Wednesday, March 05, 2008

Theory of (Appraisal) Relativity

Taking cue from the saying that 'when you're not near the girl you love, you fall in love with the girl who is near you,' I would like to outline the gist of the theory as 'In the absence of an ideally cheap stock to chose from, the context in which a stock is appraised can have a huge impact on the quality of classifications done.'

Accordingly, if the context in which something is appraised makes a difference in the quality of the appraisal, then it would make sense to spend some time thinking about the general context in which potential bargains are appraised and try to make sense out of it.

Cheap Stock (vs.) Cash:

For various reasons, the chances are quite high that any given point in time, one has a portion of his portfolio in cash/bonds, to be deployed in securities. This could be because of new cash coming in (or) closure of our existing positions. Thus, while appraising a potential equity canditate for a place in our portfolio, the competitor facing it is cash (or) High quality bonds.

Under such circumstances, I have many a times felt that the urge - to replace excess cash/bond position in the portfolio with some potential bargain having high reward ratio - is quite high. Given that urge, I think that that impulse makes a given opportunity look a far better opportunity than it truly is, to some extent, because of an unattractive canditate it replaces.

Let me clarify here that my concern is more severe in terms of getting a rough idea about the magnitude of a potential bargain's attractivenesss and not necessarily in terms of the inherent attractiveness itself. Thereby having an impact on your portfolio allocation decision, rather than investment decisions themselves, which are none the less equally important.

Antidote: What to Buy (vs.) Which one of these to Buy?

'Heart has its reason that reasons don't understand' - Blaise Pascal

It appears that every man, to varying degrees, seeks to derive reward from the investments made in terms of time and effort. This tendency can sometimes lead him to fix reality to fit his representation of the reality to justify his initial commitment. In the context of security analysis, I think this tendency plays a crucial role in making investment decisions.

For ex: having spent a week analyzing a potential canditate for investment, the urge to have it qualify as a replacement for cash is relatively high. The prospect of all the effort summing up to zero and sticking with the cash component might trigger a whole set of behavioral biases preventing us from moving towards an optimal decision.

The possible antidote, which I can think of, is to substitute the weak competitor in the form of cash/bond set with a canditate having similar attributes - potentially cheap stock on our radar - being analyzed side by side, in terms of their investment attributes. A slightly weaker but slight better, than cash/bond as the competitor, could be an incumbent investment from our portfolio.

The reason, I think, this should help one make better investment decisions, in terms of quality and allocation, are as follows:

1)Induces Falsification:

'So convenient a thing it is to be a reasonable creature, since it enables one to make or find a reason for anything one has a mind to do' - Benjamin Franklin

One of our most powerful tendency, for good or for bad, involves forming an opinion about something, based on our first impression, and go about looking for evidence comforming it. It is only when we fail to find confirming evidence we tend to revert our opinions.

In the context of the discussion on security analysis, it seems that when we have two or more competing ideas to chose amongst, the process of comparing and chosing one, should induce the use of falsification (why this one and not that one?) as a means rather than a confirmatory one, which is generally prevalent otherwise (Should I buy this?).

2) Doesn't make you a slave of initial commitment:

Also, in the process of comparing the pro's and con's of two distinct propositions, the chances are quite high that we would not shy away from discovering (or) looking for con's. Moreover, the difficulty of chosing one over another, shall induce an urge to look for negatives in both the situations, eventually leading to nullifying one or both of our initial presumptions because it would lead to an overall positive sum game as compared to a negative sum game otherwise, when seen in terms of investment made in time and effort.

3) Shall Optimise Allocation Process:

Moreover, this game of comparing amongst their pro's and con's should better bring to light the overall attractiveness of a security than seeing in their individuality leading to a better ability in forming a set of expectations, going along with the investment decision, towards the situation leading to better portfolio allocation decisions...


Blogger Humblybob said...

I found your web site and articles very interesting. They made good reading and I am certain they will be of help to new and experienced traders and investors.

10:03 PM  
Blogger Shankar said...

Hi Arpit,

The temptation to use idle cash is very high, even if valuations donot agree. This is true for individuals and for companies that use free cash to make investments in unrelated businesses (under the garb of 'diversification') and then sell off these ill-timed, non-focussed ventures at a loss - hurting the shareholder even further.

Warm Regards

5:14 PM  
Blogger COMMUNINVEST said...

As peter lynch said when u research 10 stocks u find 1 stock for Investment and this is true in every circumstances. even if there is bubble in the market and eventhough u r value Investor. I think this is where buffet required salute wholeheartedly. In this particular article though u started with right problem I dont think u proceeded and end with right conclusion, so that one can hold their cash instead of Investing in bubble.

5:22 PM  
Blogger PauperJi said...

nice posts

10:56 AM  

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