NEVER JUDGE A DECISION BY ITS OUTCOME – Outcome Bias

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.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

The Intelligent Investor – 6 – Portfolio Policy for the Enterprising Investor: Negative Approach

We have seen the defensive investors in the last article of the same series. Now, Mr. Graham has explained what not to do for the defensive as well as aggressive investors.

Mr. Graham has explained what not to do for aggressive investors such as –

Aggressive investors also have to start with deciding an allocation between common stocks and bonds. Also, they have to be ready with more analytical work compared to defensive investors. When second-grade bonds are available at the substantial discount to the principal value and also, having a prospect then it will be more attractive compared to high-grade bonds. Aggressive investors have to compare a discount available to the high-grade bonds and the second-grade bonds. We need not forget the rule of the safety of principal while investing in the bonds. We need to check the adequate cover to the interest charge on pre-tax earnings. If such cover is not available then we should avoid bonds though they having a higher yield.

Mr. Graham has mentioned regarding foreign bonds that we do not properly know the future of foreign bonds. If any troublesome times come then we do not have a legal means of enforcing claims. So, we should avoid such opportunities though we get interested rate benefits.

Day trading – Mr. Graham has mentioned that day trading is a weapon invented for committing financial suicide. Buying and selling a stock for a few hours also bringing down your profit. The more we trade; we keep less with us which also affects our long-term profitability. Luck can provide us a benefit for a few times, but for getting consistent benefits from trading, we require great attention. Someone who can’t hold on to stocks for more than a few months at a time is doomed to end up not as a victor but as a victim.

New issues – we need to be very careful before purchasing a new issue because the majority of the times new issues comes during favorable market conditions for the seller of the new issues which means not purely favorable to the buyers of the new issues.  Majority of the time, prices of new issues get collapsed. We have seen very few winners which have given a good return by investing in the IPOs such as Infosys, Wipro, Eicher Motors, etc. but there is a huge list of losers also.

So that does not jump to the IPOs at higher valuations, lets company to work for justifying such a higher valuation.

Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

John Paulson You Only Need to Win Once

Luck is not always going to support us if we do not have the proper skill to make appropriate decisions. If we won by help of luck but make the wrong decisions thereafter then we end up with the losing a game. And for making an appropriate decision, we need to work on developing our skills. If we get success by using a stroke of luck then we cannot say that failure will not come to our way. Actually, success and failure is a cycle so that if we meet success then failure will come to meet us next. By developing a skill, we can reduce the intensity of the failure.

John Paulson has started a hedge fund company with $2 million of own fund in the year 1994. His firm is specialized into the merger arbitrage. But during the year 2005, one of his analyst Mr. Paolo Pellegrini suggested him that US housing market is into the bubble territory. And after reviewing facts presented by Mr. Paolo Pellegrini, Mr. Paulson convinced to go against the housing price. He started acquiring credit default swaps. As he got a confirmation for his idea, he has started acquiring more swaps. The largest mortgage guys of the country were positive on the sub-prime during the year 2005. But outside of his team called him a crazy. He has earned during a fall of subprime in the year 2007 worth of $15 billion for the fund and $4 billion for personal.

After the big success, he started searching for a similar big winning idea. When we get a huge success then we need to save ourselves from the trap of ego. This is a very crucial emotional bias which enters to us and we remain unknowable about it.

Mr. Paulson has an idea to buy more valuable asset compared to inflation during the year 2010. So that he bought gold and gold-related investment worth of $5 billion, he became the largest owner of gold in the world. He could not able to repeat his past success and lost 30%+ value in a year and after that, he lost value for consecutive three years. Mr. Paulson other funds also lost in value and also merger fund where he has an expertise that also falls.

We cannot able to hit winning shot every-time but when we hit a winning shot, we need to keep those value which we received. But generally, we try to repeat those winning shot again and again which create destruction of wealth for us. I learn from my Guru – Mr. Neeraj Marathe Sir, from Howard Marks and Mr. Ben Graham, that protection of wealth must be our priority. Neeraj Sir always mentioned that if we focus on avoiding mistakes then we won half of the battle. So that we should focus on not to hit a winning shot but rather focus on not to lose money. If we survive into the game then we may have a chance to hit winning shot again. But if we do not survive into the game then there will not be any probability to hit a winning shot again. If we keep our focus on hitting a winning shot then we compromise with the capital protection which is an essential part of the game. And we should not forget it ever.

