Tag Archives: cyclical

THE DUBIOUS EFFICACY OF DOCTORS, CONSULTANTS AND PSYCHOTHERAPISTS -Regression to Mean

Posted on by under Behavioral Finance

Everything in a world moves toward an extreme direction from average and come back to average. This is known as a regression to mean. Sometimes we get more happy or sad and as time passes, we start coming back to our normal feelings. We tend to be nice to other people when they please us and nasty when they do not, we are statistically punished for being nice and rewarded for being nasty.

Poor performance was typically followed by improvement and good performance by deterioration, without any help from either praise or punishment. Our performance has an average point, sometimes we perform very better than average and sometimes perform below average and sometimes reach back to mean performance. So that when performance is above or below average, then it has a higher probability to meet the average which is known as a regression to the mean.

Investment – The price of the companies sometimes go either extreme to fundamental points but as time passes stock prices start moving towards fundamental performance and at some point fundamental performance and stock prices marched. The stock price cannot be sustained at either extreme. We have seen various cyclical events, business cycle and many more are responsible for the regression to the mean. We have experienced that market always walk away from averages for a period but it comes near to mean by its self-correcting nature. So that when anything moves at the extreme side of the mean then we must have to be ready for self-correction of it. Value investing mainly focus on reversion to mean theory. It believes that if the stock price is well below its fundamental value then now or later it will catch up with its fundamental value.

We have seen that the best performance in equities has come after the worst performance and vice-versa. So that we should not focus on a smaller period of outcome to make any conclusion. Rather should focus on a decently long period to understand mean reversion. But when fundamental performance is improving then we should compare market price with improving fundamental performance rather should wait to fall in price as it has risen in past. Also, we need to study thoroughly about fundamental of any business, its prospects, challenges faced by the business. Rather believing that if the business has performed well in past then it will repeat it in future. It may or may not repeat the same performance but that we have to conclude from a detail study of business.

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

Posted on by under Behavioral Finance

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

Posted on by under Behavioral Finance

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“.

WHY YOU SYSTEMATICALLY OVERESTIMATE YOUR KNOWLEDGE AND ABILITIES – Overconfidence Effect

Posted on by under Behavioral Finance

We tend to overestimate our knowledge, ability to predict events/future, own behaviour, etc. The overconfidence effect does not deal with whether single estimates are correct or not. Rather, it measures the difference between what people know and what they think they know.

Expert suffers more from overconfidence rather than normal laypeople. We have statistically proven data but we ignore it and overestimate our abilities and knowledge. Overconfidence has been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim.

The Illusion of Understanding

In The Black Swan, Taleb introduced the notion of a narrative fallacy to describe how flawed stories of the past shape our views of the world and our expectations for the future. Narrative fallacies arise inevitably from our continuous attempt to make sense of the world.

When we read about anything, our mind starts creating an illusion of understanding regarding those concepts or event. When we make any critical decision and that succeed then we give huge credit to our skills and underestimate the role of luck.

The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact, we understand the past less than we believe we do.

We try to learn many things from the success of others but we have to understand that things can be more different than what we are understanding.

Business – Management of any business easily fall under such bias, if they have a strong track record in past. Few managers have overconfidence in their ability to run a business. So that they acquire any business or plan for a new capex at the top of the business cycle at sky-high valuation. They just follow their intuition rather than follow data and facts. We should avoid businesses having such a manager for investment purpose.

Successful businesses also can meet failure in some of their ventures. Google has achieved success in the search engine, e-mail services, mobile operating system, video streaming, maps etc. but Google also has faced failure in social media platform such as Orkut, Google Plus.    

The Illusions of Pundits

Investment – When we have research and made investment decisions then we overestimate our knowledge and think that we cannot go wrong. Though the result shows that we have got wrong in past then also we blame it on external forces.

Everything makes sense in hindsight, a fact that financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.

Few experts are becoming overconfident as they acquire more knowledge. They fall more under the illusion of skills. So that does not try to predict the future based on the past.

“The mistake appears obvious, but it is just hindsight. You could not have known in advance.”

When we see the 2008 financial crises now, we can say that such mistakes are obvious and should avoid. But we can only do it after it happens rather than during that period.

In conclusion: be aware that you tend to overestimate your knowledge. Be sceptical of predictions, especially if they come from so-called experts. And with all plans, favour the pessimistic scenario. This way you have a chance of judging the situation somewhat realistically. Experts miscalculate; championships change hands; and winners become losers.

We can save ourselves by killing our ideas.

When we are investing, we should write down every decision in an investment journal so that we can track the quality of our own decision. Also, we should prepare a checklist which helps us to reduce our emotions and improves decision.

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