05 – Illusion

Illusions of Remembering

The illusion is not only of visual but it’s also of memory.

If we have seen any words or something for even a millisecond then also when we see it again we feel it familiar. Something which is in contrast to others that also give us a feeling of familiars. This creates a memory illusion.

Illusions of Truth

When things seem familiar, we generally tend to accept it as truth. But when things seem unfamiliar or extreme then we tend to reject it.

The impression of familiarity is produced by System 1, and System 2 relies on that impression for a true/false judgment.

When we wanted something to accept by people as truth then we keep on repeating the same. Because familiar things are easy to accept as truth.

When we listen frequently that equity investment or real estate investment can help us to create wealth then we become familiar to it and we start believing it as a truth. When we see people surrounding us making money through trading then we also believe it as a truth. We also start doing it without thinking about it as a truth or not. It keeps getting repeatedly visible in front of us and we believe it as a truth.

How to Write a Persuasive Message

When we write something truth but it is not necessary that people also believe it as a truth. For that, we need to use a true illusion. We need to draft our writing in a good manner, with proper colour combination and do not make it very complex, make it memorable.

Strain and Effort

The performance was better with the bad font. Cognitive strain, whatever its source, mobilizes System 2, which is more likely to reject the intuitive answer suggested by System 1.

The Pleasure of Cognitive Ease

Companies with pronounceable names correctly better than others for the first week after the stock is issued, though the effect disappears over time. Stocks with pronounceable trading symbols (like KAR or LUNMOO) outperform those with tongue-twisting tickers like PXG or RDO —and they appear to retain a small advantage over some time.

Ease, Mood, and Intuition

Our mood has an impact on system 1 and intuition. When we are uncomfortable, suspicious and unhappy, we lose touch with our intuition. And our system 2 take control. Reversely when we are happy, comfortable then system 1 take control.

So that we need to understand our mood while making any investment decision. If we are in good mood then our system 1 will take charge and we might not be getting involved in the proper analysis of our own decisions.

Norms, Surprises, and Causes

Assessing Normality

The main function of System 1 is to maintain and update a model of your personal world, which represents what is normal in it. The model is constructed by associations that link ideas of circumstances, events, actions, and outcomes that co-occur with some regularity, either at the same time or within a relatively short interval. As these links are formed and strengthened, the pattern of associated ideas comes to represent the structure of events in your life, and it determines your interpretation of the present as well as your expectations of the future.

When something happens or surprise our first time, when similar happens again, we will get lessor surprise or treat it as a normal. Our system 2 suggest that this is not a normal but system 1 made it. Whenever we met any surprises for the first time, our mind expects similar to happens again while a similar situation arises. That previous incident becomes normal for us and if that similar incident will not occur then we get more surprised.

It has been previously happening that market falls and get recover from that fall within 1-2 years. So that when the market falls everyone thinks that it will recover easily and we should invest. But there is a possibility that it may take a longer time to recover then what it used to be in past. So that we should not believe blindly that what has happened in past can happen in future also. It can have a higher probability to happen similar but also should not ignore the probability to not happen the same again or in the same time period.

Seeing Causes and Intentions

We generally use casual intuition frequently. For example, if someone says that he lost his wallet, then first thought comes of pickpocket rather than put somewhere, forget at restaurants, etc.

A Machine for Jumping to Conclusions

Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves much time and effort. Jumping to conclusions is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information. We should not jump to the conclusion where we know that involvement of system 2 is essential. It has a higher probability to meet error if we jump to the conclusion without taking the help of system 2.

02 – Conflict, Illusions and Useful Fictions

Conflict

System 2 is an in-charge of self-control. It helps us while we are losing our control, focus, emotions. While we are reading a book and found something boring in it and start losing focus towards continuing with a book then system 2 bring back our focus to the point. When System 1 indicates that it’s boring then system 2 brings back our focus.

When we have invested in business and stock price of that company not moving then we start getting boring with time. But system 2 help us to guide that business has improved in performance and there are not any fundamental issues. Focus on our process and sticking with it is the work of system 2.

Illusions

At the first instance, we have reached the conclusion that the second line is larger in size compared to the first one. But when we measured both the horizontal lines, we found that both are identical in size.

Here, system 1 has accepted view of the second line is larger than the first one and when we have measured, system 2 took control. But system 1 prevents us from believing that both lines are equal, it’s illusions. Though we have measured and know the size of both the line, we cannot stop system 1 from performing. When we can work on accepting that both lines are identical, we will not again get fooled by multilayer illusions.