Read for more detail: Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

Jerry Tsai You’re not as smart as You Think

When the market is into the bull phase, each and every stock in upward momentum. So that everyone who has made an investment is shining and looks like a genius. But we should understand that earning during a bull phase is not our skill, it’s has a role of luck also which has supported us. Our actual skill comes during a bear phase, while we protect our wealth or fall less. But we get confuse and does not appreciate the role of luck during the bull market and make blame to the luck, market, other external factors during the bear market. Such behavior stops us from growing into the investment field.

“APPRECIATING THE ROLE OF LUCK” – Howard Marks

If we could not survive during a bear phase then we definitely going to wipe out or end up with the lower return. But bull phase of the market makes us tempting and overconfidence to our skill rather make an appreciation of luck which has actually perform a role.

Jerry Tsai was run Fidelity Capital Fund by the year 1957 and he was one of the celebrity fund managers during that time. And everyone eager to observe what he was doing.

Mr. Jerry style of managing fund-

Mr. Jerry has earned a return of 296% in the year 1958-1965 compared to 166% return of conservative equity funds. In the year 1965, Mr. Jerry has sold his ownership stake of Fidelity back to the Fidelity for $2.20 million and launched Manhattan Fund.

Mr. Jerry holds a few of the stocks during the year 1968-69 was Polaroid, Xerox, and IBM. These stocks were traded more than 50 times P/E ratio due to the high growth of earning. And University Computing, Mohawk Data, and Fairchild Camera traded at several‐hundred times their trailing 12‐month earnings.

We should be always prepared for the bear phase of the market. And also should avoid hot stocks during a time. Whenever I make any investment decision, I keep the year 1929 – great depression to my mind. So that I can survive and stay prepared for a bear phase of the market. When the market is into the bull phase, everyone talks about the return and focus only on earning a return, they do not like to talk about the risk and also do not focus on the risk. Such behavior has proven as a danger for us. And our behavior also responsible for inviting a bear phase from the bull phase.

The game which is played by Mr. Jerry was not a long term surviving but he believes that he can survive for the long term because he has huge insights for the market moves. And he was overstated for his own skills. We need to understand that everyone can earn during a bull market but survival during the bear market is essential. If things do not fall under the criterion then we should avoid it rather chase for it. Not great company will be a great investment at any price. If we are not able to understand it, then does not able to survive for the long term.

If someone has bought this company during the March-2000, at the high price of around Rs.215 then after the 19 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.138 during the March-2000 then after the 19 years of the period, he gets a returned of 9% CAGR (*Considering recent all-time high price for calculating returns). Though revenue has grown at 26% CAGR, Operating profit grown at 23% CAGR and Net profit also grown at 23% CAGR during the same period. The company is supported by a good management team, good business, leadership position into the industry. During March-2000, the company was traded at 64x P/E at the low price of Rs.138 and this multiple are common nowadays and we consider it as a quality company ask for the premium. We cannot estimate which valuation multiple is high or low but we can understand that what is reasonable and what is not.

Read for more detail: Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

BIBLIOPHILE THE MOST IMPORTANT THING BY HOWARD MARKS

One of the books which have influenced me and my investment journey is “The Most Important Thing by Howard Marks”. This book teaches us the most important thing which we need to develop for becoming a wise investor.

“The Most Important Thing” has many concepts which can help us to our investment journey. I have posted articles on the book. Now, I have compiled different articles into the one file for the ease of reading.

For, All in One Article click – BIBLIOPHILE THE MOST IMPORTANT THING BY HOWARD MARKS

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “INVESTING DEFENSIVELY”

Whenever someone asks us for an investment advice, then our first step must be an understanding his attitude towards the risk and return. We need to ask a question to him that what his choice – making money or avoiding losses is.

We cannot able to do both the things simultaneously in each and every situation.

If we provide an advice or we make an own investment without knowing attitude towards risk and return then we will not able to provide a proper solution. This is as similar as an asking for a cure from a doctor without disclosing our diseases to him. Investing is a full of bad bounces, uncertainty and random events which challenge us every time. So that such uncertainty requires knowing our risk-reward attitude for long-term survival into the market.

While we hit fewer losers then our probability to win the game is much higher. We need to choose how to play the game of investment – Offensive or Defensive.

