Stock Investment – Lesson 6

Investing is simple but not easy.

Doing number crunching, assessing the business, understanding how the business might look in 5 years, understanding the moats, calculating the intrinsic value for business..

..all this is simple but not easy.


What does that mean?

Ordinary intelligence is enough but what you need is the temperament to control the urges that get other people into trouble in investing.

Because we don’t know how to balance our greed & fears…..

It’s the human behavior, stupid !

Investing is more about discipline and human psychology than financial analysis.

Stock market as such is made up of human participants who have their own set of beliefs and biases. Right?

As a result, the market moves irrationally and you may end up losing money if you listen to the crowd.

Let me explain through a phenomena (or rather a bias) called crowd psychology.

A stock was trading at Rs 45 in 2015 and shot up to Rs 110 within a year. The stock moved up even when the company was reporting lower sales and profits for several quarters.

Then a high profile investor bought into the stock. Seeing this several brokerages came out with buy recommendations for whatever reasons.

As a result the stock shot by 75% further.

The business news channels started covering it and analysts were giving all sort of reasons to buy it.

This caught the normal investors attention and more and more investors started buying it.

Shooting the price of the stock even further.

According to my analysis the stock was overvalued. Another latest quarterly earnings report that came in also showed bad earnings.

But the stock refused to correct.

That’s because irrational crowd behavior was at play here.

Fundamentals of the stock were weak but the stock was going up because the crowd (market participants) in its collective wisdom decided to buy it.

No logical opinion can stop the rush towards the stock in such a scenario.

Once the hubris settled in the next few months, the stock crashed and all the investors lost their money.

This happens many times in the stock market.

You see in investing, you pay the price of mistakes by losing money.

Joining the crowd without a proper assessment and rational judgement is a sure shot way to lose money and of which you should be very careful off.

Read the above line again..

.. that could be the best take away for you from this course..

The biggest reason of losing money in stocks is because we don’t use our own mind and listen to “so called experts” who give free advice on TV.

You know what I am talking about 🙂

Crowd Psychology is just one of the biases that investors suffer from.

There are other biases that investors carry with them and that can hamper your chances of making money in the market.

Loss Aversion:

Investors react to losses quickly than they react to gains.

If you observe, the joy of making a gain of Rs 20,000 is not as intense as the pain of losing Rs 20,000.

An outcome of this loss aversion is that investors sell stocks as soon the price drops.

Or they buy more to average out the price.

This kind of behavior doesn’t help when you are investing in stock markets to create wealth.

As Warren Buffett says

“In equities, if you cannot bear your stock going down by 50%, don’t be in equities.”

Means, once you invest in good stocks, the stocks might go through significant fluctuations resulting in short term losses. But, if you think the fundamentals of the business are strong then you should bear this short term pain as the stocks will eventually give you good returns in the long term.

Confirmation Bias:

Confirmation bias is the tendency to seek out external confirmation that supports your beliefs.

Take Indian politics for example. Most of the nation is either pro Modi or anti Modi.

Pro Modi supporters will ignore any sort of information that criticizes government’s policies fairly.

Anti Modi supporters will deem all the good initiatives taken by the government as bad to support their inherent beliefs that this govt can not do anything good.

Both suffer from confirmation bias.

Much like in the politics example above, investors tend to gather confirming evidence when making investment decisions rather than rationally evaluate all possible information.

As a consequence, investors tend to become less critical and may end up losing money.

Therefore, try not to fall for this bias. Instead, you should be able to inculcate new information and change your views accordingly, even if it means that you have made a bad investment decision.

Availability Bias:

After the unfortunate disappearance of Malaysian Airlines MH370 involving 227 passengers in the year 2014, that was widely covered by media all across the world, the demand for travel insurance shot up.

That’s because the memory of disappearance is fresh in people’s minds and so they tend to take additional precautionary measures.

Over the time, this memory faded and the travel insurance demand came down to usual levels.

This is a classic case of Availability bias.

In fact, the odds of a plane crash are one for every 1.2 million flights, with odds of dying being one in 11 million. So air travel is very safe and may not warrant a travel insurance.

This form of bias leads to decisions being based on information and events that are more recent, observed personally, and available easily.

Under the influence of this bias, we rarely check the reliability of the information we have readily available nor do we try to search for patterns beyond a time horizon that our memory can serve.

While researching a company, investors tend to focus on data & information which are easily available to them and this results in availability bias.

Let me tell you another story.

Back in 2014 when the new government came into power and the stock market was in a bull phase, a lot of IPOs (Initial Public Offering) were getting listed.

And many of these IPOs also gave more than 30% listing gains. That became a market fad.

Seeing this more and more investors started to invest in every other company’s IPO hoping for listing gains without studying the underlying fundamentals of the business.

Importantly, without realizing that in the long run IPOs give pretty bad returns.

What’s more, having developed a viewpoint and invested in IPOs, they only focus on the information that confirms their viewpoint, rejecting any conflicting information resulting in the confirmation bias as well.

This behavior results in wealth destruction.

There are many more such behavioral biases like recency bias, liking/loving tendency, illusion of control, and so on.

So be aware of these cognitive biases and protect yourself from them if you want to create wealth in the markets.

~ End of the Course ~

Pardeep Goyal

PS:

I want to mention the last quote from Warren Buffet..

There are only 2 rules to make money from stock market

#1. Do not make the loss

#2. Do not forget rule number 1

That means you should buy the stocks where the possibility of making loss is zero.. rather than becoming greedy for the stocks where you see the possibility of gains.

Otherwise you would fall into one of the biases that we discussed in this lesson.

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