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“.

DON’T TAKE NEWS ANCHORS SERIOUSLY – Chauffeur Knowledge

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

Source – Vivify

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.

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

Overconfidence – 2

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.

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

CYCLE POSITIONING – 14 – MASTERING THE MARKET CYCLE

It is always important to be defensive and aggressive over a different period of time. We cannot be defensive for every time or aggressive all the time. The most important is when we should become defensive and when we should become aggressive, it matters a lot. If we become defensive at the bottom of the cycle and aggressive at the top of the cycle then it will be dangerous for our wealth.

We require aggressiveness, timing and skills for achieving success. Aggressiveness at the right time creates a fortune.

For getting success, we have to focus on key elements mentioned by Mr Marks.

• Risk in our portfolio in the cycle, which assets we are holding in the portfolio and among those which are overweight or underweight.
• Aggressiveness such as holding second-grade assets, leverage, macro dependent investment, putting more capital at risk. Defensive investment such as holding cash than securities, safer assets, avoid leverage. Selection from above both depends on where we stand at the cycle and what can be a future market development.
• The skill requires to make a balanced decision. Luck required when randomness has more effects on the events. Skills help us to make a decision in the portfolio but luck can fail our right decision or proven to succeed in our wrong decision in the short run. Skills win the battle in the long run.

When we found that we are positioned in the cycle where pessimism at lowest, the economy has better development, etc. and we have become aggressive towards portfolio positioning then it will reward us with greater profits while the market does well as per our assumption. And also incur losses if the market does not work as per our assumption.

Being right is not into the control of anyone due to the involvement of randomness and luck factors.

When we found that the economy started being optimistic, the psychology of investors started optimistic, good news started flowing then we need to cut position in our portfolio which we feel overpriced. This effort helps us to reduce risk when slowdown or recession occurs. But this decision requires a skill set otherwise we will underperform the market at whole.

We always have to keep in mind that when the market is low in the cycle then the probability of losses is low and the probability of making profits is higher. Reversely, when the market is high in the cycle then the probability of incurring losses is higher and the probability of making profits is lower. We cannot predict the outcome but we can take advantage of the cycle by making an assumption of it.

After identifying the market cycle, we need to make a selection of the assets. If the price of the asset is lower compared to its intrinsic value then it will do better than other assets. And if the price of the assets is higher compared to its intrinsic value then it will not do much better than other assets. We also should focus that whether the intrinsic value of the assets has scope for further growth or not.

Theoretically, it quoted that the market is efficient and all the information is available with everyone so that no one can make profits from it. But reality shows something different. It shows that few people can think differently from the crowd and get above average than all. This is called second-level thinking where we need to think wise and differently from the crowd. Those who use second-level thinking they can do above average than consensus. This is key to assets selection.

Winners have a tendency to fall less than the market and during the rising market, they meet the market. And those who do not have a skill, they fall more than the market and does not have a higher return when market raises.

Aggressive investors with superior insights, fall slightly more than market in falling time but raise more than market in good time. Whereas defensive investors with superior insights, outperform in the worst time and underperformed the market in good time. We need to keep a balance between both. The person who can make a balance between both aggressive and defensive with superior insights, that investors outperform the market at the worst time as well as in the good time also.

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

Read for more detail: Mastering The Market Cycle: Getting the odds on your side by Mr.Howard Marks

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

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 “ADDING VALUE”

If our target is to achieve returns similar to the market returns with the similar risk & reward scenario then it’s not a difficult task. We just need to buy an index fund. But if we want to add a value to our targeted returns, different risk & reward scenario then we require a superior investment skill, superior insights which we have seen in second level thinking.

For the understanding, what actually mean for skillful investors to add value, we need to understand Beta – portfolio’s relative sensitivity to market movements. And Alpha – ability to generate performance unrelated to the movement of the market (I.e. personal skills).

While we are active investors then we have a number of options available to us.

1) We can decide that whether to build aggressive or defensive portfolio compared to the index, such characteristics of the portfolio is for temporary situations or for permanent. If we build an aggressive portfolio then it will increase a systematic risk of the portfolio that is beta.

2) We can make a decision to get deviate from the index. We may buy few index stocks and exclude others or add stocks which are not the part of the index. As such portfolio gets diverted from the index so that return of portfolio also get deviate from the index. But in a long-term, the return of investors with superior insights will cover index return and can able to add value in terms of risk-reward scenario.

If we are managing our portfolio actively then we require having a second level thinking skill. If we do not have such superior insights then it is advisable to go with a passive investment. We need to shift a portfolio from aggressive or defensive as per the surrounding situation and need to avoid a frequent trades with the belief of generating a higher returns.

Different active investors hold different portfolios, some of those portfolios perform better than others portfolio, and some of the portfolios perform well during some particular time period. In a longer-term, active investors with superior insights can able to generate an above average risk-adjusted return. Combination of all different active portfolio reflects market behavior but in fact, all of those portfolios having different features.

Aggressive investor’s portfolio can able to generate a higher returns compared index in a good time and lose more compared to the market in a bad time. This volatility is measured by beta.

If the Investors who generate higher returns with risky portfolio compared to other investors who generate average returns with low-risk portfolio then always we need to put more emphasis on the risk-adjusted return. But we cannot quantify each and every risk involves the portfolio. So that we need to accept that investment skills having an existence though everyone does not possess it.

If we don’t have any investment skill then we can able to achieve index return by making an investment in the index fund. Some of the investor’s portfolio fluctuates more compared to benchmark and few of the investor’s portfolio moves near to benchmark returns and few others can able to control risk and fall less. We get a different result at the different market scenario but our core focus should be on controlling risk and able to generate a risk-adjusted return.

In bad years, defensive investor’s lossless and in good years, aggressive investors make more money. So can we say that they are adding value? We cannot able to say anything about the value added by just seeing to the one-year performance of any investor. We can able to see the value added in a long term only.

Mr.Buffett, Mr.Howard Marks have mentioned that they like to increase average in good years and fall less in bad years. This provides them an advantage to adding value over a longer period of time. Protecting ourselves against the worst period is essential compared to the beat into the good period.

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