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I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (hereand here).

Poor charlie’s almanac
Thinking fast and slow
The psychology of influence
The art of thinking clearly
Seeing what others don’t : The remarkable ways we gain insight

Lets explore a few more baises and how one can avoid them

Sunk cost fallacy
This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted,  then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.

I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.

Story bias
Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.

How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.

Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.

In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.

One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?

What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.

No silver bullets
We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

I personally think that being rational is extremely important in becoming an above average investor. So how does one become more rational?

The first step in reducing the irrationality is to name and classify the various behaviors which impact us negatively as investors. I started exploring the various biases which affect us in the previous post and will continue with a few more in this post.

I have personally avoided this bias in the above form by having a simple thumb rule – TV presenters are actors and should be watched for entertainment alone. As far as brokers and sales people are concerned, I refuse to listen to them.
The above comments may imply that I am immune to this bias – but I am not. I follow a few other bloggers and top investors. In the past, if one of them was invested in a stock, I would develop a much more positive view of the stock and even went ahead and invested in the same.

Case in point – Warren buffett talks of the buy and hold philosophy. A lot of people miss out that they he does not imply buy and forget and certainly not buy and hold bad companies. The pre-requisite condition is that one should buy a good company at an attractive price and then hold it for a long time. I have bought duds and then held it for some time, thus compounding my mistake.

First conclusion bias
This is a very common bias and we know it by another name – First impressions. We tend to form opinions of other people in the first few seconds of meeting them and then any interaction tends to re-inforce the impression. This bias has a lot of implication in job interviews, but that is a separate topic.

How does one avoid it ? For starters, I look at a company and form a view (even if subconscious) and then just drop further analysis. I make a note of the company and then move on to something else – allowing for a cooling period. I will usually come back to it after a few days and then read up on it further – making notes as I go along.

The next post will the final one on this topic and I will explore a few more biases and discuss how it is important to build routines in your investment process to reduce their impact.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

I have been reading a few behavioral finance books on the various biases which impact us as investors (and in other walks of life too). I have picked up this topic of study for a very specific reason.

The above statement would imply that I was an expert by year 5 and poised to be a good investor. Unfortunately the reality was far from that – you can read my journey till 2008 here. Knowing what to do is different from doing it.

Social proof

Although I was new to investing (around 3-4 years), I understood the importance of valuation and of not overpaying for stocks. Inspite of being cautious for the majority of my portfolio, I still went ahead and committed 25% of it to IT related stocks. As I look back, I recall that the main reason was that a few of my friends were investing heavily in this sector (and getting rich). In addition to this, a nice and pretty broker also recommended a few hot mutual funds (such as ICICI technology fund) which were sure to make me rich in a few years.

I managed to lose 80% of my capital in a short period of six months. This was unmistakable evidence that I had made a spectacularly wrong decision. Ever since then, I have followed a few simple rules to avoid getting influenced by the crowd
– Do not buy hot stocks. If the media is talking a lot about some hot sector or all my friends are getting into it, I will just avoid it. As a result I did not touch the real estate and infrastructure stocks during the 2007-2008 period and spared myself of a lot of agony
– Do not take stock tips from anyone, especially pretty girls J

Anchoring bias

This is a bias wherein one gets fixated on a variable in the decision making process and uses that to make all subsequent decision. This is a difficult bias to recognize and overcome.

I had been following Crompton greaves limited for some time and decided to buy the stock in 2011 after the company reported poor results in the first quarter. The stock dropped quite a bit after that and I started purchasing the stock as it ‘appeared’ cheaper compared to the past results.

In the case of stocks, investor returns are dependent on future performance, but the data to evaluate that comes from past performance. It is an art, more than science, to evaluate the past results and arrive at an appropriate conclusion. In the case of Crompton, I got anchored to the price and the past fundamentals and did not weigh the state of the industry and management issues more heavily.

How should one avoid this bias? Once you have purchased the stock, it is very difficult to avoid the anchor of the purchase price and past performance. The best approach I know of is to be aware of this bias and constantly question your reason for holding a stock.

