Tuesday, November 22, 2005

One sided Love Affair & Investing

"The price you pay determines (your potential) rate of return"
"The price you get determines (your actual) rate of return"

A hypothetical situation:
Consider 2 equally intelligent investors buying stock of 'Pendulum, Inc' for $50, which they both know is worth $100. As all of you might agree that there is very little chance that they both will sell out at the same time (ie) end up with the same rate of return. Why? The possible answer could be the varying levels of emotional discipline. This is brilliantly explained by Warren Buffett as,

"Only when you combine sound intellect with emotional discipline, you get rational behavior"

Emotional Discipline:
When to sell is as important as when to buy. Because once we buy a security it becomes, "I own Pendulum, Inc ","I think it will do this & this"... The psychology that comes into play here is similar to how a mother feels of her child to be the best in the world. That psychology helps life flourish on earth but that tendency can wipe us in the markets.

The puspose of this write up is to share with you all my basic understanding of 'What causes fear & greed?' & 'How can we deal with them?'

Understanding Fear:
As a human being we might not expect the unexpected. But as an investor we cannot afford to not expect the unexpected. I think Ben Graham's emphasis on diversification is based on this notion (ie) expect the unexpected & be prepared for it.

"Emphasizing once again the element of diversification as a safeguard in all such operations, we express the view that a number of purchases of this type will in all probability turn out quite satisfactorily in the aggregate. That some losses will occur goes without saying, but the proportion of such losses should undoubtedly be much lower than the favorable outcomes in a normal period"--Ben Graham.

Also as Buffett has said, "If you cannot stand 50% paper loss on your stock, stay away from the markets."

We all think we can stand such a situation, simply put, it is not just that simple. Moreover the logic is simple, 'It's not a one way road to Rome'. One might have done everything right about picking up a stock but who knows tomorrow UFO might come up and carry away the management team of the firm & keep doing it every time shareholders replace them... We never know. What I am trying to say is, there are things over which we have no control and when somehow they happen we have to live with it. This is why diversification makes sense as far as I am concerned.

Understanding Greed:
"Content makes poor men rich; discontent makes rich men poor"--Ben Franklin.

I think of greed as 'Somebody expecting to have what he desires rather than what he deserves, provided that the desire is more than what he deserves. If it were other way around it will make him a satisficer.'

As human we all at various times end up being greedy to varying degree. But when it comes to investing we should train ourselves to be desirious of what the stock price deserve to be. It reminds me of beautiful quote by Ben Franklin,

"There's none deceived but that he trusts"

Conclusion:
The bottomline is buying a stock is much like one sided affair. "The stock does not know that you own it. Even if it does, say somehow, it does not care." Stock does not understand the word 'emotion'.

We should rather train ourselves to be respectful of the feelings of stock, if she does not like being loved, we better be good people and reciprocate that by not loving her. Moreover she(stock) might say thank you for being nice to her. We all know in what denomination does stock say 'Thank you'...

"All is well that ends well"

4 Comments:

Blogger Unknown!!! said...

Hello Arpit....greattttt blog....learnt a lot...from ur blog...u seem to be a genious in writing..keep blogging..i think now on i should keep myslef updated with the info u post!...

3:36 PM  
Blogger jagadish said...

Hi Arpit, Good job.. can you pl tell me where and when did Buffet siad this "If you cannot stand 50% paper loss on your stock, stay away from the markets."? thanks.

10:24 AM  
Blogger arpitranka said...

Buffett Partnership Letters (1964)

2:13 PM  
Anonymous Anonymous said...

brilliant article,..

9:13 PM  

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