We generally accept something as right when others are also performing it and we also start following the same. When one starts clapping at Drama show, all other starts clapping and join that fellow.
Social proof is the evil behind bubbles and stock market panic. It exists in fashion, management techniques, hobbies, religion and diets. It can paralyze whole cultures, such as when sects commit collective suicide.
It has been seen in students, they select particular stream as their career because their friends or others in their family has select it. They do not focus on what they like, whether that stream is suitable to them or not.
We have seen that when a few streams are in fashion; the majority of students chase that same stream rather focus on their skill or interest. We are a human animal so that human emotions affect our decisions.
Every time social proof does not create trouble. When we decide to go out for dinner and found 2 restaurant from which one has a crowd but other is vacant. Here, we should generally prefer a restaurant with a crowd. Herding becomes particularly useful in ambiguous situations because it simplifies the decision-making process. We should follow the crowd when the decision does not have a huge impact on our financial or in life.
Investment – When few start talking about buying a few equity investments than others also start following it and by seeing them succeed more will join their party. That will result in a bubble or burst.
We follow others without thinking about anything. When we see a few others are doing something then our mind stops giving us logical reasoning. I have met a few people before Covid-19 market panic. They were telling me that I should make the large investment as many mutual funds and PMSs have generated good returns in past. If you will not invest then you will miss out an opportunity. We should not follow what others doing rather should focus on their process. Equity investment has created wealth for people and beats inflation so everyone starts herd towards it without thinking about anything and any level. All the assets class has its merits-demerits so that we need to choose an assets class according to our temperaments rather chasing what others are doing.
Majority of the fund managers also follow social proof. If we see the various scheme of the same categories then the majority of the fund has a similar kind of portfolio. They focus on matching their benchmark return. We can see below portfolio of four different schemes of different AMCs, all those have many common stocks in their top-5 holdings.
For overcoming social proof bias, we need to create our circle of competence and investment process. We need to stick with it and let others do whatever they want to do. For example, if pure cyclical businesses do not fall under our circle of competence then we should avoid it though anyone has bought it. Also, the famous quote of Mr Buffett tells us a lot about overcoming social proof bias.
In a good time, people do not care for the risk. They believe that they will be able to generate a good return by taking additional risk. But what happens when bad time comes? Does this behaviour remain the same? No, in bad times, people change their focus on protecting wealth rather create it.
Investing means to build a portfolio position in a way that future development helps the potential profit generation.
But do we predict the future? Someone believes that they can. Since (a) investing consists of dealing with the future but (b) the future isn’t knowable, that’s where the risk in investing comes from. If we can accurately predict the future then would not be investing becomes so easy and everyone can perform it in a better way?
We do not even know what is going to happen with us in the coming few moments, then how we can predict the future of the corporate earnings and economy accurately. It is just a probability of occurrence of the events. The event may or may not occur, and if occurs then may not be on the time at where we have predicted. For becoming superior investors must have to understand, assess and deal with the risk. And without dealing with the risk, we cannot become a superior investor. It’s an essential element of investment success. How we behave with the risk is to decide investment success.
It is overstated that the more you take risks, the more return you get. But if we take the higher risk then the outcome might be in lower or higher potential return. The concept should be, higher riskier investment should produce a higher potential return otherwise nobody will be going to invest in the particular assets.
If two investment avenue promises similar returns with differences into the risk scenario then we should choose the lower risk with assured return. Treasury bond and any other investment both promises same return then one should go with treasury investment.
Due to our risk aversion towards stocks, we remain careful while studying companies, keep a margin of safety, appropriate sceptical towards analysis, conservative to assumptions. For successful investing, we all need to focus on mentioned factors but not all perform these tasks and if perform then not every time.
So, investors demand incremental returns forbearing of incremental risk. But when positive scenario plays out, people become less risk-averse than what they should. Now, they put less effort and less caution for performing an analysis. Not careful with a margin of safety, not demanding for the risk premium and resulting in it, prices of risky assets raise more compared to less risky assets. These reduce the incremental returns for the bearing incremental risk. The most unwise investment made during the good time rather in a bad time.
So, the risk is higher when everyone feels that risk is lower.And the risk is lower when everyone feels that risk is higher. It’s all about temperament, comes with experience, no educational courses can teach it.
Example – Maruti Suzuki – everyone bullish when marketing goods, majority of research reports indicated per capita car in India compared to others nations such as China, USA etc. but what happen when the euphoria has been wiped out then everyone has a threat of EV, disruption of business. We have to think that the country is the same, opportunity is the same. The scenario only changes from over-optimism to pessimism, liquidity has dries.
Just as risk tolerance had positioned them to become buyers of overpriced assets at the highs, now their screaming risk aversion makes them sellers— certainly not buyers— at the bottom. Here, people realize that they have made a mistake in selecting investment Avenue, selecting a particular stock, missed a few points in the analysis, etc. etc. But when the bull phase enters, they always made similar kind of mistakes which they realized during the bear phase.
We generally take more risks when we should avoid or behave in a risk aversion. And we behave risk aversion when we should take an incremental risk for incremental returns. We need to balance between too much and too little.
Such extreme behaviour tends to work as a cycle in the market.
Risk arises when prices of the assets reaching towards high and started getting vague investment rationale to justify such a high price.
