How Equitymaster research overcomes the biggest risk in investing? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

How Equitymaster research overcomes the biggest risk in investing? 

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In this issue:
» High Frequency Trading explained in one sentence
» The biggest challenge for the new Government
» What are the US bond markets saying
» A weekly roundup of the global stock markets
» ...and more!

We are not just irrational beings; we are in fact predictably irrational. So argues the famous behavioural science author Dan Ariely. In a recent speech, Ariely opined that in principle, we all are aware what the right behaviour is. However, we often fall short of doing it because most of the times our desires override our senses. Do not trust him? Well, how many times in the past have you decided to stop overeating or say start exercising? Many times, isn't it? But Ariely is sure most of you pushed these decisions in the future and took that extra piece of cake or that extra bit of sleep in the morning. So the crux is that in the future we are all wonderful people. However, we don't live in the future. We live in the present and in the present, we make mistake after mistake after mistake.

Now, how do we get rid of this behavioural tendency that is so deep rooted in your psyche? Let us tell you something. No matter how hard we try, we can never totally rid our brains of these biases. These are something we are born with and are hardwired into our brains. So, what do we do? Educate people about long term objectives? Well, as you would know from your own experience, this is simply not going to work. Fortunately, Ariely has offered several solutions to get around this problem. One of the more important ones is to simply being aware we are going to behave irrationally in the future. And once this awareness is there, all one has to do is bring in mind a certain action plan or an idea that will prevent that irrationality from taking place.

Confused? Well, let us tell you how we are using this very effective technique to overcome what we believe is one the biggest errors in investing. The error of getting caught into a frenzy and buying an overvalued stock and also the error of getting paralysed by fear and not buying an undervalued stock. This is easily the biggest error there is and can easily make or break your long term returns. But as Ariely would say and we ourselves would have found out, we simply keep buying higher and selling lower rather than the other way round.

But now that we are aware of it, here's an idea we at Equitymaster routinely follow. And it's been borrowed from none other than the legendary Benjamin Graham. We now think of the stock market prices as not our emotional anchors but as quotes coming from a fictitious gentleman called Mr Market.

And this gentleman has incurable emotional problems. At times he feels euphoric and quotes very high price for the business. And on other occasions he is depressed and can see nothing but trouble ahead for both business as well as the world. Lastly, Mr Market has another great trait. He absolutely doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. And whether or not to transact is totally in our hands. Therefore, under this condition, the more manic depressive his behaviour, the better it is for you.

Notice how once you invoke this idea; your viewpoint about stocks undergoes a total change. You now tend to view fearful environment as being more conducive to long term success rather than getting paralysed by it. And in the same vein, excessive market frenzy makes you think that Mr Market has gone berserk and keeps you away from stocks at the prices at which he is offering them.

We know that there are a lot of other ways where one's future self is likely to misbehave in investing. Therefore the idea should be to keep an idea or an action plan ready. This can then be invoked whenever some important decision about investments are being made.

Do you use the same analogy that we have been using to buy when stocks are cheap and sell when they are expensive? What are the other Ideas that helped you look beyond short term emotions and gave great investment success Let us know in the Equitymaster Club or share your comments below.

Editor's Note: We hope you've been following American wealth coach Mark Ford's writing on the Daily Reckoning. More recently, Mark began revealing his 11 Secrets to Building Wealth with his Indian readers... They make for great reading and we strongly recommend that you access them (for Free) now.

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01:48  Chart of the day
Leveraged bets on IPOs seem to be making a comeback of sorts. As Business Standard highlights, at least Rs 40 bn worth of leveraged bets by HNIs and companies seem to be riding on the IPO of amusement park operator, Wonderla Holidays. And as the chart of the day highlights, this makes it the third largest IPO ever in terms of times oversubscribed by HNIs. Pertinent to note the other companies in the chart, which as we know are struggling to meet the high expectations that were built into their IPOs. Will Wonderla meet the same fate? Difficult to say as far the business of the company is concerned. Valuations however, were bit stretched according to us as is the case with most IPOs.

HNIs making a beeline for Wonderla

In recent times there has been a lot of interest around the concept of High Frequency Trading (HFT). Especially after financial journalist Michael Lewis released his book on the subject titled "Flash Boys". Soon after its release the book found itself at the centre of controversies. This is because it explained how HFT makes profit at the expense of other investors. Now our in house derivative expert Asad Dossani recently explained the concept of HFT in the Daily Reckoning. He explained that the slippage cost on large orders of institutional investors tends to reduce their returns. On an individual transaction, they may lose just 0.1% of the transaction value to HFT. However for multiple orders the losses do add up to a substantial figure.

