
a) Software Engineer
b) A local neta of a political party

Chances are, you will choose option b. (Btw, the person in the photo is actually an MLA from Pune)
Now is it a rule that a software engineer cannot dress like this? No! Still, we associate someone like this with a politician, based on our past observations and experience. This is representativeness heuristic. But, its not necessary that our conclusion, based on past observations, may be correct everytime..



Representative heuristic and the market

One can see this phenomenon happening in the market a lot of times. Some examples:

• Tata Steel declares phenomenal quarterly results and on that day, all steel stocks prices hit the roof. (just an example, but it happens in a lot of sectors)
• IIP numbers show consumer durables sector doing well and all consumer durable stocks go up on that day. (has happened recently)
• Rubber prices come down for a brief period and all tyre stocks go up. 

Now, it should be noted that in this phenomenon, all related stocks go up, including the ones which do not deserve to! One can see the representativeness bias in the market on numerous occasions..

Representative heuristic and delisting

Finally! Coming to the point!

In Feb 2011, Altas Copco announced its intention to delist. What followed was very surprising and quite rare in the Indian market.. The promoters were fair and generous to the minority shareholders! ;-) They gave an excellent exit price to the minority. (Also, hats off to JM Financial guys for managing this delisting beautifully!)

Now this is where the representativeness bias has creeped in, imho..

The market seems to think that 

1) Just like Copco, all MNCs will be fair and generous to the minority.

2) Hence it makes sense to buy all these delisting stories and make a killing!

If you think that this is not what the market thinks, look at the price movement in such stocks, after Copco's delisting succeeded..

Data sourced from Edelweiss Website. In some cases, the
calculation seems inaccurate. Anyways, I am not interested
in strict numbers, but in what they represent.

As can be seen, after Copco's generous-hence-successful delisting, the other delisting candidates have shot up, outperforming the index. This is indeed representative bias..

So what do we do about it?

1. It could very well be the case that what the market thinks is right and the MNC parents of these delisting candidates will be as generous as Atlas Copco. However, it is not necessary! Just because Atlas Copco was generous does not mean everybody will be equally generous. 
2. One should adopt a logical approach towards analysing delisting cases and not be swayed or affected by biases. Dont take things for granted! More on playing delisting cases here.

Cheers and happy investing!

Killing your own idea!

WHAT AN IDEA, SIRJEE!!!

Yes, this post is about investing. I am not going to talk about how great Abhishek Bacchan was in Yuva or how baaaaad he was in Tera Jadoo Chal Gaya.. (Didnt see the movie, the trailers were enough to scare me off!)

Anyway, lets come back to the point before I start talking about Drona and frustrate you all!!  :-)

"Killing your own idea" is a concept that can save an investor's "synonym for donkey" time and again. Imho, any and every investor should understand this concept and try to apply it as much as possible. Lets see what it is all about...

The concept

The concept is pretty simple and common sensical. Basically try finding fault with any stock idea that you get. If you think something is good to invest in, try and find out as many reasons as you can, to come to a conclusion that it is not good to invest in. Try and kill your own idea as much as possible.

The process

The process is much more difficult than the concept. e.g. If someone asked you to describe yourself, how many negative points will you put forth? Similarly, when we like a particular investment idea, our mind automatically and subconsciously starts weeding out or justifying negative points associated with the idea. To counter this is extremely difficult, yet extremely important. (I also am not fully there yet). The first thing to do is to mentally disconnect yourself from the stock idea and look at it afresh. Be as skeptical and negative as possible. Best thing to do is, try and write down, point-wise, why that particular idea would be a terrible investment. You will, of course, be in denial first and will try to avoid and justify the worst things about the idea. But its a process and you will surely get there slowly. In the mean-time, what you can do is, ask a friend of yours, who hasnt seen the stock, to point out bad points about it. That should surely help.

The utility

Has this ever happened to you: you bought a stock after studying it properly. Few months down the line, some event unfolded which hit the company and the price sank. And you thought ' Oooo why didnt I think of that???' This happens to all of us a lot of times. We miss out some key point or factor, which seems obvious in hindsight a few months later. This happens because we have not taken a 360-degree view, we have not considered the negatives, we have not killed our own idea..