If we want to save ourselves from the carefree market situation then we have to accept the lower comparative return during the carefree market scenario and have to look like an old-fashioned investor. This is only a way to save our reputation and wealth.
I have experienced the same in my investment career. I have mentioned many times in the past articles that I remain in huge liquidity position since the mid of 2017, and this has given me much rough and sarcastic behaviour from people. But now, they have lost their major part of the portfolio and I am searching for a good investment opportunity with a flat portfolio.
When a negative situation prevailing in the market, people tend to become more and unnecessary sceptical, they show risk-averse behaviour about the investment which they did not perform during the boom period. Such behavioural bias left them with a lower return with incremental risk. During the boom period, people have a fear of missing out an opportunity and during the negative period, they have a fear of losing the capital. When people have to show a risk-averse behaviour, they show a risk-tolerant behaviour and vice-versa.
We always need to check; how much positive news is discounted into the price? Whether upcoming positive events already discounted into the price? Higher price compared to the intrinsic value left with a lower margin of safety. We have to be sceptical towards the decision making but sceptical in pessimism environment is for optimism and sceptical in the optimistic environment is for pessimism.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
One of the Pharma Company of India which has sold one of the business segment into the FY2011 and company becomes a Cash bargain. The company has done a buyback at that time.
The company has a total Cash balance of Rs.1770.28 crore + Upcoming cash due to the sale of the business worth of Rs.7136.00 crore = Rs.8906.28 crore. And the company was available at MCap of ~Rs.7830 crore. Entire continuing business was not given valued by the market.
One of the two-wheelers and commercial vehicle manufacturing company has done a buyback in the year 2009
The company has a total Cash balance of Rs.1260.05 crore. And the company was available at MCap of ~Rs.608 crore. Entire continuing business was not given valued by the market.
One of the metal company in the year 2016 has come up with the buyback. In the year 2016, the price of iron ore was traded lower.
Company had a cash balance of Rs.14806 crore in FY16 and PAT of Rs.2517 crore. Company was available at MCap of ~Rs.28440 crore. Entire continuing business ex-cash was available at 5.94x of PAT (MCap Rs.28440 crore – Cash Rs.14806 crore + debt Rs.1497 crore = Rs.15130.86 crore; EV Rs.15130.86 crore / PAT Rs.2517 crore = 5.94x).
We need to analyze financial statements and notes to accounts with huge care so that we can identify flaws which management wants to hide.
Indian companies Examples – Companies having growing sales but the majority of sales from related parties.
The company engaged in manufactures pumps, motors, valves, and custom-built power systems/manifold blocks.
The company is a travel management company.
Warren Buffett’s Letter 2002
Berkshire has made a five investments in the year 2002 which are Albecca (U.S. leader in custom-made picture Frames), Fruit of the Loom (the producer of about 33.3% of the men’s and boy’s underwear sold in the U.S. and of other apparel as well),CTB (a worldwide leader in equipment for the poultry, hog, egg production and grain industries), Garan (a manufacturer of children’s apparel, whose largest and best-known line is Garanimals) and The Pampered Chef – Founder Doris Christopher (in a business of manufacturing kitchen tools, food products, and cookbooks for preparing food in the home).
John Holland who is managing Fruit has Rescue Company from the disastrous path. We can see that if the management of the company is capable enough then he can run the business in a good manner rather than spoil it.
Two company from the same segment one has survived under the worst period and other has made a disaster.
The company has a sales growth, growth in cash balance, free cash flow for the cumulative period, a major portion of the assets side of the balance sheet is Net Block as a company is into the capital-intensive industry but investors of the company do not lose money.
Second company which has made a disaster
Another company from the same segment where the company has does not have a sales growth, reduced cash balance, no free cash flow for the cumulative period, a major portion of the assets side of the balance sheet is other assets and investors of the company has lost money.
We can see that the management of the company plays an important role in making a company successful and survive during the worst period also.
Berkshire has made an investment into MidAmerican Energy Holdings in the year 1999 for $35.05/per share and per-share earnings of MidAmerican Energy Holdings in the year 1998 was $2.01 (P/E 17.44x, Earning yield of 5.73% – US interest rates during the year 1999 was similar to earning yield).
View on Derivatives
We should wait for the opportunity which is falling under our criteria and till that time we should be inactive. We should work for staying into the game rather than try to hit on each and every ball thrown to us.
I will be going to make a detail explanation regarding weak earning quality later on. But I learn from my Guru that we need to start analyzing every company by considering it as a “Chor” so that we will not be biased about the company. If our process proves that the company has not a weak quality of financial then only need to consider the company as a clean company.
Warren Buffett’s Letter 2003
Mr. Buffett has again mentioned waiting for an opportunity which matches our criterion.
Director of the company should have the freedom to make an independent decision and they also should be an owner of the company so that their interest and interest of shareholders will not have any kind of conflict.
One of the lesson if there is a bubble scenario and we know that the price at the business traded is much higher than what actually an intrinsic value of the business then we need to sell out our position.
One of the wealth creator from IT segment. If we have sold out shares during an IT bubble period year 2000 at half price Rs.140 from the high price Rs.279. then we have lost return of 9% CAGR since the year 2000 (current price Rs.650). Now, we have bought Nifty Bees from those sold amounts then we have earned 13% CAGR till now.