This is a tendency to be consistent with one’s behavior in the past. It is a good way to behave in life – if you have been a decent and honest person once, you want to continue and be committed to that behavior.

Look at any stock boards – majority of the investors are talking about the positives of the company. If you are already invested in the company, does it make sense to find any additional information which just confirms your belief? How will that benefit your decision?

The approach I take now is to rank all the companies in my portfolio in a descending order of attractiveness. This forces me evaluate more idea more objectively. Once I have my rank, I compare any new idea with the last idea in the list. If the new idea is better than the last one on the list, it gets replaced.

I plan to cover additional biases such as the authority bias, availability bias and more in the subsequent posts.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

‘Only when the tide goes out do you discover who’s been swimming naked ‘– Warren Buffett.

Now the tide (liquidity and enthusiasm) has gone out and the visible symptom of years of mis-management is the crash of the rupee. I am extremely pessimistic about the macro picture and the ability of our political system to fix it.

No, I am not blind to the risks and as depressed about the country as any other Indian. Let me explain my reasoning behind this apparently contradictory stance.

So if you have some capital (equity, real estate, cash  or FD) with you, what are the options for it ?

The second option is real estate. I have been pessimistic about real estate for a long time and with low gross yields of 2-3%, think it is overvalued. However if one has the skill to find some undervalued property and can hold on to an illiquid investment for some time, then this could be a possible option. At the same time, if you are thinking of using a loan  to finance it – forget about it. If the currency rate continues to depreciate, we may see a further rise in interest rates (which has already started) and the loan which you are planning (or already have), may become even more expensive.

I know that readers of this blog already know where I am going with this logic – equities. But before I get there, let me digress a bit.

The last option, which seems to be the most risky is equities. The reason it appears to be risky is due to the vividness of the risk. If you own a stock and inflation rises, the impact is visible immediately. On the other hand, options such as cash or real estate seem to be safe as we do not get a quote on it daily. However that is just a false sense of safety as the real value is eroding silently. A fixed deposit or debt instrument in the last five years has lost value due to inflation and so has real estate (if it has not appreciated by more than 12% per annum).

One can easily point out that equities are no better as the index has dropped in the last five years and hence the loss is even higher in real terms. That is true if you have been invested in the index for the last few years. At the same time, there are several companies such cera sanitaryware or crisil which have done quite well during the same period.

Let’s look at the same point mathematically – If you are able to buy a company, which is earning around 20% return on capital (and can do so for the next 3-4 years), one is likely to double his money in this period (unless the economy implodes completely) if the valuation remains the same. Finding such a company is not easy, but if the market keeps dropping, one is likely to find good companies at attractive prices

– You have some amount of skill in finding good companies. Investing blindly worked only from 2003-2008.

– You don’t need the money in the next five years. If you are retired or need money in the near term, please don’t think of putting it in the stock market.

I keep a wish list of stocks – these are companies which I would like to buy, but the price was never attractive in the past. One such company was crisil, which I bought in 2008 and have held on to it since then. There are a few other companies such as ITC , Marico (and more) in the list which I am watching. If the market keeps dropping, my wish may come true.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Bear markets are a good time to reflect !

In a bull market, any pick – good or bad, goes up and everyone feels like a genius. However at times like now, where any kind of mistake is brutally punished, it is easier to uncover flaws in one’s investing process.

So, I have been thinking about my investing process and have realized that one part of my process is exceedingly weak – The selling process

Why should one worry about the process ? If you are interested in understanding it in more detail – read this noteon ‘process versus outcome’. In a nut shell, if you get the investing process right, the outcome (investment returns) will take care of itself.  It is the equivalent of getting your batting technique right, if you want to be a good batsmen and get high scores consistently.

As most of you are aware, I am heavily influenced by warren buffett and his investment philosophy. My introduction to investing was through his ‘shareholder letters’ and as a result, I have taken his teachings to the heart.

