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I am happy to announce that my blog has transferred to new URL –
Now, all my post will be available on it.
Keep learning, keep investing.
As an experiment, We prepare different chits and write down different stocks name on those piece of paper. Then we give it to different monkeys to pick it for a week. Few come out as a winner and few as losers. We continue playing the same with winners only. Over some time, one monkey comes as a right in all the time. The media calls that monkey a successful monkey and call everyone to understand his success mantra.
This is an outcome bias; we tend to evaluate decisions based on the result rather than on the decision process. When a person has a good performance track record of stocks picking then we consider him as a good stock picker or an expert rather than knowing the process or it can be possible that past results can be due to pure luck. I met few fund managers who do not read books or annual reports thoroughly but they have survived for 10-12 years so people call them successful and an expert.
In conclusion: never judge a decision purely by its result, especially when randomness or ‘external factors’ play a role. A bad result does not automatically indicate a bad decision and vice versa. So rather than tearing your hair out about a wrong decision, or applauding yourself for one that may have only coincidentally led to success, remember why you chose? what you did?. When we start understanding the process behind success, then we can easily recognize success as a part of luck or efforts.
Everything in a world moves toward an extreme direction from average and come back to average. This is known as a regression to mean. Sometimes we get more happy or sad and as time passes, we start coming back to our normal feelings. We tend to be nice to other people when they please us and nasty when they do not, we are statistically punished for being nice and rewarded for being nasty.
Poor performance was typically followed by improvement and good performance by deterioration, without any help from either praise or punishment. Our performance has an average point, sometimes we perform very better than average and sometimes perform below average and sometimes reach back to mean performance. So that when performance is above or below average, then it has a higher probability to meet the average which is known as a regression to the mean.
Investment – The price of the companies sometimes go either extreme to fundamental points but as time passes stock prices start moving towards fundamental performance and at some point fundamental performance and stock prices marched. The stock price cannot be sustained at either extreme. We have seen various cyclical events, business cycle and many more are responsible for the regression to the mean. We have experienced that market always walk away from averages for a period but it comes near to mean by its self-correcting nature. So that when anything moves at the extreme side of the mean then we must have to be ready for self-correction of it. Value investing mainly focus on reversion to mean theory. It believes that if the stock price is well below its fundamental value then now or later it will catch up with its fundamental value.
We have seen that the best performance in equities has come after the worst performance and vice-versa. So that we should not focus on a smaller period of outcome to make any conclusion. Rather should focus on a decently long period to understand mean reversion. But when fundamental performance is improving then we should compare market price with improving fundamental performance rather should wait to fall in price as it has risen in past. Also, we need to study thoroughly about fundamental of any business, its prospects, challenges faced by the business. Rather believing that if the business has performed well in past then it will repeat it in future. It may or may not repeat the same performance but that we have to conclude from a detail study of business.
People respond to incentives by doing what is in their best interests. What is noteworthy is, first, how quickly and radically people’s behaviour changes when incentives come into play or are altered and, second, the fact that people respond to the incentives themselves and not the grander intentions behind them.
We all seek self-interest; our efforts get changed with incentives. We act for getting back something. Proper incentives can improve performance but improper incentives can spoil the performance. We assess the risks and the associated rewards and respond in a way that seems to best serve us.
Business – For example, incentives for selling every single loan will spoil credit quality but if we keep negatives incentives on every NPAs then performance will get improves with safety in nature. The sub-prime housing crisis in the US is one example of incentive bias.
Investment – There will be incentives on different products to marketing personnel and due to that incentives, they sell products where they get higher incentives. The same happens with the stock market products. We have experienced Franklin mutual fund debt scheme example where distributors have decent commission available. And distributors have aggressively sold scheme to the investors.
Many a time, management focus on their performance incentive over an above of long-term benefits of shareholders. That is the reason to provide ESOP to top management (aggressive ESOP has its disadvantage, which we will discuss later on).
When we study pieces of advice given to us by others than 90% of cases having incentive effects hidden into it. We need to study the given pieces of advice thoroughly before accepting it. If we work on anyone’s advised without putting our efforts then that will become our fault.