An example...

One idea I mercilessly killed recently was that of Gujarat Reclaim. Now, this idea seems actionable to a lot of respectable investors I know. But to each his own!
A bit about Gujarat Reclaim:

• Essentially, the company recycles waste rubber. With rubber prices hitting the roof, the prospects of the company seem bright. Its the largest company in its sector in India.
• I really liked the management of the company. They are very conservative, they have grown well, the books seem clean and the way the management talks makes me very comfortable. They also know their business and have been working continuously on technology.
• Gujarat Reclaim has established numerous collection centers and agents, which supply the necessary waste rubber (essentially waste tyres) for recycling. (can be thought of as an entry barrier)
• The company has also announced an expansion plan recently. All details can be found in the annual report.
• The valuations are not very expensive. Market cap of about Rs.125 cr, 10 times trailing, 2% dividend yield, manageable debt on books, 18%+ operating margin.

So what killed the idea?

The above table shows the rupees per ton cost of rubber scrap and chemicals (raw materials) and the per ton selling price of reclaimed rubber (finished product) for various years. The last column shows the raw mat consumption as % of sales. It can be seen that while the rubber scrap prices have gone up 70% since 2005, the selling price of reclaimed rubber has gone up only 40%. Meaning, that the company has not been able to pass on hikes in raw material prices. There seems to be no pricing power. So will this situation worsen as rubber prices go up? (Since scrap rubber prices also go up). So, will this company benefit due to increase in rubber prices or will it be hit because of the same? Something to think about! (Btw, for the December 10 quarter, raw mat consumption to sales stood at 46.67%.)

I really like the company, but the valuations do not seem to reflect the above. They are not 'sitter' valuations. I will wait for the stock to correct, if at all, and then take a decent position in the same.

Cheers and happy investing!!

Bring out the animal in you!!

If one looks hard enough, one can see 'investing' all around. One can learn something or the other about investing from virtually all aspects of life.
A good investor needs to possess some qualities. A lot of these are 'in-built', others can be learnt.
In this post, an effort has been made to compare certain qualities of a good investor with those possessed by various members of the animal kingdom!! (If you think I am going bonkers, I wouldn't blame you! But still, do read on.)

Please note that:

• All investors may not possess all the qualities mentioned and honestly, its not necessary too.
• What is most important is that the investor displays the right quality at the right time. (not all the time)
• Some of the qualities mentioned are mutually exclusive.
• Please don't take everything in this post 'literally'.

Sloth - Inactivity

The first one on our list is the Sloth. This tropical rain-forest mammal is an amazing creature. It moves at a top speed of 0.15 mph! 'Sloth' also happens to be one of the seven deadly sins, denoting extreme apathy and inactivity.

In today's 'investing' world, where one is constantly pounded with information, where the need to do something all the time is all-pervasive, where inactivity is unheard of, investors can surely take a cue from the good old Sloth. A lot of times, the best thing to do is to do nothing at all! 

As Warren Buffett quotes "Lethargy, bordering on sloth, should remain the cornerstone of an investment style."

Of course, one should not be a sloth all the time. Inactivity is most called for when one can see frenzied activity all around. In short, be a Sloth selectively. :-)

Honey Badger - Fearlessness

Just a few months ago, the indices were at record lows. Valuations in a lot of companies were tempting, to say the least. There were even some well established companies with market cap less than cash on books! But how many of us bought big? Very few. Why? Afraid that the overall stock prices will tank further? 

Well in that case, one can learn a lot from this mean little guy, the Honey Badger. The Honey Badger has been entered in the Guinness Book of World Record as being the world's most fearless animal. About the size of a house-cat, a Honey Badger in a bad mood will attack almost anything that moves. One can find youtube videos of Honey Badgers attacking leopards and lions!

Again, if done inappropriately, this attitude is plain stupid. But one should certainly be fearless specially at times when everyone around is afraid.

Mama Turtle - Emotional Detachment

The female turtle is probably one of the most emotionally detached dudette ever. She comes ashore, lays its eggs and just leaves. She neither cares for the eggs nor for the new-born. They are left to fend for themselves!!

Now i agree this is totally extreme! The only thing we should take from this is emotional detachment.. in this case, towards stocks, not children! A lot of times, for a variety of illogical reasons, investors become emotionally attached to stocks and don't sell them even at ridiculous valuations. Other way round, investors don't buy 'sitters' due to certain mind-blocks or biases. (happens with me too) Emotions often cloud logic and reason. One should not be emotional while investing. So, while emotions may play the central part in other walks of life, in investing, the lesser their involvement, the better.

House Lizard - Cut Your Loss!

The common house-lizard (chipkali) will cause most of the female readers to scream with disgust. But there is something to be learnt from this velvety creature too. :-) When faced with danger, the lizard detaches its tail, which keeps on wriggling on its own. As the predator gets distracted by the wriggling tail, the tail-less lizard makes good its escape. Better to lose a tail, than to lose its life, right? The tail will grow back.
In investing too, sometimes, we need to lose our tail. (not literally of course!). E.g. When we realise that buying a particular stock was a wrong decision and its now quoting at a small loss, we should sell it off immediately without waiting for it to come 'cost-to-cost'. A small loss due to an incorrect decision is perfectly acceptable than losing a big chunk and peace of mind.


Hyena - Opportunistic

This rather repulsive looking creature is a super opportunist! Hyenas are opportunistic feeders and have a keen sense of judgement and risk. They typically trail the bigger cats and feed off the leftovers of their kill.
Similarly, in investing, one should be on the prowl for opportunities where the risk-reward ratio is in one's favour. Special situations (mergers, demergers, acquisitions, takeovers, slump-sale, etc), rights issues and warrants are prime opportunities available for opportunistic investors and decent money can be intelligently made in them. One needs to keep one's eyes and ears open for such opportunities always.


Cat - Curiosity

"Curiosity killed the cat"..so goes an idiom. Well, we aren't planning to do any killing here, don't worry. Cats, by nature are extremely curious. You can play with a cat for hours and it will still want more. They like to explore, try new stuff and often get into trouble.
I believe that an investor also should be just as curious. Curious with regard to companies, their products, the nitty-gritties involved. Curious with regard to learning new stuff, appreciating new techniques and always wanting more. The day one's curiosity ends is the day learning stops. And in investing, one should continue to learn all the time. So a big MEOW to all..


Sheep - Humility

I also do not know why, but sheep look so very humble, don't they? Well, at least to me, they do! (dunno if they are really so) The stock market is a place where humility is rare. People often claim to be far more than they are or something they are not! Successes are trumpeted and failures are quietly swept under the carpet. A lot of people think they are the best, much better than everyone else! In such scenario, a healthy dose of humility is an absolute must. One should never think of oneself as the greatest investor on planet earth. The market shows such people their rightful place soon enough.


Crab Spider - Patience

This cute looking fella is the Crab Spider. The most curious feature of the Crab Spider is that it does not weave webs. It does not go hunting after insects too. It sits still patiently, allowing the prey to come within striking range. It can sit still for long periods of time waiting patiently for the next yummy meal.
Now thats patience. Waiting and waiting for the right opportunity to come by. Today, patience is totally lacking in the overall investment community. The definition of 'long term' has become very flexible. In such a scenario, one cannot help but admire the Spider Crab! :-)


Black Panther - Solitude

This fabulous looking creature, the black panther (leopard) lives alone its entire adult life, except during mating. (Hmmmm)
Anyways, relating this to investing, as my good friend Dnyanesh says 'investing is a lonely profession'. I completely agree (although loneliness and solitude are vastly different concepts). As individuals, we are different in all respects. Our investment ideas and processes are equally different. Our decisions are also, in a way, unique. Getting together in groups and discussing investments will only lead to confirmatory biases taking over. Buffett has also strongly advocated the limited use of committee-style investing for getting extra-ordinary returns. Taking cue from the black panther, one should 'hunt' alone. (Also, the idea of the lone hunter/lone ranger sounds so Hollywoodishly cool!)


