Over-reaction and investment decisions

The  majority of investors tend to formulate investment strategy by naively extrapolating recent trends. Second, they tend to be overconfident in their ability to predict the immediate future accurately. Finally, their confidence intervals are skewed, which means their best guesses are not evenly spaced between their high and low estimates. Why does this happen? In effect, individuals are most influenced or tend to ‘anchor’ their predictions on just how salient they believe recent history is. Nobel Prize winner Daniel Kahneman suggested that we tend to judge the probability of an event by the ease with which we can call it to mind. The more vivid our memory of something similar in the past, the more probable it will seem to happen again. Remember 2008 — AIG, Lehman Brothers, Bear Stearns.

Paul Slovic, psychologist has an explanation that is based on our intuitive sense of risk being driven by two factors — dread and knowability. His conclusion: These two factors ‘infuse risk with feelings’. Dread is really a function of how dramatic, controllable or potentially catastrophic a risk appears to be. The knowability of a risk depends on how immediate, specific or certain the consequences appear to be.

Therefore, our perceptions are distorted such that we underestimate the probability and severity of common risks such as inflation. On the flip side, less comprehensible risks that we have never personally experienced seem potentially lethal. As Jason Zweig put it, “We see the world through warped binoculars that not only magnify whatever is remote, but shrink whatever is near.” So, blinking in the face of risk might well be natural, yet the over-reaction is incredibly dangerous in arriving at investment decisions.
 
The financial media seems to revel in highlighting the current woes of the stock market with laser-like precision — the interminably long list of new 52 week lows, faltering corporate earnings, the soaring price of gold and the incredibly muddled response of policymakers around the globe. So, does financial holocaust beckon just round the corner or are there signs that the deathly pall of gloom might lift within the next two or three quarters?

Your Money and Your Brain

•  our investing brains often drive us to do things that make no logical sense—but make perfect emotional sense. That does not make us irrational. It makes us human. Our brains were originally designed to get more of whatever would improve our odds of survival and to avoid whatever would worsen the odds. Emotional circuits deep in our brains make us instinctively crave whatever feels likely to be rewarding—and shun whatever seems liable to be risky.

•  To counteract these impulses from cells that originally developed tens of millions of years ago, your brain has only a thin veneer of relatively modern, analytical circuits that are often no match for the blunt emotional power of the most ancient parts of your mind. That's why knowing the right answer, and doing the right thing, are very different.

•      "Financial decision-making is not necessarily about money It's also about intangible motives like avoiding regret or achieving pride." Investing requires you to make decisions using data from the past and hunches in the present about risks and rewards you will harvest in the future—filling you with feelings like hope, greed, cockiness, surprise, fear, panic, regret, and happiness

•   There are three kinds of investors: those who think they are geniuses, those who think they are idiots, and those who aren't sure. As a general rule, the ones who aren't sure are the only ones who are right.

•   Monetary loss or gain is not just a financial or psychological outcome, but a biological change that has profound physical effects on the brain and body. Financial losses are processed in the same areas of the brain that respond to mortal danger.

•     expecting both good and bad events is often more intense than experiencing them.

•   our intuitions can often mislead us, he fails to emphasize that our intuitions about our intuitions can be misleading. Among the most painful of the stock market's many ironies is this: One of the clearest signals that you are wrong about an investment is having a hunch that you're right about it. Often, the more convinced you are that your hunch will pay off big, the more money you are likely to lose.

·                      The best financial decisions draw on the dual strengths of your investing brain: intuition  
             and analysis,   feeling and thinking

 Your investing brain the reflexive (or intuitive) system and the reflective (or analytical) system.

The reflexive system: 

• (which some researchers call System 1) gets "first crack at making most judgments and decisions,".   We  count on our intuition to make initial sense of the world around us—and we tap into our analytical   system only when intuition can't figure something out., "We run mostly on System 1 software."our brains can't possibly keep up with everything that's happening in our environment. Whenyou are at rest, your brain—which accounts for roughly 2% of the typical person's body weight—consumes 20% of the oxygen you take in and the calories you burn. Because your brain operates at such a high "fixed cost," you need to ignore most of what is happening around you. The vast majority of it isn't meaningful, and if you had to pay separate, equal, and continual attention to everything, information overload would fry your brain in short order. "Thinking wears you out,".  "So the reflective system tends not to want to do anything unless it has to."  
  
  Therefore, our intuition acts as the first filter of experience, an instantaneous screen that enables us to conserve our vital mental energy for the things that are most likely to matter. Because of its phenomenal skill in recognizing similarities, the reflexive system sounds an instant alarm when it detects a difference.

Reflexive system is so fixated on change that it makes it hard for you to focus on what remains constant.( your reflexive system will prompt you into paying more attention to a single stock rising like a rocket or sinking like a stone than the much more important (but less vivid) change in the overall value of your portfolio)

The reflexive system this way: "It's kind of like a guard dog. It makes rapid but sort of sloppy decisions. It will always attack the burglar,but sometimes it might attack the postman,
too."