Many of us have different superstition about our acts. We believe that if we perform a few tasks in some pattern or after performing some other task then we will gain. The illusion of control is the tendency to believe that we can influence something over which we have absolutely no sway.
Government, central banks and the world’s largest authorities believe that they have many tools by which they can control things the way they should be. And they use one tool after another. Few things might get control for that particular period but cannot be guaranteed for the future. We should rather focus on everything and try to control it; we should learn what we can influence and should perform.
Investment – Many participants in the stock market think that they can have tools by which they can catch every market movements and reap profits from them. Yup, they maybe can do it for some time, for some short period but is it possible for them to do it again and again? We cannot control the majority of things which we have to understand and perform the task according to it. The majority of the time, we live in an illusion of control but should understand that we cannot control the majority of things in the world. Many market participants focus on capturing each movement of the market and try to catch all gaining stocks. But should have understood that, it is not possible to do. So that rather than running behind each strategy to operate in the market, we should define a strategy that can be suitable to us and have to do it tested for longer periods. We only can control our own behaviour so we should focus on that part.
There are two types of knowledge. First, we have real knowledge. We see it in people who have committed a large amount of time and effort to understand a topic.
The second type is chauffeur knowledge – knowledge from people who have learned to put on a show. These people just make show that they know everything but they just speak what they have heard from the source. They speak as per the predefined script ready for them.
Any fool can know. The point is to understand. – A. Einstein
Investment – It is difficult to judge who is an expert and who has just a bird view of knowledge.
In 1998 Wesco meeting, Charlie Munger Quoted –
I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge. To me, they are like the bee dancing its incoherent dance. They are just screwing up the hive.
Mr Warren Buffett suggests us to decide what we know and stay with it, what he calls a circle of competence. Mr Munger suggests that the size of the circle is not important but important is, we stay within its limit well. If we do not know anything, we should simply say we don’t know rather act as an expert. I also faced such problems during the initial days of my career. I considered people with Chauffeur knowledge as an expert until I do not meet real experts.
In the stock market, we meet many people who act as an expert but the majority of them not. We have to carefully check their knowledge before trust on them. We have to understand their investment philosophy and process before making a judgement of them. True experts recognize the limits of what they know and what they do not know. If they find themselves outside their circle of competence, they keep quiet or simply say, ‘I don’t know.’ We also have to perform the same for becoming an expert in our field.
The Illusion of Validity
Subjective confidence in a judgment is not a reasoned evaluation of the probability that this judgment is correct. Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it. It is wise to take admissions of uncertainty seriously, but declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.
Business – When the business personal preparing blueprint for a particular project and the narrative of the project seems good then he starts believing that this project is very good. Thus, they have to execute that project. But this confidence can turn out as overconfidence.
Investment – When we study a particular company and its narrative looks so good then we start getting confidence in the future performance of the company. But this confidence has created a story in our mind and that does not necessarily to be proven as true so that we also should work on writing down what can kill this idea. This helps us to make wise and rational decision.
The Illusion of Stock-Picking Skill
What made one person buy and the other sell? What did the sellers think they knew that the buyers did not?
Buyers think the price will increase and sellers think that price will fall.
Individual investors try to react to each news but institutions are selected about the reaction on the news which also proves their label of Smart money.
The majority of people have an illusion of skills. The majority of people believes that picking stocks and getting a return on them is mostly responsible for their skills and does not appreciate the role of luck.
But it is not the ultimate truth. There is a role of luck that should be appreciated. Not believing the role of luck will lead to overconfidence in their skill. And that will tend to make any irrational decision. So that after buying or selling, we will think that stock price will move as per our expectation because we have completed with all necessary study and confident about movement.
We should always think that the seller/buyer has much more insights than us which make him selling/buying a particular stock. This thought process helps us with widening our thoughts process.
We tend to overestimate our knowledge, ability to predict events/future, own behaviour, etc. The overconfidence effect does not deal with whether single estimates are correct or not. Rather, it measures the difference between what people know and what they think they know.
