Saturday, August 20, 2005

Argumentative Conscience

“Miracles do not happen in contradiction to nature, but only in contradiction to that which is known to us in nature”–St. Augustine

Similarly, Successful people do not have anything in contradiction, to what every human being is blessed with, but to the extent that they make the most purposeful use of what is given.

Every action of ours is influenced by 2 faculties – our thoughts & our feelings. What abridges these 2 faculties is the ‘argumentative conscience’. It is this conscience that determines the course of our action and, in effect, its rationality. This whole process is made complex by what we call as ‘emotion’ and terminated by leaving everything upon ‘fate.’ On fate, this quote by Thomas Jefferson seems most appropriate to me

“The more hard work I do, the more lucky I get.”

I shall try to simplify this complexity by rationalizing the causes and effects of the same.

“Heart has its reasons, that reasons don’t understand” – Pascal.

This quote by Pascal, I feel, highlights the most vicious and most common cause of this complexity (i.e.) when what we feel is in contradiction to what we think.
Example: People know they should not smoke; yet they smoke.

What causes this disparity between our feelings and thoughts is the domination of our ‘emotion’ over our ‘intelligence.’ Just as an argument won by force is ‘fallible,’ emotion taking over intelligence is ‘irrational.’

“The worst enemy of investor (man) is he himself” – Ben Graham.

The most common effect of this contradiction is ‘illusion.’ Example: Many people are ready to believe that Duryodhana walked on water, but may not accept that sun is star.

In short, the most common effect is ‘Faith becomes the shortcut for knowledge.’

Inner Discipline:
When we try to win this argument, instead, by rationalizing the disparity, we do justice to both our thoughts and feelings. Because in this fair battle, it is the action that is the winner. The neutral judge who helps decide is the argumentative conscience and the rule that governs it is ‘Inner discipline.’

The argumentative nature of our conscience is not realized because of the instinctive nature of our brain. This is often termed as instinct, hunch and very often as sub-conscious mind. This is where ‘inner discipline’ can play a pivotal role. Intellect governs our thought process and perception governs our emotions. So we can in effect develop a right inner discipline by providing our brain with appropriate intellect and our heart with rational perception about our intellect and its need.

Just as a mother cares of her child, we should feel blessed that we have 2 faculties – thoughts & feelings, which may or may not agree upon common course, but work towards a common cause of taking care of prospective actions. It took me two pages to explain what Warren Buffett did in a line,

“Only when you combine good intellect with emotional discipline, you get a rational behavior.”

Wednesday, August 10, 2005

Common Man & Uncommon ‘Thoughts’

(Here the common man represents to the guy who tries to beat the market day in and day out.)

Scene Infinity:
Mr. Bull and Mr. Bear are two guys who do the following things with a stock named ‘Prediction, Inc.’. Mr. Bull buys it for Rs. 225, hoping to sell it back at Rs. 240. Mr. Bear goes short on it at Rs. 225, hoping to buy it back at Rs. 210.

Now Prediction, Inc unaware of the positions of Mr. Bull and Mr. Bear just starts swinging. It goes to Rs. 235. Mr. Bull at this point time grows in confidence, for his contention is supported by validity and grows greedy. On the other hand, Mr. Bear loses confidence for now fear reigns higher than Greed and closes his position.

Prediction, Inc got bored and swung the other way. It now quoted at Rs. 215. Mr. Bull realizes that he was greedy and can’t help but close his position. They both leave thinking that they were right in some sense. After all no loser agrees that he is incompetent. If he does that he might be asked to leave the field.

The Problem:
The inherent problem with Mr. Bull and Mr. Bear is that they wanted to seek value (or) make money out of predictions rather than the business that the stock represented. Also not being able to stick to that prediction highlights characteristics of human fallibility (I will discuss that in next paragraph). Everybody when speaking in a group agrees, “Markets, or life for that matter, are anything but predictable”. Yet when left to themselves they try to predict the unpredictable.

‘Only a beggar can stick to their predictions and hold on, not out of confidence but only because they have nothing to lose’. When the elements of apparent ‘real risk’ are combined with irrational action, it eradicates the confidence out of the irrational predictor. (This somehow qualifies as a tautology as far as I am concerned).

The purpose of this write up is certainly not to discuss the stupidity of people, for I am not smart enough to do that, but to discuss the impact this stupidity has on the markets. All the advocates of EMT say that a stock price discounts everything that is known about the company. If they do that or not nobody can say, but I will like to say that they discount ‘predictions’ of this sort into their price, which in effect, nullify all the other factors that can make a difference.

Having said that I will also like to say that I tried to explain the way markets work in a short span of time. But in the long run they work in a completely different way, which I don’t wish to discuss in this write up. May be, the following words will explain much more brilliantly what I may not have been so good at,
“In the short run markets are voting machine, but in the long run they are weighing machine”

Contradictions do not exist

I think, "Fear is a consequence of doubt. Doubt is in contradiction to purpose. And contradictions do not exist"

Very often, I hear people quote one-liners just as if it contains all the answers to a given problem. The problem is not in the one-liners, but the way people end up using them.

The people who can’t differentiate between rationality and irrationality are naïve, but those who try to rationalize the irrational end up making fool of themselves.

I shall try to list few such one-liners and the misuse there in:

Fortune favors the brave:
People often use this when somebody is reluctant to go ahead with something. Instead of analyzing the odds of it and deciding upon it, they say to themselves (and if unlucky, the guy next door reminds) "fortune favors the brave". Sure it does, if braveness is not in contradiction to rationality.

Take care of the means & the end will take care of itself:
Sure it does, if the means chosen are not in contradiction to the end desired.

This time its different:
Market people love this when they read this (in substance) in the newspaper. They feel vindicated. I shall like to explain the fallacy of this one using a one liner
"Appearance can be deceptive"

Better luck next time:
Only when somebody has done everything right this time and its only the odds, like a player in coin toss game, that s gone against him. But quite often this is not the case.

Believe in yourself:
Surely we all should believe in ourselves. But not when the belief is in contradiction to rationality.

God will look after you: (The most widely used)
If God is up there or not, nobody can answer. Even if He exists, He would certainly not look after somebody who’s means lead him to hell. He would, rather, drop him up to hell.

"Learn from your mistakes and you’ll end up being wiser, at the least" said somebody. But ever since people commit the same mistakes, only the form is changed substance remains the same. The reason, I think, behind this is that people end up trying to rationalize the irrational.

Tuesday, August 09, 2005

Uncommon man & common thoughts

(Here the uncommon man refers to value seekers and those who can manage to sleep well)
(By nature, Mr. Value never gets tempted whereas Mr. Market is very enthusiastic)
Today, Mr. Market is negatively enthusiastic and offers to Mr. Value a Rs. 100 worth of note for Rs. 60. Mr. Value picks it up and goes into deep slumber. Meanwhile Mr. Market consults a doctor. He advises him to take anti-depressant. Being an enthusiastic person by nature Mr. Market takes over dose of that and now he is singing in the rain.
He is excited about everything. So he goes on a buying spree. He goes back to Mr. Value and wakes him up from his slumber. Mr. Market offers Rs.120 for the same Rs. 100 note. Mr. Value being a good fellow keeps his friend happy, by selling the note to him. And goes back into sleep just having doubled his wealth.

The complexity about ‘value investing’ lies in understanding the simplicity of the same. The scene above only highlights the simple idea behind the whole concept of value investing and using markets to seek value. But there are few complexities that make this simplistic approach very hard to implement.

I shall divide the complexities into 2:
i) Competence
ii) Human Behavior

i) Competence:
Mr. Value might suffer from bad eyesight. He may get duped by believing that the note is worth Rs. 100 just because Mr. Market promised it to be. What I mean to say is that the meaning of value is subjective. What may be considered as value now, might turn out to be self-delusion in hindsight. Just because Mr. Market throws a business at throwaway prices does not make it cheap and similarly just because Mr. Market quotes high price does not make it expensive. Value as such is not related to price and as an investor one has to have that competence to understand that.
ii) Human behavior:
Mr. Value might end up being awake and asleep at wrong times. On a more serious note, we often mistake Mr. Market irrationalities (or) sporadic movements for values. And anybody who tries to rationalize the irrationalities will be caught napping. I personally feel that human behavior is the hardest nut man will ever, if at all, crack.

At various times, the frenzied behavior of Mr. Market makes business quote below (or) above its ‘intrinsic value’. I don’t see any other reason as to what makes a stock rise or fall. If we can manage to buy good business for less than what it is worth and hold on until Mr. Market gets enthusiastic, we can manage profits. I all together avoided discussing economic and geo-political factors, but in short this provides the foundation for the type of mood Mr. Market gets in. (Just the foundation which at times is very weak).
The purpose of this write up was to touch upon the things that I think can help one understand the mood of the markets. I also wanted to touch upon that it pays to being able to sleep well (i.e.) to be patient. I shall like to end the write up using Ben Graham’s Immortal words,

"Enthusiasm can be an advantage in any activity but not in investing"

Sunday, August 07, 2005

Emotional Discipline & ‘sell’ decision

The other day I was thinking to myself ‘What makes a successful investor?’ I found a clue in the words of Warren Buffett “Only when you combine sound intellectual with emotional discipline, you get rational behavior”. The emotional discipline, I feel, determines if a man with sound intellectual is successful or not.

Now I wanted to answer, “What is this emotional discipline?” One thing was for sure that it dealt with dealing with ones intuitive responses to the various unpredictable situations. Does this mean that we have no control over that faculty? I, rather, concluded that the problem lies in the fact that not many people are able to recognize the problem rather than not being able to solve it. Recognizing this problem can help one control this faculty.

If so how should, I as an investor, go about recognizing this problem or becoming more emotionally disciplined? I divided the whole process in 2 parts:

(i) Emotional discipline and ‘Buy’ decision
(ii) Emotional discipline and ‘sell’ decision

I also feel that the “emotional discipline and ‘sell’ decision” is much more important to comprehend. Because once we buy a security we develop various types of subconscious attachment to our earlier decision. We develop a desire to prove ourself right.

Warren Buffett said, “Being a reasonable creature, human beings can rationalize anything they set themselves upon”

I also recognize that once we can see that we are developing that kind of attitude we can deal with the problem. But it is much easier said than done. All I can think of now is recall Ben Graham’s word, “The worst enemy of an investor is he himself”

Ben Graham is absolutely right but leaving it that way will be like faking the reality. We should rather use this knowledge to find support towards helping out ourselves.

Now I thought of the possible attitudes an investor can develop after committing himself to a particular stock. I was able to think of 2 possible attitudes (or) syndromes. And I would call them as:

(i) Hail me syndrome
(ii) Masochist syndrome

Hail me Syndrome:
This leaves an investor with a burning desire to prove himself correct to ‘himself’, primarily. This he does by convincing others that he is right in committing himself to a particular stock. He starts to discount all the good news and say that he foresaw this and that (in hindsight, of course). What about the bad news? He goes about finding counter evidence (real or unreal) to a seemingly real problem.

In its extremity, this syndrome can be similar to a patient who has cancer but does not accept it until he faces Mr. Yamdoot.

Masochist Syndrome:
When somebody is suffering from this syndrome he is too self-critical and worries a lot about all the bad things that might happen (he does not see things in terms of probability). Also he does not speak about his commitment in public fearing reproach. What about good news? He sleeps well for a night or two.

In its extremity, the investor decides to give in that he was wrong and get rid of the commitment on any of the minor dips caused by speculative drive.

How to deal?

Which syndrome is bad among the two is not the question. Both the syndromes in their extremity cause severe loss. Also I think everybody suffers from either of the two syndromes, it is the magnitude that varies.

I think that having recognized this problem is very much the solution in itself. Whenever we conclude that a particular stock is to be sold, we need to answer the following questions

“Am I acting in favor of my financial well being?”
“Am I acting rationally based on facts, rather than illusions?”

The first question requires one to be intellectually sound and second one requires one to be rational. Again the degree of difficulty in answering the above question determines if one is successful investor or not.

As of emotional discipline and ‘buy’ decision I think it very much depends on his perception about his own intellectual and the realistic expectation that he prefers to seek from the commitment. Moreover I have not bought any stock in my life as yet to be able to comprehend this in its entirety. (May be this is an excuse for I have not sold any stock either)

For decades people have spend there lifetimes in trying to understand how the human mind works. I, rather, feel that if we can understand our own mind we will be much better served.

I would like to conclude this write up with Keynes words “It pays to be partially correct than being precisely wrong”.

Thursday, August 04, 2005

Relive The Past

Santayana said, “Those who don’t learn from the past are condemned to repeat it”

As an individual, one should strive towards improving his life. This improvement can be brought about by ‘learning’. Each one us should remember his parents say “learn from your mistakes” or in other words “reason out your failures”. It is easier said than done because we all have, to varying magnitude, an ego or bad temperament, which makes it harder for us to rationalize our own irrationalities.

As an investor, we should change that advice to “learn from other people’s mistakes”. The reason is quite simple. Tuitions in stock market does not come cheap. One of the most commonly committed mistake and without doubt the most costly of them is ‘speculation’. I define speculation as “making buy or sell decisions based on 3 Illusions – Hope, Greed or Fear”. This illusion makes one seek value from the prices rather than underlying business. This is in contradiction to the very purpose of owning a share, which implicitly means, “Share in the underlying business”.

Warren Buffett has said, “Only when you combine sound intellectual framework with emotional discipline, you get a rational behavior”.

Keeping oneself away from the ‘speculative drive’ is the most important discipline one needs to develop. I feel that to keep away from such a strong drive, one needs to understand the causes and implications of speculation.

Thus I wish to take a ‘random walk’ into the circumstances of a major and fantastic ‘speculative episode’ of 17th century.

In 1562, I left Constantinople for Amsterdam. I took with me the best tulip I can found. When I landed in Amsterdam, the beauty of tulip made a few people at port question me about it. I, out of my love for the flower, talked in its appreciation and basic utilities of the flower. A guy offered me $1 for the flower. As a visitor, I let him have that tulip as a sign of thanksgiving.

I went into a deep slumber and got up in 1635. (Ya…I do need a lot of sleep. I was born with a sedative in my mouth). The headlines of the newspaper read, “Happy times lay ahead – for everybody”. I got into the illusion street down below; I was amazed to see a tulip in display. But I was more amazed to see that it had a starting bid price of $2000. And I was shocked as to why so many people were bidding for the tulip. I thought of myself as dreaming and pinched myself. Oh… it was for real.

I had not even digested what I had seen by the time I entered Delusion Street. I saw people lending their houses in exchange for tulips. Whenever I stopped to ask what made tulip so attractive. They unanimously replied, “We all ought to be rich”. In their search for the next intellectually vulnerable buyer, a few even asked me “If you need to be rich – then buy a tulip from me at $2500”. Though I had no intention of buying it, I told them that in the illusion street it was selling for $2000. He instead replied, “This is what I mean when I say everybody ought to be rich”. Seeing that everybody was happy and certain about the uncertain future, all I could do was recall what Bagehot has said
“All people are most credulous when they are most exuberant”

Reminding myself that tulip as such had no inherent value to claim such a price and trying to convince myself that I was not making a fool of myself by bucking the trend, I entered Peak Street. There I overheard a politician who, out of his exuberance, was saying, “Once we open up our market for foreigners, they will pay anything for tulip”. I could not help myself but say “I am a foreigner and I don’t think that ill even pay $10”. He laughed at me and advised me “you better learn to change to newer times”.

I reminded myself “Much bad advise is given for free” and ventured into Bang Street. I saw a man crushing a tulip under his feet and shouting “I lend my wife for this tulip to be able buy her a house after selling it for a profit. But nobody wants to even buy it”. (May be he could not find a bigger fool or a more optimistic person than himself)

Just when I was thinking that what could drive the prices so high. I heard a mob following me and throwing stones at me. I heard them shouting “This is Mr. Tulipomania. The guy who brought tulip into our once sacred land”. I wish I could have told them one sentence before being made the scapegoat, “Reason out your mistakes”.

Key Takeaways:

Ø Mass illusion is a common feature during the course of any speculative episode. Before Great Crash, 1929 Irving Fischer of Yale University said, “Stocks have reached a higher plateau and only way forward is up”

Ø Leverage provides the needed fuel to keep the fire going. During 1929, margin calls required only 10% of the underlying value and this is heaven for the speculation hungry people.

Ø Intellectually vulnerable buyer accepted anything for value when it had a chance of doubling next week or month. In 2000, people were buying into stocks at P/E of 600. Ø Everybody wants to be rich believing that they deserve to be rich. They mistake their initial success for skills and start betting heavily until reality hits hard on the face.

Ø Influential people: They are the ones who lead the herd. They don’t dare to buck the trend because of the fear of being called obsolete and insulted. Fidelity’s fund manager Jeremy Vinik was fired for bucking the trend in 1996. He was proved right in 2000 but he had to face insults for 4 years and I don’t think he will ever again buck the trend.

Ø Just before the crash the leveraged position reach their highest levels.

Ø In the aftermath of crash, the angry people set onto find the culprit. And there starts their blame game, which includes everything but speculations.

This is generally what has happened in all the major speculative episodes of the last 3 centuries. Just the main elements are every time disguised in to a newer version. Until and unless people realize that ‘Speculation’ and their ‘emotional indiscipline’ are the culprit, this will happen every now and then. During such periods, for the people who manage to sit tight, it is time to thank our ‘Reasonable historians’.

I think we shall all remember Ben Graham’s immortal words in ‘The Intelligent Investor’

“In the short run, stock market is a voting machine and in the long run it is a weighing machine”.