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

Risk V/S Uncerainty

In our day-to-day language, and even in finance, people tend to use the terms risk and uncertainty interchangeably. But in the 1920s economist Frank Knight made a distinction that I find quite useful. He argued that risk describes a system where we don’t know the outcome, but we do know what the underlying probability distribution of outcomes looks like. So think of a roulette wheel—when the croupier spins the wheel, you don’t know where the ball will land, but you do know all the possibilities and their associated probabilities. Risk also incorporates the notion of harm—that is, you can lose.

In contrast, uncertainty reflects a situation where you don’t know the outcome, but you also don’t know what the distribution of the underlying systems looks like.  Uncertainty also doesn’t necessarily imply harm, although it often does. So it’s not hard to see that most systems we deal with in the real world are really uncertain, not risky. Uncertainty better describes issues like terrorism or the avian flu, or even markets. Here’s why I’m stressing this distinction: we can model risk using probability calculus. In fact, the statistics of risk are relatively straightforward. In contrast, we can’t model uncertainty easily. And real trouble arises when we model uncertain systems using the mathematical tools of risk. Yet this is precisely what many people do in financial markets and in other domains as well. We’ll come back to this issue of risk or uncertainty quantification in a moment.

Psychologists have demonstrated that  events that are not vivid in our minds get assigned very low probabilities—much lower than the facts warrantI suspect for us to mobilize, as a society, to address risks like global warming or energy constraints we will need one or more 9/11-type events—a tragic incident that reveals what’s really going on.

To summarise, we humans are still not very good at dealing with risk or uncertainty. We are still linear thinkers, we have a nearly-insatiable need to link cause and effect, and we assess probabilities poorly.  However, we do now better understand some of the mechanisms that underlie complex systems, and that  knowledge can be very helpful in preparation for future catastrophic events.

Being Value Investor means

• Under 5% of all assets are run under value investors, a real minority in the investment world.

• The stock market is created for the other 95% of people, that is where your opportunity and challenge is..
• Biggest challenge: understand whether you are the 5% or the 95%
• It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
• 5% have a spectacular return, but 95% of money probably always resides to somewhere else.
• Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
• If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
• You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
The more you know, the better you are as an investor.
• Politics, science, technology, literature, poetry, everything can affect businesses and help you.
• Occasionally you can find insights that will give you tremendous insights that other people don’t have.
• Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?

To summarize value investing not natural habit, most often you will alone/in minority, so your rational thinking is only the only friend in the process.
To fight and succeed against the majority you need to have edge that comes from patience , patience and patience and independent rational thinking and  virocious reading.

Smart Investors traits

What sets the smartest investors apart from the rest? More often than not it comes down to consistently superior decision making in ‘uncertain’ conditions.

Any effort in coping with uncertainty must define, recognise and understand its different dimensions. McKinsey & Co. have developed a four-level format to identify the spectrum of possibilities.

At Stage 1, the future is relatively clear and dealing effectively with a single uncertain variable is adequate.

Stage 2 needs the ability to cope with several different views of the future but the alternatives are limited, discrete and fairly easily defined.

 Stage 3 is where the level of uncertainty is complicated by the fact that a large number of dynamic interrelated variables come into play.

 Finally, Stage 4 is about a truly ambiguous environment that requires constant learning and great agility, as investors can never adequately anticipate enough of the future in advance.

While dealing with a Stage 1 situation, it is vital to make an accurate assessment of just how much you really know. Once you get to terms with the limits of what’s known, the best way forward is to estimate a range for the unknown outcome and identify the level of confidence one has with the given range as opposed to the false comfort of a single-point forecast. The knowledge that there is a 75 percent chance of Sensex EPS in FY12 being in a range of 1,170-1,280, is far more useful than a number such as 1,240 which has a 10 percent chance of being right.

Stage 2 demands that one generates multiple views of the future by recognising the inherent uncertainty rather than seek a single ‘most certain’ outcome. The time tested technique of ‘pro versus con’ reasoning is effective since it typically leads to a balanced view. Equally interesting is ‘back to the future’ reasoning. In effect, you need to harness your ability to explain events in hindsight to enhance your skill in anticipating what lies ahead — or oxymorons being permitted, prospective hindsight. The impact of such intellectual time travel is usually greatest in coping with decisions involving large stakes!

Stage 3 events are difficult to tackle given the incredible complexity at work. Scenario planning — a disciplined method for envisioning a range of plausible future outcomes — is by far the most widely used analytical technique. It is a mistaken belief that more information will always lead to better decisions. In fact, additional information inputs are of value only to the extent that they help to ‘see’ the jigsaw with greater clarity. Beware of the genuine risk that increased information will lead to a misplaced rise in confidence with no corresponding impact on the accuracy of the decision.

So where does that leave us given the nuclear fallout possible in Japan, the turmoil in the Middle East, the debt mess in Europe,  a raw material related margin squeeze about to hit corporate profit margins, high domestic inflation .

Maybe Samuel Butler had a profound take on investing when saying: “Life is the art of drawing sufficient conclusions from insufficient premises”.

Value Investors and different types Risks

Risk management is the essence of a value investing approach. Creating a margin of safety at each stage is really nothing but a form of protection against errors of judgment and bad luck

My  belief in behavioural economics and the importance of “fundamentals”, risk seems to be probably the most misunderstood concept in modern finance. Clearly, risk is not defined numerically by measuring the standard deviation of historic returns. Rather, it is a concept that helps an investor to focus on the factors that might lead to “a permanent loss of capital”.

The Dean of value investing, Benjamin Graham, identified three primary sources of danger: Valuation risk, business risk and balance sheet/financial risk.

Valuation risk- Most of us know that the stock-market performance of a company is driven more by changes in expectations rather than actual corporate results. This is further compounded by the basic math that determines investment results: If you suffer a 50 percent decline, you must double the current value to just get back to where you started out from.

The second source of danger — business risk — is really to assess the lasting damage that can be caused to earning power as a result of negative changes in the environment. Quite often we assume that current margins can be extrapolated indefinitely into the future rather than contemplate the prospect of mean reversion caused by cyclicality and a deterioration in the business outlook. Indian IT services companies find themselves at an important turn in the road — greater long-term strength for the rupee, an inability to move up the value chain, increasing competition as well as a more hostile political environment in the US. The habit of comparing current earning power to long-term averages can help you keep out of trouble — at least one will receive early warning signs of a “value trap”.

The final element of this unholy trinity is balance sheet risk. In essence, this translates into a compulsive focus on cash flow. Rising debtors or inventories, relentless capital expenditure leading to greater financial leverage or constant equity dilution, declining operating efficiency, an inability to improve or maintain productivity, eccentric capital allocation, all lead to fragile cash flows and deteriorating financial health.

Interestingly, investors are pre-occupied with “reported earnings” and growth at the height of booms, oblivious to the seeds of destruction being sowed for the long haul!