There are illusions of thoughts along with visual illusions and that called as a cognitive illusion.

Many times, a person does not accept the reality and try to stay in the illusion, means their system 1 only works and they do not accept what system 2 indicates. System 1 has intuitive errors and biases which system 2 is not aware of. Errors can be prevented only by the enhanced monitoring and effortful activity of System 2. But it seems impractical to continue monitoring of thoughts and go slow on routine works. It will be inefficient if we replaced system 1 by system 2. We have to identify where mistakes are likely to happen and then have to give control to system 2. It’s difficult to identify your own mistakes compared to others.

Example – when we analyse the company and see a few characteristics which we like about the company then we stop focusing on others which can have a negative impact on the future prospects of the company. Dividend-paying companies are good which is stored in system 1 so that when we look at the company which is continuously paying out a dividend. We do not focus on other aspects and make an investment. But when system 2 take control, it will analyses whether the company has the ability to keep dividend continue in future, does company paying dividend from free cash flow or from raising external funding. 

We should use system 1 where rules are predefined such as we are not eligible to get a dividend if we purchase shares on or after ex-date. But analyzing the longevity of dividend, we need to use system 2. 

Useful Fictions

System 2 required a mental calculation so that we should not use it with other tasks.

When we are driving on a similar road frequently since long, our system 1 works automatically. It will suggest that when to take turns, at which area have slowdown speed, etc. It will not be going to ask for system 2 helps. We can drive on a known road while making a conversation. But the same does not happen when we drive on an unknown road. Our system 2 take control and if we make conversation while driving on an unknown road, we may meet accidents or miss with target place.

Anything that occupies our working memory reduces our ability to think. So that we have to be careful to perform multitasking. When people get involved in both trading and investment than both require the involvement of system 2 so that it will become difficult for the human brain to make a wise decision to cover all aspects. And that can result in missing out of something at both the area.

The Intelligent Investor – 13 – A Comparison of Four Listed Companies

When we have decided to make an investment then we need to perform an analysis work so that we do not be stuck with the wrong investment avenues or at the wrong time. For making an analysis, we must need to focus on a few points.

Profitability – how the company performs? Return on invested capital, margins, growth in sales-profits, earning per book value, etc. If the profitability of the company gets hampered then we need to check whether it is permanent or temporary.

Stability – earning of the company decline in any of the years from the past ten years? Do the earnings of the company get fluctuations? Does a company involve in a seasonal or cyclical business?

Growth – companies with higher growth command for the high multiples and lower growth with low multiples. The growth of the company can help us to grow our wealth also. The growth provides an opportunity for the company to use capital appropriately.

Financial position – liquidity ratio, the position of a balance sheet, debt, preference share, etc. Tree does not grow in the sky. If financials are not strong then the business will not be surviving for a longer period. So that we need to put emphasis on the financial. How does a company utilizing assets? Company is capital intensive or asset-light? Working capital intensive or negative cash conversion cycle?

Also, we need to check what the company is doing with the capital generated. What is the capital allocation decisions of the management? Long dividend track record, increment into the dividend, buyback, buyback at higher than intrinsic value or lower than intrinsic value and if a company requires fund for growth then reinvest profits for growth rather pay dividend or buyback.

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: The Intelligent Investor by Benjamin Graham, Jason Zweig

WARREN BUFFETT’S LETTER – 1996

Warren Buffett’s Letter – 1996

Acquisitions

Kansas Bankers Surety (KBS)

The company is an operating into the business of insurance which has a presence in 22 states, decent underwriting record with Don Towle as a manager. They made a deal to acquire a company at $75 million.

FlightSafety International

The company is the world’s leader in the training of pilots. The company operates in 41 locations, outfitted with 175 simulators of planes ranging from the very small, such as Cessna 210s, to Boeing 747s. About half of the company’s revenues are derived from the training of corporate pilots, with most of the balance coming from airlines and the military. They made an acquisition at $1.5 billion.

WB 1996 01

We need to prepare a list of the errors which can be dangerous for the health of our investment and work to avoid those errors. If we work on the avoiding mistakes then we can win 50% of the battle.

List of mistakes which I have experienced during my investment journey –

  • Never ignore the true value of the company—Every business has some value and that we should not have to ignore. If we commit such a mistake then the market will defiantly punish us. Be careful with the true worth of the company and only buy it when it falls below its true worth. And if business not available below its true worth then ready to missed that opportunity. Loss of opportunity is better than the loss of capital.
  • Don’t buy HOT —-If we buy the hot business such as recent trend, new IPOs, business on which everyone is bullish etc., then we must have to exit it at the proper time. So if we aren’t able to exit at the proper time then it’s better to let it go such opportunities. If we buy HOT then that HOT will BURN our portfolio.
  • Buying a high leverage business — We need to avoid a business which has a huge borrowings, such borrowings can kill the business and also kill our investment journey.
  • Using the wrong valuation method — Every business will not get valued with a similar valuation matrix. We need to identify the nature of the business and then value a particular business. Such as we should not use the valuation matrix of growing non-cyclical business for cyclical business, should not use the valuation matrix of assets light business for assets heavy business and vice-versa. If we made such a mistake then whether we might miss a decent investment opportunity or we might lose our capital.
  • A mistake of buying a story, not a fundamental — I have never ever made such a mistake because I am a hard-core lover of numbers. But I have seen many of the people who always focus on the story and also which is very trending to the market. I believe that without the support of numbers, no story can survive for long. In the year 2014-15, Logistics stocks due to GST gets a trending story but due to lack of good numbers, the story gets failed. People generally avoid numbers due to lack of understanding of it. I firmly believe that “Stories are for kids, not for investors.”
  • Investing without a process and philosophy — I can overcome this mistake at the initial period of my investment journey and that is only because of my guru – Neeraj Marathe Sir (who always believe on having a process and philosophy for making an investment). I have seen many people who spent lots of time into the market but they do not have any process or philosophy. They change their philosophy as they meet various people. If we do not have our own process and philosophy for making an investment then we will not able to create a successful investment journey. I also learn from my guru that we must have our philosophy in a written format so that we can refer it over a period of time and stop ourselves from occurring a mistake.
  • Not using a checklist — We should have a checklist for a business, industry, financial, management etc. so that we can focus on the points to study and also not forget any point to study. I am using a checklist for the last 3 years and I can say that having a checklist helps me a lot. My checklist keeps on improving as my experience grows.
  • Making an investment decision with disturb mind — We should avoid making an investment decision while our mind is disturbed. Disturbance in mind will end up with the faulty investment decision and which can be harmful to our wealth.
  • Cloning a well-known investors/fund managers — Again I can overcome this mistake at the initial period of my investment journey and again credit goes to my guru. If we have our process and philosophy then we will not try to clone others. I have seen many people who have spent 10-15-20 years to the stock market then also not having any process and philosophy & they clone others. Many of the people have cloning as their investment philosophy because they love to use shortcuts. I always remember the quote of my guru –

NM

WB 1996 02

When Company does not have an opportunity to reinvest earnings at a higher rate than the company should distribute those earnings to the shareholders so that they can use it somewhere for getting a higher return. If the company does not have a good opportunity to reinvest earnings and then also company does not distribute earnings as a dividend then we need to be careful with a company (Question on the capital allocation decision of a management or earnings can be manipulated or business always needs a huge capital to sustain only).

Examples – No/Low growth high dividend payout

GI

CI

Examples – No/Low growth low dividend payout

AIE

WB 1996 03

We need to check the above-mentioned factors in the company where we have made an investment and where we want to make an investment. Most important is to gain a market share. The company cannot able to gain market share, though the company has a competitive advantage then that competitive advantage not useful for us. We should not focus on the leadership position of the company rather need to focus on the companies which focus on the manufacturing, distribution, packaging and product innovation. Market leadership can be changed if the company does not focus on the mentioned points.

WB 1996 04

According to Mr.Buffett, paying a higher price does not risk for the good companies compared to paying higher prices for the bad companies.

WB 1996 05

Let me take an example of one the biggest wealth creator company of the Indian stock market—

INFY Chart

If someone has bought this company during the March-2000, at the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all-time high price for calculating returns). Though revenue has grown at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by a good management team. During March-2000, the company was traded at 64x P/E at the low price of Rs.275 and this multiple is common nowadays.

When management of a good business diverts their focus into the business which is not performing well then such decision of the management affect the performance of the business.

WB 1996 06

Example – We have seen examples such as liquor manufacturer enter into the airlines business, airport contraction business has diversified into the power business.

Mr.Buffett has also mentioned the Circle of Competence concept –

WB 1996 07

WB 1996 08

Control on our temptation, control on our emotion towards our investment is essential to survive and create wealth from our investment.

Warren Buffett’s Letters 1957 – 2012

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