One of the key tenets of buffett’s philosophy is buy and hold, where one looks for companies with sustainable competitive advantage and buys them  at a reasonable price. Once you make the purchase, buffett advises the investor to hold for long periods of time (provided the business maintains its competitive position)

The above is a very sensible approach and would work for majority of the investors. At the same time, the key point in the ‘Buy and hold’ philosophy is to buy a high quality company where the intrinsic value is growing and let time do its magic (via compounding).

A differentiated approach
It has become slowly dawned on me (I am slow learner J), that one needs a more nuanced approach to sell, depending on the nature of the investment. In the rest of this post and the next, I will try to  categorize the various types and look at the sell approach one needs to adopt for each of them – This is ofcourse a work in progress and by no means any kind of rule set for me.

Such companies look cheap when the economy is doing well and expensive when things are bad, such as now.  If you were to buy and hold such companies over the course of the entire economic cycle (from bottom to top to bottom), the overall returns would be very average. The key in such type of investments is to be able to buy when the company is at or near the bottom of the cycle (difficult to identify usually) and sell as the business recovers – without waiting for the cycle to top.

I wrote about the company herein 2008 and kept buying it as the stock crashed during the lehman crisis. My average cost basis was around 11 / share (post split).  I was out of the stock by mid 2010. You can see the price action below

The commercial vehicle business turned in 2010 and has been going downhill since then. The stock price has followed suit

So the key point with cyclicals is this – Buy and hold does not work (usually) and timing is critical for above average returns

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

v\:* {behavior:url(#default#VML);} o\:* {behavior:url(#default#VML);} w\:* {behavior:url(#default#VML);} .shape {behavior:url(#default#VML);} Let’s see what all has gone wrong and may get even worse

No, this is the market drop from Feb 2000 to May 2003. The market dropped 38% during this period, with IT stocks dropping even more.

 My point is that market drops happen from time to time and is the risk of earning high returns. The mistake most investors commit is to extrapolate recent events into the future. An investor looking at the market in 2003 would have missed one of the biggest rallies from 2003 to 2008.

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 Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

I wrote about hinduja global solutions (Now HGS) in jan 2009 (see here). The company was selling for below cash and thus the operating business was available for free.

As we know, the stock markets recovered by May 2009 and HGS was up 200% in a short span of 4 months.

In case you are wondering, this post is not about how I smartly exited in July and make 200% of capital.

The company performed extremely well in 2010. Net profits were up by 100%, Net margins hit 14% and this was inspite of the company carrying a large amount of cash on the balance sheet. I was feeling pretty smart about it.

The slow slide
 

The price action from the peak in 2009 shows only part of the story. The company has increased its sales from around 900 Crs in 2010 to around 1550 Cr in 2012 at a CAGR of 30%+. The net profit  however dropped from 130 Crs to around 106 Crs in 2012 and may drop further to around 80 Crs in the current year.

I kept buying the stock during this period, anchored to the earlier levels of profitability.
The company has thus been able to grow through a combination of organic initiatives and acquisitions, but saw a drop in profitability due to lower margins and lower capital turns. In effect, the growth came through, but the economics of the industry has deteroriated during the same period. The company has gone from above average profitability (20%+ROE) to below average levels in the current year (single digit ROE)

The lessons
There are two key takeaways from the above loss.

The first lesson is that if the initial expectations on the economics of an industry do not play out, one should accept the reality as soon as possible and act on it. The second lesson for me is that I should give a higher weightage to the qualitative aspects of the business and not focus too much on the valuation. In case of HGS, the large amount of cash on the balance sheet (and corresponding low valuation) distracted me from the deteriorating economics of the business – A value trap.

The blind spot problem
I have looked at the various companies in the past and have wondered why others keep buying/ recommending it when it is obvious that the company does not have above average profitability and cannot be a good long term investment.

The thing with blind spot is that the same issues are not visible to yourself, where one may keep rationalizing your own decision for a long time.

It is not easy to accept a mistake, especially a slow one , resulting in the boiling frog problem. Hopefully this lesson will stay with me for a long time and prevent me from making the same mistake again (new ones will however happen)