Dolphin - Have Fun

Dolphins are synonymous with fun. Have you ever seen a sad dolphin?! Even when they are working (a.k.a hunting), they jump around and seem to have a good time.
Similarly, if one is not having fun in one's work, that work is not worth doing, imho. Investing is tremendous fun. (at least I think so) So enjoy, have a good time and make good money. If your investing activity is synonymous with ulcers, blood pressure, tension and sleepless nights, believe me, its just not worth it. Having fun will make you a better investor and a better human. :-)


Well, there you have it. Some of the key qualities of good investors that one can observe in nature. (I am not at all claiming that the above list is exhaustive).
I love to co-relate multiple disciplines and different streams of study and knowledge with investing. It gives one a fresh approach and perspective. If you also liked what you just read (hope you are still awake), then do read this book. Its mind-blowing and a trillion times better than what you just read.
Would love to hear your comments..

Cheers and happy hunting!!!

An interesting (and profitable) experiment..

As I had mentioned in my introductory post, as a hobby, I teach in 3 B-Schools in Pune as a visiting faculty. Besides the regular syllabus, I discuss lots about psychology, investor behaviour etc in class. Sometimes, I also conduct certain experiments where my poor students become the guinea-pigs! (evil smile)

I recently conducted an experiment in Behavioural Finance which i had adapted from one of the many books i read on the subject. The results were pretty interesting!

I started by telling the students that I am going to sell them a Rs.50 note. The concept of 'buying money' itself was a bit hard to digest for some, but what the hell. I also told them that this note was signed by a very famous personality and they could get at least Rs.1000 if they sold that autograph. (This was a mere distraction; the note was signed by just me, but I refused to tell them whose sign it was!!) Almost everyone started fixating on whose signature it might be.

Then I asked them how much would they pay for it. Most of the students quoted an amount up to Rs.50. Some dare-devils also quoted beyond 50. I asked them if they would be ready to buy this Rs.50 note for Rs.5. Everyone said yes. So I said lets have an auction. The auction had the following rules;

1. The bids would start at Rs.5 and in multiples of Rs.5 thereafter.
2. A person can talk only to place the bid during the auction and for no other reason. (So that no-one influences others)
3. The highest bidder wins the auction and gets the Rs.50 note.
4. The second highest bidder (runner-up) has to pay me an amount equivalent to his bid. (This was the critical condition which no-one really understood. They were all busy thinking about the signature!)

Well, the auction started at Rs.5 and rapidly went up to Rs.45. Almost everyone was interested in bidding. I now told them that the signature was mine and the Rs.50 note was worth Rs.50 only! Then the fun started. (Evil smile again)

• One chap bid Rs.50 for the note. (After all, it was Rs.50 for a Rs.50 note..no-profit-no-loss right?)
• Then i told the Rs.45 bidder that if he loses, he needs to pay me Rs.45 as per the rules. So, in order to avoid the loss, he needed to win. Naturally he bid Rs.55.
• Then I came back to the Rs.50 bidder and told him the same thing. He too placed a higher bid at Rs.60 in order to avoid loss. 
• None of them could afford to be a runner-up, otherwise they would have to pay me the amount of their bid. The bidding frenzy continued unabated.
• In a matter of minutes, the bidding had reached Rs.210!!! It was then that I had to decide to stop the auction. 
• Well, the chap who had bid Rs.210 won the Rs.50 note. And the runner-up who had bid Rs.205 had to give me Rs.205. In effect, I sold a Rs.50 note for Rs.(210+205) = Rs.415! Sweeeet!

We all have observed similar things happening to us during investing in the stock market. So what are the lessons we can learn from this exercise;

• One should become a teacher and swindle unsuspecting students. Its quite profitable. (Ok ok, thats not a lesson to be learnt. In fact, I gave them all chocolates out of the money I collected from them!!)
• We all fixate and concentrate on un-important stuff and become blind to the obvious. Just like everyone fixated on the signature on the note so much that they failed to carefully consider the trick condition of the auction! While investing, we must give due importance to all parameters and conditions and not get excited or influenced by some single attractive parameter. We wouldn't want to miss out on something important, would we? 
• We are extremely loss-averse: Our brains are wired in such a fashion that we will do anything to avoid losses. Its a natural human tendency. In the experiment, everyone started with the objective of earning profits, but ended up trying to avoid losses!! The loss aversion of humans plays out well. We have to learn that there is no need to pay more than Rs.50, for something which is worth Rs.50. This was a losers' auction and those who participated were destined to lose. Similarly, in stocks, if one has made a mistake, then one should get out immediately upon recognising it, irrespective of the loss.