Expert suffers more from overconfidence rather than normal laypeople. We have statistically proven data but we ignore it and overestimate our abilities and knowledge. Overconfidence has been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim.
The Illusion of Understanding
In The Black Swan, Taleb introduced the notion of a narrative fallacy to describe how flawed stories of the past shape our views of the world and our expectations for the future. Narrative fallacies arise inevitably from our continuous attempt to make sense of the world.
When we read about anything, our mind starts creating an illusion of understanding regarding those concepts or event. When we make any critical decision and that succeed then we give huge credit to our skills and underestimate the role of luck.
The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact, we understand the past less than we believe we do.
We try to learn many things from the success of others but we have to understand that things can be more different than what we are understanding.
Business – Management of any business easily fall under such bias, if they have a strong track record in past. Few managers have overconfidence in their ability to run a business. So that they acquire any business or plan for a new capex at the top of the business cycle at sky-high valuation. They just follow their intuition rather than follow data and facts. We should avoid businesses having such a manager for investment purpose.
Successful businesses also can meet failure in some of their ventures. Google has achieved success in the search engine, e-mail services, mobile operating system, video streaming, maps etc. but Google also has faced failure in social media platform such as Orkut, Google Plus.
The Illusions of Pundits
Investment – When we have research and made investment decisions then we overestimate our knowledge and think that we cannot go wrong. Though the result shows that we have got wrong in past then also we blame it on external forces.
Everything makes sense in hindsight, a fact that financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.
Few experts are becoming overconfident as they acquire more knowledge. They fall more under the illusion of skills. So that does not try to predict the future based on the past.
“The mistake appears obvious, but it is just hindsight. You could not have known in advance.”
When we see the 2008 financial crises now, we can say that such mistakes are obvious and should avoid. But we can only do it after it happens rather than during that period.
In conclusion: be aware that you tend to overestimate your knowledge. Be sceptical of predictions, especially if they come from so-called experts. And with all plans, favour the pessimistic scenario. This way you have a chance of judging the situation somewhat realistically. Experts miscalculate; championships change hands; and winners become losers.
We can save ourselves by killing our ideas.
When we are investing, we should write down every decision in an investment journal so that we can track the quality of our own decision. Also, we should prepare a checklist which helps us to reduce our emotions and improves decision.
When an unpredicted event occurs, we immediately adjust our view of the world to accommodate the surprise.
A general limitation of the human mind is, its imperfect ability to reconstruct past states of knowledge, or beliefs that have changed. Once you adopt a new view of the world (or of any part of it), you immediately lose much of your ability to recall what you used to believe before your mind changed.
Business – When businesses running well then businessman start thinking that business is always going to do well and they start making huge Capex for it. Or they feel that a strong business environment will remain to continue and business has more value creation left (top of the cycle) so they will announce a buyback. Such things happen especially with cyclical businesses.
Investment – When we keep evolving with the new process, philosophy to invest then we start replacing it with an older one which helps us to make the best of ourselves. But with it, we should not forget good things about the previous process, mistakes made by us in an older process because these all help us to keep evolving over some time. We should document our learning over a period so that we can evolve in a better way by retaining our previous learning. We have seen the evolution of Legendary investor Mr Buffett, who has evolved from ciggarbutt to moat investing but still he has not forgotten his learning from a past strategy.
When we look back then past events look very obvious to us. But that was not as obvious as it looks now. People who know hindsight bias, also fall under the trap of it. So, the author has suggested us a way to handle it.
When we read any history book then feel that events that occurred were so obvious but living those moments are much difficult.
Business – If any businessman achieved success then he will look back in past and rate his probability of success much higher.
Investment – In 2007, everyone talks about the great growth potential of the economy and in 2017 also, post GST we will have a strong economy, we will post stronger economic growth. But when we look back to 2008 and recent GDP falls. It looks obvious to us.
So, when we have maintained records of our observations and decisions then we can track the quality of our decisions. We can look back on our decision and on what basis, we have taken a decision.