The Reflective Brain 

The reflective system may rely on what they call "tree-search" processing.
   
In the financial markets, people who rely blindly on their reflective systems often end up losing the forest for the trees—and their shirts as well.  There's always something to measure on Wall Street, which spews out a torrent of statistics on everything under the sun 

If the reflective system can't readily find a solution, the reflexive brain will resume control, using sensory and emotional cues as shortcuts. 

you need only to understand that the most reliable way of determining whether something is true is to try proving that it is false.

6 lessons from Warren Buffet on investments

Invest in quality business and not stock symbols

Let me ask you how far do you analyze the business you invest in? Well most of the investors don't. They simply follow the symbols or brands of successful corporate houses. If you plan on investing in IPOs, you need to do a complete research about the concerned company, its past performance, how the IPO money will be utilized, details about the company management, and when the operations will commence so that company starts generating profits. Before buying stocks the stocks of a company find out what kind of products they sell, how consistent they are in the sales, how do they survive the competition from their investors.

Scan through the stocks

It is common to see investors investing in the stock that has a great demand. But what differentiates a smart investor from the rest is when you identify which stock are available at a low and reasonable price and which has a great potential to grow in the years to come. Carefully analyze the company and its business.

Maintain the right temperament

Stock values keep fluctuating. Don't dwell on the price of stocks. Instead, study the underlying business, its earnings capacity and its future. If other investors panic when the value of the stock drops you have to maintain the right temperament that will help you get out of that situation. Remember staying invested in a value company will pay you rich rewards over a long-term period. This will help you succeed in the market.

Know how the company uses the money

The success of any business depends on how well its management uses its capital. You can make this analysis on two factors Return on Equity (ROE) and Return on Capital Employed (ROCE). Interpret the company's financial statements and understand the quality of return on his investment. Invest in companies with good returns on capital invested.
Make your own investment decision

It is your money that you plan to invest and you know needs well. So when you to invest in stock don't listen to brokers or analyst. They could probably be selling it to you. Make your own decision. Become a value investor. Don't invest in stocks that are recommended by stock analysts/editors on popular television channels. You should perform your own research then make vital investment decisions. Be a conscious investor.

Sell loss-making stocks during a bull run

The best practice of warren is to sell loss-making stocks during a bull run and buy the winner stocks during a bear hug. The amount you get after selling the stocks could be used to buy stocks with future growth potential and there by achieving better returns.

The Seven Immutable Laws of Investing

James Montier of GMO, LLC recently penned a piece titled “The Seven Immutable Laws of Investing.”  These “laws” are certainly not new to adherents of value investing.  However, I believe we need to constantly reinforce these laws, especially since they are often inconsistent with our natural tendencies.

So, now, for the moment of truth, I present a set of principles that together form what I call The Seven Immutable Laws of Investing.

1.  Always insist on a margin of safety

2.  This time is never different

3.  Be patient and wait for the fat pitch

4.  Be contrarian

5.  Risk is the permanent loss of capital, never a number

6.  Be leery of leverage

7.  Never invest in something you don’t understand

MANAGEMENT FAIR OR FOUL

· Promoters who keep diluting equity. In Corporate finance studies the cost of equity capital is taken to be higher then that of debt. It therefore makes sense for companies to take on debt for further growth and be very conservative with equity dilution.

· Promoters who issue warrants to themselves at substantial discounts to market price.

· Check whether the company sticks to its guidance. Mastek and Polaris are two Indian software companies that have often deviated from what they promise. While Mastek and Infosys were incorporated at around the same time the latter trades at a market cap of more then 100 times the former.

· Whether the stock price moves just about a fortnight before the unexpected news (e.g. acquisition, hefty dividend etc). Investors will have to distinguish between what is known asmosaic theory. This theory assumes that the analyst committee can forecast some of the corporate actions. Stock specific news that hit the market after the stock has been ramped up is a bad sign indicating that the insiders knew of this development. E Serve and Digital Software were up quite a bit before the company came out with their open offers.

· Companies that buy back their own shares only to reissue them later at huge premiums areagain playing foul on small investors. Bharti Airtel did this but investors have benefitted since then. there is nothing easy in this business!

· Companies that buy back their own shares are always a great bet on the bourses

· Companies having good managements have a large dividend pay out ratio.

· Decline or rise in promoter holdings. After the 2000 tech debacle the promoter holdings in companies like DSQ Software and Himachal Futuristic saw a continous decline.

· A very high Tax Payout Ratio is a signal that earnings are for real and the management genuine.

· A very large Institutional Ownership means that the company is well researched and prima facie management concerns are not there. But companies that have large institutional ownership do not generate above market returns.

· The CEO position. Whether it is within the family or outside?

· Educational Qualifications of the top Brass. It has been my personal observation that companies that are headed by graduates from IIM and IIT perform very well. They also follow a very high level of Corporate Governance. Alternatively Companies headed by Accounting professionalsare unable to perform that well.