Emotions and thought patterns are truly wonderful (or harmful) and it is fascinating to study them. We just had an introduction to some concepts of behavioural finance and i intend to post separately on each topic.

Hope you all enjoyed this one. (Including any students of mine who are reading this!)

Cheers and happy investing!!

Hindsight Bias - Don't Watch Your Behind Too Much!

Things are so obvious. Its obvious that valuations in late 2007 were crazy. It was a bubble for sure and one just had to sell at that point. 
Its also obvious that valuations in early 2009 were equally crazy. One just had to buy at that point. 
These market tops and bottoms are so obvious. One really wonders why most of the market participants didn't act on it...
Well!! If investing was so easy, there would be no other profession! :-) All these facts I mentioned above are obvious today. They were not so obvious at that time. In fact, everything that has happened in the past (not just in investing) seems pretty much obvious when we think of it at present. We sometimes lament at obvious mistakes made in the past, or sometimes justify them, so that we don't have to lament! Think about it, isn't that right? This is the basic funda of the concept of 'hindsight bias'.
Wikipedia defines hindsight bias as 'inclination to see events that have occurred as more predictable than they in fact were before they took place.' Boy, thats one big sentence. In essence hindsight bias is the phenomenon where we look at events in the past, and  convince ourselves that we knew they were going to happen and were prepared for it. While in fact, we just weren't. 


I like parties. Parties are fun and can be useful too. If I get surrounded by people talking about stocks and offering me tips, its probably time to sell, whereas if everyone is avoiding me, its probably time to buy. (Well, to be honest, I go to parties for the booze, not to take buy/sell decisions!). Anyway, the following is a very common conversation, which happened last year. We all must have heard such stuff at parties and social gatherings.


Mr.A: Boss, bazaar dekha? Its gone real bad man..Sensex below 10000!
Mr.B: Of course, what did you expect yaar? You really believed in the 'India shining story' and all? It was so obvious that the crash was going to happen. In fact, I had told my friend Mr.C in December 2007 itself, that dude, sell off. We can't sustain these crazy levels. And see what happened..
Sounds familiar? Such dialogues like 'maine bola tha', 'I had told you that time only', etc are extremely common, specially in equity investing. 
Unfortunately, since I am also part of the conversation, I ask Mr.B: Sirjee, since you knew of the crash so confidently before it happened, did you sell your stocks? Or better still, did you go short on the index? I am sure you must have earned a truck-load of money. 2008 must have been the best year of your life!
Mr.B: Umm, wellll actually I did not sell my stocks. Umm, you see I am a long term investor. The losses at present are just 'paper losses' and i am sure that the prices of my stocks will rise a lot again. So its quite ok since I think long term.
Me: Well, to quote Keynes; 'in the long run, we are all dead!'
Mr.B laughs awkwardly and drifts away. Thank god!
This is a great example of how we think about past events at present. About how we justify our past actions to convince ourselves that we were right.
Another good example is that of technical analysts on TV. Now i do not have any disrespect towards any person. Neither am i saying that technical analysis does not work. It may work for some people. I am not one of those. 
This is what is typically said in the morning, before the market opens:

Nifty closed at 5155 yesterday. We remain cautiously optimistic (my favourite market term) on the market. On the higher side, nifty would face resistance at 5182. If that resistance is overcome, nifty could shoot up to 5200, which would be a major resistance. Beyond 5200, nifty would face resistance at 5215 and at 5032. On the lower side, support is seen at 5140. If this support is broken, a very strong support is seen at 5120, below which nifty has a support at 5100. In case 5100 is broken, nifty could free-fall to 5075. We would see strong support coming in at 5060.’

WHAT EXACTLY SHOULD ONE INFER FROM THIS?


