December 29, 2008

Lure of the long shot

Let me tell you a short story : There was once a smart young guy who like all of us was a charming, intelligent and hard working fellow (please replace guy with gal – for the ladies reading this blog). Now this guy, like others knew that the stock market is the place to invest your money if you want to get a good return. So he would occasionally dabble in the stock market and would make a few bucks here and there, nothing serious though.

One day our friend was relaxing at home, watching CNBC, where a smart confident looking analyst recommended the stock of a hot upcoming company (lets call the company longshot). The analyst was extremely bullish and was going ga-ga over the prospects of the company. This was a hot company in a hot sector (hot – hot !!). The company had increased its profits by 5 times in the last 3 years and was growing rapidly. The promoters were confident that sky was the limit and they would be the next infosys of their industry.

Our friend on hearing this tip was intrigued. He decided to call his friends and his broker to find out more (research !). His broker was ofcourse estactic about the company and his friend (who was a budding investor himself ) was also very positive. So having received two solid recommendations, our friend decided to invest 100000 (20% of his networth) in the company.

Fast forward 2 months : The company’s stock rose 4 times during this period. Our friend was completely delerious. He felt like a winner now. Ever since he bought this stock, he was following it closely. He would read every article on the company, every interview by the CEO. He was even participating on various stock forums where are almost everyone was more than 100% sure that the company would do very well. There were a few morons, who kept pointing to the high valuations, but then what would they know !.

The company had been reporting rising profits for the last 10 quarters and the next quarter was expected to be great. Our friend was giddy with excitement. He dreamt of the stock going up still further (everyone believed that !).

Fast forward 6 months : No one saw it coming. The company report good profits, slightly below expectations, but still good profits. The market reacted strangely to this news. The stock dropped 20% !!. Our friend was surprised. However he was re-assured by his friends and fellow investors on the stock forum that this was just a temporary reaction and the management and other analysts believed the same thing.

A few morons again pointed out that the valuation was too high, but they were abused and kicked out of the stock forum (sheesh !! what spoilsports ..our friend thought).

Fast forward 3 months : The company reported profits below forecast. They still reported a good growth, but below forecast. They however reduced the outlook for the next year as recessionary conditions had reduced the order inflow. Once this news came out the stock tanked by 50%.

Our friend was still up by 60%. However he was surprised by the sudden drop in the stock. How could the stock drop so rapidly ? He felt regret that he had not sold when the stock was at its peak. Now the stock had dropped almost 60% from that level. There was no point selling now …so he held on

Present day : The bad news kept flowing in. The stock dropped another 50% and was now below his cost. Our friend was angry with the analysts and the management who misled him. He was feeling cheated. He still visits the stock forum and is now looking for the next PRIL or L&T or infosys (or whatever you can think of)

End of story

I am currently reading a book ‘
your money and your brain – the science of neuroeconomics’. It is a great book on the behavioural aspects of investing. I have not written much on emotions and behavioural aspects of investing on my blog. However I think these aspects of investing are equally if not more important than the analytical aspects.

The above story is something which a few of us have gone through or seen others go through. Some will learn the right lessons from it, whereas others will keep their head in the sand and blame others for their losses.

There are several behavioural baises in the above story which I will discuss in the rest of the post.

tendency to consider gain, but ignore the probability of gain
social proof bias
hindsight bais
commitment and consistency tendency bias
predicition bias
pattern seeking bias

Let me go through each of the above now

tendency to consider gain, but ignore the probability of gain : The book mentioned above discusses this bias in detail. I have know about this bais, but when I read about it in the book, it was like a light bulb going on. Humans have a tendency to over wiegh the gain, but tend to underwiegh the probability of gain. This tendency explains why people buy lotteries. The odds of winning the lottery are very low, but the likely gain is very high. An odd of 1 in 10 million cannot be ‘felt’. However a gain of 10 million is vivid. You can imagine all the stuff you can buy with it.

This bias explains why people go for long shots in investing even if the valuation (or odds) is high. The gain appears tangible, but the low probability does not register. This is also the reason why people are looking for the next infosys or the next L&T or PRIL etc. What most people forget is that the odds of finding one is low (would you have predicted that infosys would do as well in 1993 ? the promoters could not !). This bias explains why our friend is still looking for the next longshot.

social proof bias : If others are recommending the stock, then I must be correct. As the above book and countless other books on the same topic have stated – Humans are social creatures and like to stay with the crowd. You don’t want to stand away from the crowd and be proven wrong. Easier to buy a hot stock and be proven wrong, than buy a beaten up stock that no one likes.This bias explains why our friend felt comfortable with the company when others were recommending it.

Hindsight bais : This is the tendency to believe that you always knew the outcome after it has occurred. The book explains this bias very well. You will find a lot of pundits saying that the stock was bound to drop (or rise) after it has done so. What they don’t tell you is that they did not have this insight before the event happened. One of the key reasons for writing an investment thesis and publishing on this blog is to avoid this bais. I am no different than others and could easily fool myself that I always knew what was bound to happen.

Commitment and consistency bias : Once you make a commitment (especially public), you have tendency to be consistent with it. No one likes a person who changes his mind and is not ‘faithful’. Our friend bought the stock, committed to it and hence could not bring himself to selling it when the fundamentals turned bad. I personally try to avoid this bias by publicly not committing to buying or selling a stock on the blog. I prefer to publish the analysis and leave it to the readers to take their decision

Predicition bias – The book explains this bias in a lot of detail. Humans have a bias to predict events. If you toss coins in front them, there is an automatic tendency to predict the next toss even if they know it is random. There is a deep biological basis behind it (too lengthy for me to go into). All of us suffer from it and it seems to be a sub-conscious tendency. This bias explains why people are continously tryind predict price movements in the stock market even though they are random. This bias also explains the attraction for technical analysis.

Pattern seeking bais – This bais also has a biological basis and closely linked to the previous bais. All humans try to find patterns, even in random data. It is an inbuilt tendency and an automatic one. The book (
your money and your brain) goes into detail and explains it fairly well. This bias explains why people on seeing 4 quarter of rising earnings or 3 weeks of rising prices seem to find a pattern in it and predict that the next quarter or price will be higher than the previous one. Our friend with others was suffering from the same bias and assumed blindly that the earnings and the stock price will continue to rise.

There are several other such biases which I will cover in future posts. I personally think all of us suffer from these biases (less or more) and the difference between a successful and average investor is that the successful ones are able to reduce or compensate for these baises.

These biases are not weakness. These tendencies come from the human evolution and served us well in the past and continue to do so. If some one yelled fire and everyone started running away from it, would it be smart to be a contrarian to run towards it ? The worst that can happen if you follow the crowd (social proof) is that everyone will look foolish if there was no fire. But if everyone is correct and you go against the crowd, you may pay with your life.

These biases however work against us in the financial markets. They cannot be compensated easily. I have been reading on them (see this article by charlie munger on it) for the last few years and know several times that I am operating under their influence, but can still not avoid acting otherwise. The bigger problem is when you don’t even know that you are operating under their influence and they are hurting you.

Now if believe you are above all these influences and it is others who suffer from them, then you are suffering from another bias – where almost all individuals think that they are better than the average. The book gives example of several experiments which were done to demonstarte this bias. Most investors, drivers etc feel that their skills are superior than the average (even if the evidence is to the contrary).

I personally operate with the assumption that I am influenced by all these biases and instead of ignoring them, I should be focussing my effort on reducing their impact.

8 comments:

Anonymous said...

hi..
i am a big reader of this suject (behavioural finance)
may i suggest a few good books on this subject?

http://www.amazon.com/Behavioural-Finance-Users-James-Montier/dp/0470844876

http://www.amazon.com/Smart-People-Money-Mistakes-Correct/dp/0684859386/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1213205544&sr=8-1

http://www.amazon.com/Inefficient-Markets-Introduction-Behavioral-Clarendon/dp/0198292279/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1213194456&sr=8-1

http://www.amazon.com/Irrational-Exuberance-Robert-J-Shiller/dp/0767923634/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1213194474&sr=8-1

http://www.amazon.com/Advances-Behavioral-Finance-Roundtable-Economics/dp/0691121753/ref=pd_bbs_sr_3?ie=UTF8&s=books&qid=1213194514&sr=8-3

also read one called as Blink by malcolm gladwell..

cheers
neeraj

Anonymous said...