Beliefs and pshycology-In Investing

I love this story of Cialdini’s Three Legged Stool. The stool is stable because it has three legs. Take one away and it will fall. However, this magical stool does not fall because when one leg is taken away, another one grows to replace it.

The human mind pretty much works like the three-legged-stool. You do something for a reason, and then more reasons are created in your mind to justify your decisions. And when the original reason for doing that thing is taken away, new reasons are invented to allow you to continue with the decision. You are never wrong this way because there are always enough reasons to maintain your prior beliefs.

Take an example. You buy a stock because you think its prospects are good. Then you learn that the company’s earning power will be hurting for the several years in the future. In the meantime, the stock has fallen 20% from your cost. You mind will now invent new reasons to hold on to the stock. You will start thinking that this is just a temporary adversity, or the drop in price has made it even a better bargain so you should buy more, or you have new cash coming in which you can invest in new opportunities so no point liquidating this position, or the company is developing a new product line and that will surely result in resumption of profit growth, or the company has become an attractive acquisition target and will surely be acquired at a large premium to the prevailing price, or blah blah blah – you get the point I think.

Is your mind the functional equivalent of the three-legged stool magically growing legs to allow you to be consistent with you past dumb calls?

Equity Dilution : The unseen enemy….

The startling observation that the BSE 100 Index’s “real” EPS growth lagged India’s “real” GDP growth over a three and five year horizon. Over the three year period, FY07-09, the BSE 100 real EPS CAGR at 4.7%, was much lower than the 8.5% real GDP growth. Over the five year horizon, FY05-09, real EPS growth at 8.4% was marginally below the 8.5%. The primary reason behind this was equity dilution.

There have been tomes written about how India will be the one of the key global growth engines for the next decade (at least) and how as investors we should hop on to the bandwagon by investing in equities. No doubt this appears to be compelling logic since “net profit” growth has often outpaced GDP growth rates. However, “real” EPS growth has not kept pace mainly because capital intensive companies have diluted their equity at regular intervals. Although there are some sectors/companies which are cash rich (frontline FMCG and IT companies are prime examples) most other sectors require dollops of capital in order to attain the next level.

While the overall financial leverage in our corporate sector has reduced over the past two years, this has often been achieved not through retained earnings but by refinancing high-cost debt through fresh equity issuances. Buoyant equity markets provide a temptation that few promoters can resist. There have been some promoters who have even candidly admitted that they are raising money while the going is good even though they do not have any concrete idea as to how to deploy it profitably.

The James Montier of GMO stating that between 1970-2001, US, UK and Germany too experienced the same problem.

As investors, this could hurt us in two ways :

1. Money which may have deployed more profitably ourselves, could be transferred into the hands of promoters with vague notions and intentions.

2. Other than EPS growth, constant dilution also affects the Return On Equity (RoE) adversely since most dilutions take place close to the current market price and RoE takes the premium component into account too. This is especially true in case of projects being commissioned over the next few years instead of the near-term (Eg. Metals, mining and oil & gas companies).

While, it may be difficult to avoid such companies entirely we can take some precautions in order to ensure that only a small portion of our portfolio is in companies prone to regular dilutions. Of course, often cash-rich companies with predictable earnings command a stiff valuation premium. However, there are bouts when the premium reduces. This especially happens during frothy times when risk aversion is very low and the companies’ conservative nature and the cash on their books is actually seen as a liability. Patiently waiting for such times may serve us well……

Timing really is crucial

There are enough investing philosophies out there to make your head spin. Buy and hold. Ride the commodity wave. Value investing. Technical analysis.

Each has its own merits, but sometimes you just need to look at the numbers to make sense of it all.

Ed Easterling, who runs an investment management and research firm in Corvallis, Ore., did just that, and he illustrated his findings in a graphic that The New York Times has published.

As the Times describes it, in 2001 a client asked Mr. Easterling what kind of return investors should expect over the long term. Instead of rushing his response, Mr. Easterling did some research and found that the answer, as it is with so many things related to finance, is that it depends. What exactly does it depend on? Timing.

Mr. Easterling tracked the S&P 500 average real return -- that is, the return that accounts for dividends, average taxes, fees and is adjusted for inflation -- from 1920 on. His analysis determined an investor's average annual return depending on what year he or she entered and exited the market.

For instance, if money was invested in 1994 and held to 1996, the average annual real return was about 7 per cent. But if the investor got greedy and kept the money in there until 2002, the annual return over that period fell sharply.

The analysis also determined that the best 20-year period to invest in ran from 1948 to 1968, when the average annual real return hit 8.4 per cent. The worst 20 years ran from 1961 to 1981, when the average annual real return was negative 2 per cent a year.

The graphic might take few minutes to figure out, but it’s worth the time.

The secret to investment success: Self Awareness?

The secret to investment success: Self Awareness?

I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.

There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.

. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.

Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.

As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt idek,

Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes.