June 1, 2010

Trusting your gut

One of the least discussed topics on investing is emotions. I have rarely found any discussion on this topic. Behavioral finance does take up this topic and there is a lot of academic analysis on the various pitfalls and mistakes of investors. However there is still a lack of discussion on emotions and how one should handle them while investing.

Are emotions important?

If you are Mr. Spock, then emotions do not matter. For the rest of us, emotions play a very important role in our lives and definitely in investing.

As an investor, one is faced with feelings of joy, confidence, euphoria or despair, frustration, fear and similar other emotions. I can’t speak for others, but I have had all these emotions and more.

Should feelings be ignored?
One school of thought is that one should be a completely rational investor and should take emotions completely out of investing. I find this as the stupidest advice.

Do you think that is possible? Can you invest without ‘feeling anything?

The only time one does not ‘feel’ anything is when one does not care about it. If you are dealing with your hard earned money, how will not feel anything?

Understand and manage feeling
I have found that it is far more important to acknowledge your feelings and then try to think rationally about them. In some instances, you may be able to realize that your feelings are leading you down the wrong path and you will be able to correct yourself. In other instances, your gut or feelings are telling you something and you are better off listening to them

My own experiences
During the start of my investing life, I rarely thought about how I felt and just went with the flow. For example, if I started analyzing a stock and ‘felt’ confident, then my tendency would be to rush through the analysis and just build a position.

Once I had created a position, a confirmation and consistency bias would set in and I would avoid negative information on the stock if it went against my view. If you think you and others are immune to it, think of the time you and your friends have tried to ‘defend’ your stock (as if your stock needs defending!) and have discounted someone who is giving you contrary information. This tendency sometimes gets vicious on public stock forums (which is one reason I avoid criticizing other’s stock picks)

The converse of the above situation occurred when the stock market was down and everyone was bearish. I found myself overly pessimistic like others and would constantly keep questioning myself. As a result I did not build as big a position as I should have – case in point: I bought concor in 2002-2003 at a PE of 5. I should have built a big position, but never did. Same with blue star and several others

My current approach
I did not get hit by lighting or have achieved any enlightenment like Gautama Buddha. I tend to feel the same emotions as earlier. The difference is that I try to acknowledge them when they happen and to understand what they are conveying.

During 2008, I too had feelings of uncertainty and some amount of doubt. However based on past experience and based on the valuations I could see, I decided to ignore them and went ahead with my positions.

Conversely, I have been feeling fairly smug and happy with my positions and optimistic (atleast till last month) in general. This matched with the feeling, others have about the market. I think this itself is a red flag for me. The time when I start feeling confident and on top of the world is the time to start getting worried. In response to this, I have started reducing my fully valued positions and have not really been buying much (though have been tempted several times).

I don’t go against my feelings always. On analyzing my past positions, I have realized that my position size is driven a lot by my feelings. I maintain a few major and some minor positions (see my portfolio here). I have found that the stocks in my minor holding are cheap and at a higher discount to fair value than major positions.

However for some reason which I cannot articulate, my ‘feel’ for the minor positions is not as good as the major ones. For example, I always felt that a grindwell Norton is a better position than a VST. As a result my position size has been larger in the former than the latter. On analyzing my past results I have found the major positions have done far better than the smaller positions (though I did not realize that at the time of making these investments).

I don’t claim to infallible. Far from it ! I have done enough silly things and confident that I will continue to do so (options may be one :) ). However I think listening to your gut is important, even if you do not always follow it.

As an aside – I think if you feel a little bit apprehensive and scared when trying something new, it’s a good thing. It means that you are pushing the boundary of your learning. I feel the same with arbitrage and options and think that it is the right thing to do.

17 comments:

sachin8778 said...

Hi Rohit,
A very good post, thanks for sharing. I enjoyed reading it and hope to apply it in practice.

Cheers,
Sachin

VISHNU said...

