Over-reaction is dangerous in investment decisions

The overwhelming 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, an eminent 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.

What I’ve learned from Warren Buffett-Klarman:

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Warren Buffett

As Warren Buffett was a student of Benjamin Graham, today we are all students of Warren Buffett.

He has become wealthy and famous from his investing. He is of great interest, however, not because of these things but in spite of them. He is, first and foremost, a teacher, a deep thinker who shares in his writings and speeches the depth, breadth, clarity, and evolution of his ideas.
He has provided generations of investors with a great gift. Many, including me, have had our horizons expanded, our assumptions challenged, and our decision-making improved through an understanding of the lessons of Warren Buffett.



1. Value investing works. Buy bargains.
2. Quality matters, in businesses and in people. Better quality businesses are more likely to grow and compound cash flow; low quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them. Always partner with highly capable managers whose interests are aligned with yours.
3. There is no need to overly diversify. Invest like you have a single, lifetime "punch card" with only 20 punches, so make each one count. Look broadly for opportunity, which can be found globally and in unexpected industries and structures.
4. Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.


5. Risk is not the same as volatility; risk results from overpaying or overestimating a company's prospects. Prices fluctuate more than value; price volatility can drive opportunity. Sacrifice some upside as necessary to protect on the downside.

6. Unprecedented events occur with some regularity, so be prepared.
7. You can make some investment mistakes and still thrive.
8. Holding cash in the absence of opportunity makes sense.
9. Favour substance over form. It doesn't matter if an investment is public or private, fractional or full ownership, or in debt, preferred shares, or common equity


10. Candour is essential. It's important to acknowledge mistakes, act decisively, and learn from them. Good writing clarifies your own thinking and that of your fellow shareholders.
11. To the extent possible, find and retain like-minded shareholders (and for investment managers, investors) to liberate yourself from short-term performance pressures.
12. Do what you love, and you'll never work a day in your life.

Investing- Size does matter

Investor who wants to beat market must have EDGE and view on how much money to invest on that stock. i.e optimum amt of money to maximize the geometric mean.

One important thing I have disclose by my own learnt lesson that “ you are unlikely to get an edge out of what you see in news/tv.” . The stock market more effient than the many small investor think. The way to achieve edge is path shown by Charlie Munger, Multidisciplinary thinking which I had discussed earlier.

Today we will discuss about How much to invest (Bet Size) when you  have EDGE.

Always Geometric Mean (GM) less the arithmetic mean (AM) so geometric mean is conservative way of valuing the risky proposition.

Warren Buffet repeatedly stressed the importance of  patience as the most important trait investor has to posses in investing , which means that you should invest only when you have edge and Jhon Kelly tell how much to bet .

Kelly criterion maximizes the median wealth and The Kelly system leads to a distribution of wealth (among scenarios or parallel universes) also shuns the tiniest risk of losing everything, for unlikely contingencies must come to pass in the long run. The Kelly criterion has, “automatically built in… air-tight survival motive.”

Kelly  formula  gives fraction ( f ) bank roll to invest.

f =Edge/odds                       where: edge: Amt you will win

                                                                           odds : profit if you will win

=(P*W-q)/W                   P= probability of winning ,   q= 1-p = probability of losing

                                                  W=winning amt per Rs invested

                                                                                                                                                                       

Example:  In coin tossing on one Rs bet, Heads u get Rs 2, tails you loose. So fraction of your bankroll  to bet for maximise  GM is (p=1/2,q=1/2,W=2)  25%.                                                                                                     

f=( ½*2-1/2)/2=25%

Same can be applied to buying stocks to maximise your portfolio return.

No other money management system has a higher geometric mean than the Kelly system does.Another good feature of the Kelly criterion is that it maximizes the median wealth.

Kelly system cannot do is engineer luck. It is possible to be unlucky when using the Kelly system, to end up with less than the median. When you do, you may be worse off than you would have been with another system.

The ever-expanding web of possibilities is like that interpretation of quantum theory where every chance event splits the world into parallel universes. By the fourth toss, there are 16 distinct parallel universes, corresponding to every possible sequence of heads and tails

In an infinite series of serial Kelly bets, the chance of your bankroll ever dipping down to half its original size is…½. A similar rule holds for any fraction 1/n. The chance of ever dipping to 1/3 your original bankroll is 1/3. The chance of being reduced to 1 percent of your bankroll is 1 percent.

The good news is that the chance of ever being reduced to zero is zero. Because you never go broke, you can always recover from losses.

The bad news is that no matter how rich you get, you run the risk of serious dips. The 1/n rule applies at any stage in the betting.