Hi Rohit
I am tracking Revathi Equipments for a long period. I asked you about that couple of months back. Also you have mentioned this Company in your rejected ideas list.
What is your take on Revathi now? it's CMP is 415.
Following is your comment about revathi on one of the blog..
=====
Rohit Chauhan said...

hi
i have analysed the company in detail and was very impressed with abhishek. he clearly follows buffett and is very share holder friendly.
he is the only manager i have read (and i have read quite a few) who goes into detail in explaining his business with all the negatives, risk and problems around it.
he seems to be a very rational allocator of capital.
you can find the AR on icici direct.com.
i too have found the price outside my comfort zone and would like to wait for it to fall within my target zone
rohit
Sunday, April 15, 2007 8:48:00 PM
=====

I did some calculation about revathi, and it's intrinsic value comes around 1000, which means i should buy it on or below Rs. 500.
CMP 415 looks quite OK to enter

What is your take on this?

regards
Ani

VISHNU said...

Hi Rohit,

Sorry about my half baked comments for your earlier post. I didn't read your post fully as I was busy in the work. I will re-read your post and excel sheet and will come back to you.(I am taking print out of your posts and reading it in free time)

Everyone is influenced by these biases; none knows how to avoid this in a particular scenario. (Say while managing money). In other circumstances, these biases are helpful for human beings.

I think Thaler gave some useful tricks in the form of NUDGE (www.nudge.org). NUDGE is nothing but feedback mechanism. I will explain why this is important to avoid our biases. Think for a moment between Digital Camera and old camera. Why digital camera is effective? Because it give instant feedback. But our old traditional camera doesn’t give feedback until we get the photo which is too late.

Real example. Person A who is very healthy and he wakes up daily morning and does his daily routines. One day he sees a French fry advert and experiment with that. Then he starts eating French fries daily. No feedback. He wake up next day and eat French fries. Again no feedback. This goes on for 5-6 years. One day he wakes up after 5-6 years, found that he got big belly. Now this feedback is very late. (An alarm which gives irritating sound whenever one eat french-fries is very good NUDGE. But I am not sure how practical this may be).

Some of the NUDGES in Real time---Obama’s economic policy

Obama's top economic adviser (Austin Goolsbee)...If you automatically enroll workers in 401(k)s but allow them to opt out, most stick with it. Obama's savings plan exploits this so-called 'status quo' bias."

Regards
Vishnu

Vic said...

Rohit,

I'm glad that you covered an extremely important topic in details.

This is one of the reasons that buying entire Market (Index MF/ETF) and DCAing (Dollar Cost Averaging) is recommended for most of the people who don't have much time to do stock picking and have tendency to buy High, Sell Low.

Vikas

Rohit Chauhan said...

hi neeraj
great recos on the books. thanks a lot. i am planning to read the second book in your list - smart people ....
i am planning to focus on this topic for the year and these recos will be great for me. will definitely read a few books from the list. which ones in the list did you like the most ?

regards
rohit

Rohit Chauhan said...

Hi ani
yes revathi seems attractive now and is now on my short list.
problem is with all the stocks becoming cheap ..my portfolio is becoming a zoo :) ..too many holdings

i plan to review my list soon and will look at replacing some holding with revathi ..if it is better than the stock going out.

regards
rohit

Rohit Chauhan said...

hi vishnu
great examples. i have been reading similar examples in the book and have read about them elsewhere too. for ex: in some countries the default option is yes for organ donation ..you can opt out though. in all such cases the overall donation levels are high
on the negative side is the auto offer and opt out scam which several marketers use to play on this tendency

i understand several of these biases ..but still it is not easy to overcome them . trying to figure that out ..but then these biases are not supposed to be easy to overcome

regards
rohit

Vic said...

Hi Rohit,

Seems like my comments are missing again, I posted two today.

Perhaps I've to post twice.

Vikas