Tag Archives: losses

WHEN YOU HEAR HOOFBEATS, DON’T EXPECT A ZEBRA Base-Rate Neglect

Posted on by under Behavioral Finance

Base-rate neglect: a disregard of fundamental distribution levels. The majority of the people ignore statistical data to conclude.

Representativeness—ignoring both the base rates and the doubts about the veracity of the description.

We focus on the other aspects rather than statistics for making a decision. For example, selecting a player based on his build and look rather than his past performance statistics.

Selection of investment by story prevailing at street rather than the past performance of the company. This falls under this bias.

When the stereotypes are false and the representativeness heuristic will mislead, especially if it causes people to neglect base-rate information that points in another direction. Even when the heuristic has some validity, exclusive reliance on it is associated with grave sins against statistical logic.

Investment – We know that very few companies survive after 10 years of operations. So, when we have seen any companies that come as a next google, Facebook, Amazon, Infosys, Dmart, etc. then we should have data which suggests that if the company has not seen 10 years of journey, then we should stay away from it.

When we make any decisions, we should not avoid statistical data. Because avoiding such data can misguided us and we ended up taking miserable decisions.

It is also logical that low return ratio companies will not be going to give a higher return to us (else we have bought it at deep discount-then also the lower probability to give multifold returns), then also when we have any good narrative about the company, we start chasing it. Never avoid the voice of numbers because it can tell us a real story.

We focus on the stories of management, industry, economic growth potential but forget to focus on the past performance of the company. If past performance says that the company is not strong enough to perform then enough external opportunities also cannot do anything. But people follow stories and avoid base rates or probabilities and end up with blunders.

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

WHY THE LAST COOKIE IN THE JAR MAKES YOUR MOUTH WATER Scarcity Error

Posted on by under Behavioral Finance

When we see that something is different, unique, and having a shortage then we love to own it. That things attract us and we see them as more valuable than others. Rare is valuable. The scarcity error is as old as mankind.

We need to assess products and services solely based on their price and benefits. It should be of no importance if an item is disappearing fast, nor if others are also interested to buy it.

Business – Many business houses try to attract customers by creating a scarcity of their products. They show the availability of only a limited number of products which forces customers to make any impulsive decisions. When we make an impulsive decision then we scarify rational thinking. 

Investment – Few listed businesses are unique, different than others, well managed. Such businesses are few so People are attracted towards such businesses and suddenly those become more valuable and started trading at a higher valuation. This is what we have experienced about the quality companies in the recent stock market cycle.

Many times, businesses getting premium as an only listed company on the bourse but that should not be the only reason to invest in a company or to give a higher premium to the business. People mostly fear missing out (FOMO) particular opportunity and run behind it, so that float available for a particular stock starts reducing and demand for it starts increasing which will increase the price of a stock.

We should check whether the company has fundamental value compared to the price commanding on the bourse. If the company is not fundamentally stronger then it is no right way to chase uniqueness of business or only listed company or low shares floating in the market. We should have well-defined philosophy to invest in businesses and if the stock does not fall under it then we must avoid it. Also, we should not take a speedy decision, speedy decisions can be harmful. We are not going to miss any opportunity, the market has thrown opportunities before our birth and also going to throw after our death. We remain or not, opportunities in the market always are there to serve.

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

WHY EVIL STRIKES HARDER THAN GOOD Loss Aversion

Posted on by under Behavioral Finance

Many of the time, we have to make decisions from options, there is a risk of loss and an opportunity for gain, and we must decide whether to accept the gamble or reject it.

It has been proven that, emotionally, a loss ‘weighs’ about twice that of a similar gain. Social scientists call this loss aversion. “Losses loom larger than gains” and that people are loss averse.

Business – When we show fear of loss to people and sell our products then it will become easy to sell our products to them. The firm has its own entitlement, which is to retain its current profit. If it faces a threat of loss, it is allowed to transfer the loss to others.

Investment – When there is an increase in a stake, our loss aversion also increases with it. When we have invested in stocks and the price of it falls and we know that we have incurred loss but we do not book it. So, we sit on the stock, even if the chance of recovery is small and the probability of further decline is large. If we book loss then it becomes real and that is more painful. Fear of loss stops us from booking loss though it has already been incurred.

We should make a basic calculation of what would be future cash flow generation from the company and what if our assumption get fails. These basic calculations help to understand the risk and return scenario so that we can make a rational decision. And also, can use the margin of safety concept properly. We should be ready with a calculation that mentioned what can be a probability of losing some % of our current net worth if an investment does not work according to our plan so that we get mentally prepared in advance and also make a decision accordingly.

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

Charlie Munger Handling Big Losses

Posted on by under Bibliophile, Bibliophile: Big Mistakes

BM C14 01

Majority of the big winners’ companies have also seen the worst period during their journey. It is not necessary that if the company has delivered a 25%+ CAGR then it will get into the smooth way. There always be a huge up and downs to it. Many storms such companies have experience but as investors, we need to stay during those storms if we have made an investment into the great companies then only we can able to earn good returns from it.

Mr. Munger has established a hedge fund company, Wheeler, Munger & Company in the year 1962 which has a pre-fees return of 37.10% during the year 1962 to 1969. And 14-years of partnership, Mr. Munger has delivered around 19.82% CAGR compared to 5.20% CAGR with the dividend of S&P500.

BM C14 02

If we love when stocks moving into the upward direction then we must have to be ready to accept its downward journey also. It is a part of the game and without accepting the losses, we cannot become a seasoned investor. Even Mr. Sachin Tendulkar cannot hit a century into the each of the match, some of the match having a ZERO score also. If he only focuses on the century then it might be possible that he cannot able to play well. Similarly, if we keep focussing on the scoreboard then we may not able to create a good investment fortune.

Mr. Munger has an investment of 61% of his portfolio to the Bluechip stamp and original business of the bluechip stamps has started getting deteriorate from the peak revenue of $12.42 crore in 1982. Bluechip has made an investment into the See’s Candies, the Buffalo Evening News, and Wesco Financial before getting merged into the Berkshire Hathway in the year 1983.

The firm of Mr. Munger has lost 31.90% in the year 1973 and 31.50% in the year 1974 v/s 13.10% and 23.10% decline of Dow Jones respectively. And he bounces back by 73.20% of the gain to the year 1975 but few of the large investors have left him which break him mentally and emotionally. He decided to liquidate the partnership. But after the worst performance during the year 1973-1974, Mr. Munger has delivered a 24.30% CAGR before fees.

BM C14 03

We need to be mentally ready for the big losses during our investment journey if we want to earn a decent return for the long term. If we are not mentally and emotionally ready we will not able to survive to the investment journey.

BM C14 04

We should not sell stocks just due to a fall in the price of the stocks. If we keep on doing such practices then we will not survive for the long term to the stock market. If we know that stock can fall by 50% after we bought it, then we will make a position which is comfortable for us during the decline.

BM C14 05

We need to make a balance between equity and debt as per own comfort. So that we can able to play an investment game in a good manner. Also, get the strength of absorbing such shock.

Read for more detail: Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick