Here's what successful investing is all about

Oct 24, 2015

In this issue:
» The dominant sector over the years
» Marc Faber's latest comment
» Weekly round up
» ...and more!

One of the quirks of our brains is how the same thing explained differently can produce entirely different emotions.

Let us take the example of a wonder drug that is useful in the treatment of, say, arthritis. Imagine that a new version of the pill has come out. And while it is more effective, there are confirmed reports that the risk of suffering a potentially life-threatening side effect has gone up by 100%! What would you do? Panic? You most certainly will, and you'll probably stop taking the pill.

But what if instead I told you that the risk has gone up from 0.02% to 0.04%? Would you still panic? I doubt it.

The information conveyed is the same in both the cases. The only difference is the means of conveying it. While the first explanation spoke in relative terms, the second used absolute numbers. The emotions that were triggered were as different as chalk and cheese.

I believe the most lucid explanation of this phenomenon is given by the Nobel Prize winning Psychologist Daniel Kahneman.

Kahneman likes to describe our brain in terms of two systems. System one is the brain's fast, automatic, intuitive approach. Its main role is not to analyse but to give instantaneous feedback so that an appropriate action can be taken. It is the system responsible for making us run at the sight of a predator in a jungle. And it is in such situations that it truly excels.

However, its limitations come to the fore in an environment that demands analytical thinking and sound reasoning. Here, it is the System two that excels.

Our evolution was largely determined by the most important goal for our ancestors - survival in the wild. One shouldn't expect them to have been rational or deeply thoughtful when face-to-face with a large beast. They used system one much more than system two, and it is these genes that have been passed on to us. While we don't have to roam in the wild and be alert for beasts, our mental hard wiring is still of the Stone Age, and system one still informs our reactions to many environmental inputs.

This is the reason our first reaction was fear when we heard the statistics about the arthritis drug. We didn't consult system two for a deeper understanding. We just ran.

But in making important decisions, you could do yourself a huge disservice if you rely on system one alone. Try to bring system two as much into the equation as possible. Keep asking why until you arrive at a conclusion that makes sense.

Most long-term investing is about fighting the forces of system one. It is about letting system two get into the driver's seat as often as possible. When a stock falls by 50%, don't be directed by the fear reaction of system one. Don't panic and run away from the stock. Instead, involve system two and ask whether it has become more attractive relative to its intrinsic value. And then let system two do its work of calculating its intrinsic value.

Also, when a stock touches a 52-week high, don't let system one pull you in with everyone else. Instead, involve system two and question whether the stock has already crossed intrinsic value and is therefore risky.

Here's the most powerful statement in terms of system two thinking if you want to be a successful long-term investor: 'Be fearful when others are greedy and greedy when others are fearful.' Explained differently: Use system two when everyone else is hell bent on using system one.

Do you think using System 2 based thinking can lead to great success in investing? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Which sectors have played a strong role in the market run up over time? This is an interesting question considering that every bull market is usually led by a sector. We came across a fascinating article on which indicates how the various sectors have contributed to the rise in market value over time. The website used its own in-house index - the BT-500 - as the universe for this study.

The following chart indicates how the index's market value has risen over the past two decades.

As you can see, the combined value of these companies has risen by nearly 35 times over a twenty year period.

Movement in market cap of the BT-500 index over the years

But the key question remains...which are the sectors that have played a strong role in the rise over the years? of today, the major contributing sectors include Banking, Financial services and Insurance (BFSI), information technology and information technology enabled services (IT& ITES), oil & gas, FMCG and auto & ancillaries. This remains the hierarchy presently.

But this has not been the order throughout this period. While the BFSI space has steadily played a more influential (in the market movement) role over the years, there were times in the late nineties when the FMCG had the highest share of the index. Around the millennium, it was the IT & ITES sector that drove the market run up. On the other hand, the auto & auto ancillary sector's share has pretty much remained range bound. However, what is interesting is that in present times, the share of the sector is similar to that of the FMCG and oil & gas space.

The BFSI space currently stands out with a share of a little less than a fourth in the index. Within this space, the top four positions are shared by HDFC Bank, SBI, HDFC and ICICI Bank. So the key question remains...will the BFSI space be the leader of this rally? Your guess would be as good as ours. However, one point is clear. This sector's prospects do remain quite crucial to market sentiments as things stand today.

Dr. Marc Faber is in the news again. We are always interested in what the editor of the Gloom, Doom, & Boom Report has to say about markets. This time around, he's predicting a stock market crash in 2016!

He believes, and we agree with him on this point, that the US markets are over-priced. The odds in favour of a serious correction have increased since the start of the year. Earnings growth in the US has moved in to negative territory right now. And valuations are near record levels.

The US economy never fully recovered from the recession of 2008-09. The recovery is still so weak, that the US Fed refuses to normalise interest rates. And Faber believes more easy money policies could be on the way.

With the EU and China already having cut interest rates, Marc Faber thinks the Fed may launch another round of QE! If that happens, then the crash will be averted, at least temporarily. However, it will not resolve the underlying economic problems. World markets would only set themselves up for an even bigger crash down the line we believe.

Global markets closed the week on a positive note with a majority of the indices ending in the green. Stock markets in Europe and US surged upwards after the European Central Bank hinted that further rate cuts were being considered to stimulate the euro zone economy. The stock markets in Germany and France were up by 6.8% and 4.7% respectively during the week.

The China's central bank cut interest rates on Friday for the sixth time in less than a year. Further it again lowered the amount of cash that banks must hold as reserves in a bid to jump start growth in its stuttering economy. Majority of the Asian markets ended the week on a positive note. The stock markets in Japan and Singapore were up by 2.9% and 1.2% respectively during the week.

Coming to the US markets, Fed holds two more policy meets this year: next week and in December. Market expectations for a rate hike have shifted to next year in recent weeks, though some haven't completely ruled out a hike in December. Data released on Tuesday showed US housing starts rose solidly in September on soaring demand for rental apartments, a sign that the housing market continues to steadily improve. The stock markets in US were up by 3.1% during the week.

Back home, the Indian markets ended higher by 0.9% during the week. The Index of Industrial Production (IIP) rose to 6.4% for the month of August. Electricity generation, mining, and manufacturing output grew by 5.6%, 3.8% and 6.9% respectively during the month.

Performance during the week ended 23rd October, 2015

 Weekend investing mantra
"We have consistently tried not to lose money and, in doing so, have not only protected on the downside but also outperformed on the upside."- Seth Klarman

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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1 Responses to "Here's what successful investing is all about"


Oct 24, 2015

One of the most outstanding aspects of investor behaviour i have read.The hard wiring of our responses in crisis.congrats for this write up.Thanks.

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