Rohit,

Contrary to popular opinion that people should remove emotions while investing, NNT in his book "Fooled by randomness" talks about what will happen when you strip the emotions from taking decisiosn. Even taking simple decision like waking up is very difficult becase there are so much permutation and combination of possible actions , mind will keep on calculating possible odds.

What we need to do is rather work with our emotions and emerge as investor unique to our capabilities and emotions.

Regards
Vishnu

Navjot Kashyap said...

Nice post.
I like your posts,probably because you talk and share things which I too would have liked to discuss with others.
You are right.People do trading,not just for the fat bank balance in the end,but for the gamut of emotions involved in it.Why do all these people give tips-to feel important and loved by others.Of course,money part is involved too.No one likes to loose money.But,as they say process is equally important.
So,I consider it as a hobby.
Dealing with emotions,the biggest thing that helps me is to think long term at that point.Feelings are knee jerk reactions to some short term events.If we can expand our view,it helps,but not always.
I'll give you an example.When the sensex was at 21,000 levels,all warnings were ringing in my head.So,one fine night,I vowed to sell all my shares,the next day.Luckily[in hindsight], I did the same.Sensex went a bit higher and I was getting mad and angry at myself.
Then it tanked and I couldn't stop laughing.
The story doesn't ends here.
I entered market at 17k levels,thinking it to be undervalued.The worst decision,but in hindsight.Sensex dropped to 9-10k.
So,you see,how emotions can be good and bad.

Neeraj Marathe said...

Extremely valid points Rohit..
I too wish i cud b Mr.Spock as far as investing is concerned..
Another side-effect of 'feeling' things is the urge to time the mkt..it is quite difficult to control and resist..currently, i see a lot of people selling their holdings simply coz they 'feel' that they will be able to buy it later at lower levels..typically their wait will keep on increasing as price decreases, only to repent when it rises again! :-)
emotions are truly awesome!
Cheers!
Neeraj

Avadhut said...

Hi Rohit,
Great Post.
It happens with everyone, with me too. I read a lot about that company,then do some quantitative analysis, li'l bit of forecasting( difficult thing to do :)), and if I think the stock looks attractive,I PLAN to invest it. But the buying decision takes some time,as you need to recheck your analysis and you need some green signal from someone...this is a part of emotion again.
You have done your mistakes and go by your analysis and gut feeling. Can you guide as how to reduce the mistakes and strengthen your gut feeling? :)

valueinvestinginindia said...

"For example, if I started analyzing a stock and ‘felt’ confident, then my tendency would be to rush through the analysis and just build a position. Once I had created a position, a confirmation and consistency bias would set in and I would avoid negative information on the stock if it went against my view."

I am going through this and am unable to control it. The moment I find something is cheap, I start thinking how great a find it is and how it is going to go up immediately and all optimistic thoughts start building up. I built 4-5 positions so far with an analysis I would not be proud of and guess what, except one, most are trading at the same level, some even lesser. I hurried my analysis and bought it thinking the stock price would jump and run away and it has not gone anywhere.

How did you deal with this? :)

Vic said...

Wondeful post Rohit, you brought up some execellent points.

It is a difficult thing, I also have hard time implementing what "valueinvestinginindia" mentioned i.e. "I am going through this and am unable to control it. The moment I find something is cheap, I start thinking how great a find it is and how it is going to go up immediately and all optimistic thoughts start building up. I built 4-5 positions so far with an analysis I would not be proud of and guess what, except one, most are trading at the same level, some even lesser. I hurried my analysis and bought it thinking the stock price would jump and run away and it has not gone anywhere.".

Would love to hear from your experience on the same.

Thanks,

Vikas

Navjot Kashyap said...

Keep some friend whom you trust and discuss things.He will keep you grounded in those situations.

By the way-Punj LLyod in distress.Might be good buy at low levels.Keep an eye...

Rohit Chauhan said...

hi sachin
thanks for the comment

vishnu - you are right. there have been experiments which have shown that emotion impaired individuals actually perform worse as they cannot evaluate risk and made worse decision. so the key is to understand and manage emotions

rgds
rohit

Rohit Chauhan said...

Hi navjot
i completely agree with your comment. i too exited early on in 2007, and started entering the market in mid 2008. i however avoid regret by reminding myself two thing
- i cannot time the market and will never know the peak or the bottoms
- focus on the valuations - the controllable factor and ignore the market levels - uncontrollable and things will work out

rgds
rohit

Rohit Chauhan said...

neeraj
emotions are what separate the average from the good investors. i think it is difficult to avoid regret on missing highs and lows of market ..but as i said in the previous comment - focus on valuations and on what you know and control. that helps in keeping my sanity

rgds
rohit

Rohit Chauhan said...

avadhut
i will put a post on it. i have written on it in the past, but it is scattered across various posts

rgds
rohit

Rohit Chauhan said...

hi valueinvestinindia/ vic
normally if i feel adrelaine kicking in - especially in a bull market - i do two things
- first i will start with a small token position to satisfy the itch or the urge to get into the stock. that takes care somewhat of the itch
- second i allow a cooling period. analyse the stock, build a token position and then leave it for 2-3 weeks. then come back to the stock and re-analyse. check and recheck and then build the position more if it is still cheap. ofcourse you will miss out on a stock if it rises in that time ..i think one has to live with that
- finally avoid building a full position in one shot ..build it over time as you get more comfortable with the compay

hope this helps

Pradeep said...

@Navjot: I have also downloaded the AR of Pun-j Lloyd and plan to look at it. From what I understand from cursory glance from news reports is that it has a UK subsidiary called Simon Carves which has screwed up on a few projects and hence the consolidated results are pretty bad. I think we should do a sum of the parts analysis of its various businesses and subsidiaries. Will work on it next week.

@Rohit: Thanks for the inputs. I do think that is a good strategy. I hope to implement it.

Navjot Kashyap said...

2pradeep,
Do share your views on it[Punj] after you look at it.I am also looking.Sector is Heavy Engg.The moat is good.Other players can't enter easily.Moreover other HE comps can't fulfill all the demand.The demand would be good for at least 3-5 more years.But,the thing that irks me is the management.Will all those Punjs at top and surely chachas,mamas too,I hate it.At PE=14 it sure looks cheap but not very.Lets see ARs

Vic said...

Thanks Rohit, your detailed answer/steps helps very much. Actually, this is what I did with few cheap (relatively) picks over last few months.

I have gotten better over time to not rush things. I do remember you mentioning this strategy few times in past. so I think it is always on back of my mind while entering or exiting.

Thanks again.

Vic

Anonymous said...

Hi Navjot, Punj Lloyd’s operations were managed by it’s CMD VK Kaushik. He has resigned after working more than 30 years with Punj.

Atul Punj is the only “Punj” in the Punj Lloyd and generally does not interfere in the operations and provide vision / finance only .

About moat – There is no moat in this industry. Only moat is previous experience to qualify for new projects. Any company can do this by signing a memorandum of understanding with other partner (who has got qualification & pay fee if project is awarded). Once they finish the project, they will also be qualified for future projects of same size /type/ capacity. Only moat might be experienced management.

But due to increased competition in this industry – margins are very low now. If you made a mistake during bidding (normally you got very limited time to review all the drawings, spec, etc and submit bid), all your profit is gone. Normally, companies include contingency for such mistakes.

One positive – Punj will not be using their UK subsidiary for construction any more. They will use their qualifications (previous completed projects) to bid for new projects. UK subsidiary will do only engineering job (low value jobs). Construction part will be handled by Punj Lloyd.

Discloser - Holding postion in Punj Lloyd since more than a year - bought at thier previous low (almost current price)

Thanks

Anon