Nevertheless, most people in Wall Street continued to argue in favour of the liquidity brought in by HFT. Interestingly in his latest letter to clients, hedge fund manager David Einhorn has distilled the whole debate in one sentence. He called the problem of HFT "the classic dilemma of concentrated benefit and diffuse harm"! High frequency traders offer tons of liquidity to the markets. But in the process they are able to skim small sums of money for themselves. While the problem seems well highlighted by the book, Wall Street seems to be in no mood to get rid of its liquidity intoxication.

There is a broad consensus prevailing that a business friendly opposition party will assume power at the centre once 16th Lok Sabha elections culminate. There is belief that this new party will push economic reforms and revive the economy. As a result, Indian stock markets have reached new highs. However, many believe that the new government's ability to pass sweeping reforms will be limited if it does not get a clear mandate. In other words, if it has to seek coalition with other parties, which is a likely possibility, the reform process will take a backseat. And this is likely to be a major growth hindrance.

Apart from coalition pressures, inflation will be another factor that will make growth revival a big challenge. Persistently higher inflation has forced central bank to adopt a hawkish approach until now. This has increased the cost of capital and hurt capex cycle of corporates. If inflation does not subside and interest rates remain high, liquidity will be hard to come by. This will again restrict growth revival. In nutshell, a difficult economy awaits the new Government. Thus, it would be interesting to see how it manages to steer the economy after assuming power.

It was billed as the most hated asset class of 2014. Yet, four months into the year, it has proved even the most diehard pessimist wrong. We are talking about US treasuries. Almost every economist thought that the price of US government bonds would fall this year as the economy picked up. This would have sent yields on these treasuries higher. However, the exact reverse has happened, surprising economists and fund managers alike.

The US benchmark treasury yield is lower than its level at the start of the year. Thus, treasury investors have had a good year so far from the gains in rising bond prices. If the US economy was truly on the upswing, one could have expected bond prices to fall (rising yields) as investors would have become wary of higher inflation. Quite clearly, the US bond markets do not believe that there is a real economic recovery. It is yet another indication that US investors are becoming increasingly cautious about the optimistic announcements being made by the US government and the Fed about the economy.

It's quite common for investors to get panicked when the stock they purchase moves very sharply in a short span. Either up or down; it does tend to make one quite restless. In cases when the stock prices declines sharply, an investor would also doubt his rationale behind buying the stock; and this tends to get him to take a hasty action. In short, the focus tends to become quite short term in nature. A suggested action here would be to write down the key reason for purchasing the stock before actually doing so. As long as the intended rationale is intact, investors should not worry about short term fluctuations and rather focus on the bigger, longer term picture.

Also, with the Indian stock markets having surged sharply, the time has come for investors to be cautious. This we say because of the numerous small to micro cap stocks doubling to trebling in a period of a month or two. Bottom fishing has started as investors seem to be running out of ideas at the top of the pyramid. It would be best for investors to take a cautious approach and definitely consider valuations of the stock they buy before doing so.

Meanwhile, escalating tensions between the West and Russia over the Ukraine crisis continued to exert pressure on markets worldwide. However, positive performance by a handful of Asian and European indices reduced the overall weakness in the world stock markets. Among European markets, UK and France ended higher by 0.9% and 0.3%, respectively whereas Germany was marginally down.

The geopolitical tension continued to loom large on the US markets even as the Thomson Reuters/University of Michigan's consumer sentiment for April was upbeat and ahead of market expectations. The US markets were down by 0.4% for the week.

In Asia, the poll frenzy kept Indian markets buoyant whereas the Japanese market ended higher on a weak yen. Even the Singapore markets ended 0.4% higher for the week. However, the Chinese and Hong Kong indices were down by 3% and 2.4%, respectively.

While the Indian equity markets continued to scale new highs during the week on increased buying by foreign institutional investors, some gains were pared off in the absence of positive cues from global markets. Most of the sectoral indices ended in positive territory for the week with capital goods (up 4.3%) and banking (up 1.9%) being the biggest gainers. FMCG (down 2.5%) and power (down 1.5%) were the biggest losers for the week.

Performance during the week ended April 25th, 2014
Data source: Yahoo Finance

04:56  Weekend investing mantra
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for 10 years." - Warren Buffett
Today being a Saturday, there is no Premium edition being published. But you can always read our most recent issue here...
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1 Responses to "How Equitymaster research overcomes the biggest risk in investing?"


May 5, 2014

I agree that taking contra view on market is better than going along with market . However a retail investor should carry all the emotions of the markets like hope , confidence , worry and fear , use them at appropriate points and play the game according to his plans . His ball should not be carried away by the winds of the market . I have discussed the emotional issues of the market in my blog at wordpress Interested readers may go through the same .
manjunathan bellur

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