We just need to do is to protect our wealth by not picking wrong opportunities. In investing, only avoiding losers is in our control, not everything else. We do not know what will happen in the future, our best investment can be turnout as the worst investment. But we have to be ready for it. We have to focus on missing wrong shots so that can protect game if our best turnouts as a worst.

If we look at the sports, many a time we need to protect our wicket rather play aggressively to make scores. Staying on a pitch provide us an opportunity for making a score while we get a good hitting opportunity. Investing also having many points which are similar to the game either positive or negative. As in cricket, Dhoni, Sachin, Rahul Dravid, Virat all having a different style to play a game. Some play defensive, some play aggressive and some make the balance of it. We cannot able to judge any players by looking towards his one match. Successful players perform well over a longer period of time with consistency.

Sometimes even a good players overestimate short-term success and forget to focus on the consistency of performance over a longer period of time.

As all players cannot be a Sachin, Dhoni, Dravid. As similarly, all investors cannot be a Warren Buffett, Charlie Munger, Howard Marks, etc. We just need to focus on our game in our comfort zone.

We are not able to know what will the result of the game we played, any uncertainty can affect it. We cannot only focus on one single investment ideas, we need to work on a selective group of ideas.

Negative side – If we keep on playing an aggressive investment game then we might not able to stick for the longest period of time in the game. Many uncertain events work as bounces for us.

Many a time, short-term investment success can become a reason to ignore the durable and consistent track record of investors. And few get attracted towards shine without checking its durability.

When opponents try to keep on throwing bounces then referee blows the whistle to give warning sign to opponents but in investing, there is no one who blows the whistle, we cannot able to get protected. Also in sports, we get notifications for the change of turn from our to opponents. But in investing, there is no notifications are available to us. We have to decide ourselves for changing the game from offensive to defensive.

We need to focus on the outperform into the bad time rather focus on outperforming into the good & best time. In good time, everyone can able to generate a good return but skill comes when we can able to outperform into the bad time. Doubled your Money in Last 3 Years? Skill or Luck?

Every player can able to play well against a weak team but a good player who can able to play well against strong opponents.

We should focus on either making more score or stay on the pitch for a longer period of time. We cannot say that only one way is the right way and we just need to select it. Selection of way can be based on our experience, learning, market environments in which we operate, etc.

We require a different kind of mindset for doing a right thing and avoiding doing the wrong thing.

Defense is focused on avoiding bad outcomes. It can help us to generate a higher returns but more through avoiding bad outcomes, through missing bounces, through managing risk.

If we bought an asset at Rs.100 and it falls to Rs.50; it falls by 50% but for reaching to Rs.100, that asset has to rise by 100% to just reach break-even.

When we play offensive and if it works then it will add additional returns to our investment. BUT if not works then it creates a damage to our investment and to our wealth.

Defensive game help us to stay in the game during a tough time also, it helps us to survive for a longer period of time.

Majority of a time, financial markets works in an average manner but it shows one abnormal day which has reason to destroy our financial health. We need to prepare for that worst day. We just can prepare for the worst day but cannot predict how worst it can be or when that worst day will come. But it’s sure that worst day will come.

It is hard to say in investing that whether our investment becomes successful or not and it works in the future as we have expected, economy /industries / Companies moves in a certain way and we prove to be right every time. We need to take care of the unforeseen future events which can go against us and can meltdown us. Warren Buffett has given concept which can protect us from such unforeseen events that called “Margin of Safety”.

When we buy Rs.100 worth of an investment for Rs.90 then we have a chance to gain. But when we buy that same thing at Rs.70 then we have very less chance of loss and if odds will be in our favor then we can able to make a good return. So that buying cheaper provide us a “Margin of Safety” when our assumptions go wrong.

In the over-optimistic scenario, people buy Rs.100 worth of investment avenue for more than its worth (I.e. Rs.150, Rs.160) and then find a greater fool who will buy at the higher price from him.

When we need an above-fixed returns then we need to go for more uncertainty but how to balance the defensive game with the inclusion of offense is the key area to focus. We cannot get higher returns with the exclusion of offensive game. We cannot able to win the match by just keep on making a single run. We need to hit 4 & 6 but with also focus on not losing a wicket.

Our first focus is to play a defensive game for staying on the pitch and then the inclusion of offense to the game for generating higher returns. Such approach provides us a consistency for a longer period of time.

If we take out a history of investment managers, investors then we will come to know that very few get survival for the longer period of time. Not due to their inability to make a 4 & 6 but to lose wickets in many matches. Many investors come and performed well in a good time but worst time make them disappears.

The managers who do not get survived for a longer period, the majority of them have built up their portfolio on based of favorable scenario and with the hope of likelihood of outcomes without keeping a room for the occurrence of an error.

Aggressive investors require competitive technical skills with fortitude, patient mindset, and capital. The investment might have potential to work well in a long-term but above quality provides a support to stay in a game for a long term.

We should focus on controlling risk, avoiding losses rather than try to focus on gaining again and again.

Simply defensive investing means being scared while making an investment decision. Worrying about losses, bad luck, worrying about something we don’t know, bounces etc.

Read for more detail: The Most Important Thing Illuminated by Howard Marks

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “APPRECIATING THE ROLE OF LUCK”

While we involve into any of the investment decisions then those decisions are having dependencies on the future. As we know that future is uncertain and it is difficult to predict it. In such uncertain investment environments, luck plays an important role and we have to recognize the role of luck in our investment journey.

When we get some result or looking at the result then we must have to think the role of randomness in that generated result.

Many outcomes are visible to us but we have to think those outcomes with different viewpoints. If someone has made a risky & uncertain investment and he gets a good outcome from it. We can say that such outcome happens due to luck not due to skill. But people take such outcome as their skill, not consider a role of luck.

For example, baller throw ball towards stump for capturing a wicket of the batsman and that becomes the wrong throw and ball has touch boundary line then it is not a skill of batsman but the role of luck.

Many times, people get the return on investment by just being in the right place at a right time. Not due to their skill.

If someone has invested his fund during the year 2013 with just making a portfolio with random stocks then also that person generated a good return. Doubled your Money in Last 3 Years? Skill or Luck?

In short term, we can able to generate a good return and many a time achieved an abnormal return by just being in the right place at a right time. But what about the long-term result? How we can say that luck always keeps on favoring us.

Generally, during a boom period, the person who takes a higher risk get highest returns. But that is not the reason to consider them as the best investors. Very few people appreciate the role of randomness or luck in the life or in investment journey.

Mr. Taleb has mentioned the list of things which are generally mistaken by us.

We should understand that when things going right, luck looks like a skill and people misinterpret lucky investors as skillful investors. Many a time, we get an extremely good reward by chance and we make a mistake to consider such result as our skill.

That means batsman hit ball for six and that ball also declared “No ball” and batsman get free hit and he again hit another six on a free hit.

In short run, we can win and make good returns by an occurrence of chances but in a long run, our wise decision provides us a good reward.

When we realize that investment outcomes get an influenced by the randomness then we can able to focus on every event with the different perspective. Otherwise, we just thought that such outcomes happen due to our skills only.

We have made a list of assumption for the occurrence of events but we also should focus on the occurrence of other different events; which we may not have assumed. It might be possible that sometimes all other events have collectively more probability to occurred compared to the single event on which we have put the huge focus. Such ignorance becomes dangerous for our financial health.

Investing something like a mixture of both skills as well as luck. Investing is not a pure luck like a snake and ladder game or not a purely skilled by the game of chase.

While we play chase then we require a skill to protect ourselves from moves of an opponent’s. We cannot able to win chase just by waiting for the favor of luck and mistake made by an opponent. We have to create a scene where opponent commits a mistake and we can able to win a game.

Whereas, there is not a requirement of a skill in throwing a dice while playing a snake and ladder game.

But we generally consider our winning as our skill while we should recognize that we are winning a snake and ladder just due to a support of a luck. While we should reach towards 100, we should not forget that there is a snake on 99 number which can bring us towards number 7. And transform our success into failure due to highly dependencies luck. Similar happens to us while we play an investment game on the base of pure luck. We may win till number 98 and maybe that our fortune transforms into failure by destruction in our wealth. We climb many ladders, get many multifold return generator stocks but we forget that such occurrence is due to luck. If we do not have our skill involve in it, then our wealth get destroy. We should not forget that investment requires a luck but also it requires a skill. If we fully dependence on the luck then we should never forget a snake on number 99.

Read for more detail: The Most Important Thing Illuminated by Howard Marks