Anyway, in the evening, after the market is over, the following is said:
As expected, nifty made an upmove to reach 5182 levels. Overcoming this resistance, it shot up to 5210, beyond which profit-booking set in. Nifty fell to 5150, which acted as a major support, but in the end-of-the-day’s trade, the bears took the nifty down to the support of 5120, to close at 5125.
Perfect post-event analysis, which is essentially not value-adding. Technical analysts are a great example of hindsight bias. (Again, no disrespect meant, these are just the facts)
In the market, everyone has an opinion and everyone is expert at analysing things beautifully after they happen. And everyone has that goody goody mushy mushy feeling that we knew it all along. Well it ain't so!
Now that we know that, maybe unknowingly, we can get exposed to hindsight bias, lets see what damage it can do to an investor;

1. We don't learn from our mistakes: One of the biggest aspects of investing is learning from mistakes, so that they are not repeated. But those affected by hindsight bias think that they never make a mistake! So the learning gets stunted. Not a good position to be in..
2. Gives a false sense of security: Investors affected with hindsight bias think that they have successfully predicted and knew all the happenings in the market. Hence, they remain blissfully confident that they will be able to do this in future too. In reality, this might not happen and can lead to significant losses.

So now that we know about this phenomenon, maybe next time, we'll all introspect before we claim to have predicted something that has already happened before it had happened. 

To avoid being affected by hindsight bias, we must all be honest, introspect, acknowledge our mistakes sportingly and let bygones be bygones.

Cheers and happy investing!

P.S. My apologies for the cheesy title.. :-)

Analyst Bias

"Research Analyst"... Probably the best profession in the world! Here's why:

1. Unlike other professionals like Doctor, Lawyer, etc., one does not need any specific qualification to become a research analyst.
2. There is virtually no penalty/answerability for going wrong (or even horrendously wrong). Think about it. (Of course, an analyst will be answerable to his boss, who can go wrong himself! :-) )
3. The analyst gets to blame others all the time. E.g. If a company does not declare results as per the analyst's 'projections', the analyst gets to say that the company has 'underperformed'. Arey!! How can the company ' underperform'? Isn't it the analyst who has 'underperformed', who has not made correct and logical assumptions to arrive at forward numbers? But no! Its always the company and its management who underperform! Sweet! :-)

Research analysts are known to have gone phenomenally wrong (and occasionally, phenomenally right) on the investment advice they dole out. Of course, there exists a big conflict of interest, since most of the analysts are employed by brokers. So the basic objective of their research is to generate brokerage for their employer, and not necessarily the welfare of investors! ;-)

Anyways, enough with the pointless analyst-bashing, partly because i am an analyst myself!
The purpose of the post is to discuss the phenomenon called 'analyst bias'. Now, this affects all investors and not just analysts. So it makes sense to know about it..

Let us see how an analyst should make a recommendation, logically. After that. we shall see how an analyst who is affected by 'analyst bias' makes the recommendation. Damodaran has written on this concept in his books.

The logical thought process of a research analyst:

Now, lets look at the thought process of an analyst affected by 'analyst bias':

As one can see, the entire thought process of an 'affected' analyst gets inverted. Instead of starting with research and ending with an opinion, the analyst has started with an opinion and follows it up with research!

I do not mean to demean analysts per say. Unfortunately, even though this affects all investors, the phenomenon is called as 'analyst bias'. Think about it..how many times have we bought stocks, just because someone gave us a 'tip'? And afterwards, we end up rationalising our decision one way or another.

So how to escape and guard against analyst bias? One very logical approach is to do original research, filter away the noise and ignore 'tips'. Another way is...

Remember this handsome gentleman? For those of you who are not into movies as much as i am, this is the character 'two-face' from Batman: The Dark Knight. He can provide us with an answer to our problem!

Don't get me wrong. I am not asking you to become disfigured, yet cool! :-) What we need to learn from this is about having a bit of 'split personality'.

What if we do this.. For any company that we think is a 'buy', we prepare a 'sell' report on it! I agree that this is extremely difficult, given our natural thinking patterns and biases. It takes time. So the next best thing is to ask someone (some friend, maybe) to give as many 'sell' points for the company as possible. This would help us come across points and arguments, that we might have unknowingly ignored, since we considered the stock a 'buy'. This would help broaden our view and take better and informed decisions.

So there is a lot more to movies than just entertainment after all!! Psychology and behavioural finance are absolutely fascinating and i intend to post more on these topics. Hope you will enjoy them as much as i do.

cheers and happy investing!!