Behavioral Edge

To err is human. Except, in investments, errors end up lot more expensive. In most cases, esp. in listed space, such errors are more often caused by emotional short-circuitry than any intellectual shortcomings. Emotional handicaps often occur because of mind’s inherent nature to magnify events that are current and immediate while short circuiting other material events that may not be current. To understand this better, we can try modeling this in a algorithmic fashion. Imagine, we have a computing algorithm that magnifies micro inputs using self-feeding feedback loop and throws magnified outputs based only on “recent”, but minor events, bypassing other rational “past” material inputs. This model would effectively mimic the emotional brain with a behavioral bias.

Investment decisions are supposed to be rational and logical. But in reality, they are anything but that. If investors are rational, then, markets which are nothing but collection of investors, by definition have to be rational. Since we know markets are irrational, we can deduce that investors suffer from significant number of delusional defects that deter them from making sound logical decisions. Though there is a separate stream of finance, called behavioral finance, covers extensively on the various types of cognitive biases, we would like to look at closely one bias that has an outsized impact on investment results.

To understand this special one more, let us look at two investment options in the below illustration and check how investors respond to this situation.


The choice is straightforward, if investors are logical. They should go with option-1 and accumulate/add on every fall. But in practice, what many studies have found is, much of the times, investors chose option-2. What is going on here? It is interesting to note that the emotional circuitry (blind-spots) edges out the logical circuitry in all those cases. Let us examine these blind-spots little more, by looking at the list of behavioral biases that are at play in this decision making:

• Loss aversion bias, even though loss is notional.

• Fear of more downside.
• Recency bias where mind gives more weights to short-term events.
• Tendency to over-estimate one’s ability to time the trend change.

As someone wise said, how one behaves near the top and near the bottom makes all the difference between success and failure in investing. If one has the ability not to freeze into inaction at the edges, then it brings real competitive edge in this business. This means, one has to constantly hone the emotional skills to deal with the greed of making more near the top and to deal with the fear of losing more near the bottom.

Logically speaking, both should be easy because both upside and downside are notional near the edges. But emotional short-circuitry magnifies the greed and fear so as to blind the logical circuitry. Large part of success in investing comes from how one deals with these inner demons that distort the decision cycle thro’ behavioral bias. Edge in investment business comes from simple emotional skills (EQ), not from any intellectual ability to solve three dimensional complex algorithms.

“Moat in investment business comes, not so much from thinking skill, but from silencing the emotional circuitry i.e. honing emotional skills”

Current market weakness is throwing multitude of option-1 type opportunities for investors to grab. It is time to still the mind by silencing the inner demons to capitalize on the market capitulation, not to lose bearings on probable paper losses.

Happy Value Investing!!


Year of Accumulation?

Shine is off from stocks. That is good and should be a welcome relief from the one-way reckless rally that has been ruling the roost for many months in a row. In a rare coincidence, multiple cues came together in a miraculous fashion to conspire a deadly blow to the bloated stocks. Global bond sell-off and tantrums on trade war couldn’t have come at a worse time. Just when the FM was lighting fire with his ill-thought LTCG tax (Long-term capital gains tax), global cues turned negative triggering a slump in Indian stocks. Macro fiscal worries from lavish MSP proposal and other rural largesse added to the ammunition with ten year yield Gsec yield spiking to levels not seen for many months.

All these are not completely unexpected except the eerie coincidence of all coming together. Market is hugely edgy and weighed down by uneasy calm. Weakness in the broader space should be a welcome development for seasoned stock pickers. If 2017 was an unstoppable one-way rally for much of the broader market, with volatility returning this year, 2018 should be viewed by serious investors as an opportune year for accumulation / portfolio building for an eventual breakout in 2019 when the economy starts reaping the rewards of series of structural reforms of past few years which will catapult the GDP growth rates to beyond 8%+.

“Structural reforms such as Bankruptcy code, RERA, Subsidy reforms thro DBT, Indirect tax reforms (GST), Financialization of savings, Inflation control etc. will drive the break-out for the economy from its badly stuck 7-7.5% range from FY20 onwards”

Investors should focus on portfolio construction and stock picking during
this period of volatility (because of weakening macro) by moving more additional investments into equities for benefiting from the eventual breakout that will play out from FY20 onwards. It is time to increase one’s equity exposure in a gradual fashion, not to lose bearings on paper losses.

Happy Value Investing!!


Time to invest, not to time the bottom…

Crack in the market always comes with cacophony. Investors should be wise enough not to wait for cacophony to clear and instead focus on picking undervalued stocks with high margin-of-safety without yielding to the temptation to time the bottom. As someone wise said, if you wait for robins, spring will be over.

Instead of timing, the focus should be on Margin-of-Safety (MOS). Let us turn to the anecdote of coin flipping to understand more on the concept of MOS. As we know, flipping the coin is a risky bet. Is there a way to improve odds in that? What if, heads you win and tails you do not lose? Though odds of winning do not improve, odds of not losing improve to 100%. This is exactly what Margin Of Safety does in investing. Strangely, in investing, when you are focused on downside, upside takes care of itself. Value investing is all about downside protection and MOS is the magnificent tool to mitigate the downside risk. It is the magical concept that magnifies the portfolio returns by denting the drags from losers and by earning exceptional rewards from winners. To quote Ben Graham, “Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety”

How does one get MOS in stock picking? If MOS is defined as the discount from the intrinsic value of the underlying business, primarily, it comes from the mis-pricing in the markets. Mispricing can happen on two counts. One from the broader market trend and the other from stock specific scenarios(when underlying business comes across short-term bumps). In general, mispricing is on the upside when the mercury is up and it is on the downside when there is meltdown. It applies both to stock-specific swings and to overall market moves.

The challenge is not so much about getting MOS opportunities. Vicious corrections even in a virtuous bull market are not very unusual. Similarly, stock specific slumps are not scarce in a secular uptrend. The harder part is more about having the nerve to invest when such MOS opportunities arise, as in most cases, the accompanying high decibel narrative numbs the investors into inaction. Take for example the ongoing correction. Last week, small and midcaps were mauled mercilessly (continuing as we write this). For most of the stock prices, the clock was back by one year. Yet, the same people who were waiting on the fence for a sharp correction, turned frozen because of the changed narrative. As they say, money is made not in following narrative, but in following valuations. Narrative will take care of itself as time goes.  MOS grows in manic pessimism. Time to start nibbling is when narrative turns negative. If you wait for cloud to clear, MOS too will mysteriously disappear.

“Current market weakness is nothing but market’s way of adjusting to                                      the weakening macro. Market never adjusts in an orderly fashion. To                                    that extent, as market adjusts to the new macro challenges, expect lot                                    more bumps and humps in the coming months”

But time to bet is when these bumps and humps bombard, not when it becomes seamlessly smooth. While macro may not be at its best, underlying recovery in micro (recovery in corporate earnings) may provide the required support in the medium to long-term.

Happy Value Investing!!