A fractional Kelly bet doesn’t sacrifice much return. In case of error, it is less likely to push the bettor into insane territory.

For true long-term investors, the Kelly criterion is the boundary between aggressive and insane risk-taking. Like most boundaries, it is an invisible line

Trading and investing –Tax implications

Trading and investing –Tax implications

power of compounding applies to expenses as well as profits.

. You buy a stock for Rs1. It doubles every year for eleven years (100 percent annual return!) and then you sell it for Rs2,048. That triggers capital gains tax on the Rs 2,048 profit. At a 20 percent tax rate, you’d owe the government Rs409. This leaves you Rs1,639. That is the same as getting a 96 percent return, tax-free, for eleven years. The tax knocks only 4 percentage points off the pretax compound return rate.

Suppose instead that you run the same Rs into Rs 2,048 through a lot of trading. You

realize profit each year, so you have to pay capital taxes each year. The first year, you

go from Rs1 to Rs2 and owe tax on the Rs1 profit. For simplicity, pretend that the short term

tax rate is also 20 percent (it’s generally higher). Then you pay the government 20

Paisa and end the first year with Rs1.80 rather than Rs2.00.

This means that you are not doubling your money but increasing it by a factor of 1.8—

after taxes. At the end of eleven years you will have not 2 ^11 but 1.8^11 . That comes to about Rs683. That’s less than half what the  buy-and-hold investor is left with after taxes.

Ecology - Finance and Economics

  There is no reason why finance and economics should be different. It is routinely observed that some of the biggest ideas in one particular field are often borrowed from an entirely unrelated field And if there is one discipline that could do more than any other in bettering our understanding of financial markets, it has to be ecology we believe. At the heart of ecology, lies a very important principle. If an ecosystem grows way too much, a destruction of the excess growth follows, laying the groundwork for a stronger system to evolve. This then leaves the ecosystem in a much better shape than before. And what happens if this process is interfered with.

A real life example can be had from the famous Yellowstone National Park fire in the US in the 1980s and which was 30 times bigger than any previous fires recorded there. It occurred mainly because the forest officers there had decided to stop the earlier fires at the very first blaze. In other words, they had interfered with the nature's mechanism of destroying the most fire-susceptible vegetation which eventually grew bigger and bigger in size and thus increased manifold, the intensity of the final fire.

That's it. The Governments and central banks around the world need no more than this simple lesson to understand the implications of their actions. By repeatedly bailing out sick institutions and by throwing money at the most inefficient businesses, they are interfering with the natural process of capitalism i.e. survival of the fittest. It does not take more than perhaps a sixth grader to realise that every such action is increasing the possibility of a much bigger inferno further down the road, which will have devastating consequences on the wealth of the global economy. Not to forget that just like fire susceptible vegetation, continuous support of bad businesses is also causing unemployment to remain high and growth to remain low. Thus, while the forest officers at the Yellowstone Park seemed to have learnt their lessons, the policymakers seem far from doing it. They should realise that there is hardly any other solution in sight. They will have to let the fires run their course. This is the only way to create a new groundwork for stable, sustainable growth and higher employment. We hope the New Year will drill some sanity into them. Or else the market's way of making them realise this will be far too costly and devastating as per us.

Seven Traits of good Investor

#1 – Ability to buy and sell stocks against the market

Everyone thinks they can do this…[when] the market is crashing all around you, almost no one has the stomach to buy.

#2 – Obsession

The second character trait of a great investor is that he is obsessive about playing the game and wanting to win.

#3 – Willingness to learn from past mistakes

What sets some investors apart is an intense desire to learn from their own mistakes so they can avoid repeating them.

#4 – Inherent sense of risk based on common sense

I believe the greatest risk control is common sense, but people fall into the habit of sleeping well at night because the computer says they should. The thing about common sense is that it isn’t very common.

 #5 – Confidence and Conviction

Great investors have confidence in their own convictions and stick with them, even when facing criticism

.

#6 – Get both sides of your brain working

If you don’t think clearly, you’re in trouble. There are a lot of people who have genius IQs who can’t think clearly.

#7 – Ability to live through volatility

Number 7 is the most important, and rarest, investor trait of all.

To make money, you have to cope with volatility. Volatility is not risk.

Good luck during this difficult period. I hope to see you on the other end victorious

Thought provoking for entrepreneur

Vinod Khosla's Co-founder of sun micro system thought on entrepreneur at MIT

http://www.youtube.com/watch?v=YxYVOMj6F2U&feature=youtube_gdata_player

Value Investing and Investment Psychology - By Mahesh Hamne: Thinking About Thinking

Value Investing and Investment Psychology - By Mahesh Hamne: Thinking About Thinking