Thursday, April 10, 2008

Perception of Misperception

As an investor, each one of us is trying to buy low and sell high. In the process, we, more or less, have the same set of information to help us decide. But for every trade done on the stock exchange, there is always that other guy who disagrees with you and only one of us ends up as right. What one gains is somebody else's loss. This not only highlights one of the important aspects of investing, that is, that it's a zero sum game but also highlights the fact that the people reach diverse set of opinions based on the differential in the way they construct reality. Excluding the element of luck, over the long run, the one, who is better at constructing reality or making sense out of the surrounding, is the one who will end up one amongst the winner. Thus, I think, it will be a good exercise to understand what leads to the perceptual contrast amongst people.

Bounded Rationality:
Herbert Simon, the person who propounded this theory, says that as human beings, we are not blessed with unlimited circuitry to make sense out of the complexity of the world in its entirety. To cope up with this limitation, he argues that we rely on simplistic models of reality, which helps us get through most of the things happening around us decently well, but in a complex situation this limited circuitry might fail us, leading to sub-optimal decision making. In the context of investing, each one of us has our own philosophy, which helps us decide which opportunity is suitable to deserve our attention and our capital, eventually. The more potent our philosophy is at replicating the underlying reality the better would be our results.

No matter how hard one tries, our mind-set (philosophy, in the context of investing) has its limitations and understanding where and how it might fail us would be indispensable. The prime reason, which is inescapable, but mistake prone is Satisficing.

Satisficing:
Satisficing says that we start with a tentative hypothesis and start to look for evidence supporting the initial hypothesis. (Insiders are buying. Oh, the most probable reason has to be that the management feels that the business is undervalued by Mr. Market. Is it so, let me check it out?). In the process, the goal is to seek enough information, broadly speaking, to validate our hypothesis satisfactorily.

Even though, I don’t think we can do away with rationality, which is bounded anatomically, and satisficing, which helps us reach decisions amidst uncertainty, I do think that by understanding as to how they can fail us under certain ways, we can improve our ability at constructing reality.

Pre-conceptions can lead to Concussions:
None of us can claim to analyze a problem being 'completely blank' to start with. The software (mind), which we develop in certain ways, but which is also pre-conditioned and shaped by surroundings, is different in each one of us. Moreover, no matter how hard we try, it is a mystery even to its possessor (remember, how often we end up over-estimating or under-estimating our ability at various activities). Given this understanding, it might not be wrong to assert that pre-conceptions/mind-set, when incomplete and unsuitable, can lead us to construct reality under false impression. Let me quickly add that I do not intend to say that we should do away with our pre-conceptions, which is impossible, but just that better understanding of the limitations of pre-conceptions can help us gain an edge over others (remember, the guy at the opposite end of the trade. He might not be, manic depressive, Mr. Market but, say, the smartest investor out there!)

When can pre-conceptions fail us? Mr. Munger answers it best - ‘To a man with a hammer everything looks like a nail.’ The best way to overcome is to gather multiple models and use mental tools like checklist, zoom-out, zoom-in, reductionism, backward thinking, and forward thinking. As each one of those will also help overcome the following limitation by developing multiple hypotheses...

Selective Perception:

The cost one pays in starting with a single hypothesis and looking for evidence supporting his initial claim is that he overlooks the information, which is not related to the narrowed down scale of the problem at hand, but which might none the less be substantial when viewed from a different angle. And I think, the dissonance increases, in cases where the hypothesis cannot be supported. In such cases, we simply take a pass. But who knows, looked from a different angle, the investment opportunity might have been very attractive and a cinch. Let us look at a solution, which can help us overcome this limitation.

Decomposition:
It is nothing but breaking a complex problem into numerous simple problems. For example, this is what happens when we follow Mr. Buffett’s method of asking ourselves ‘whether keeping aside the element of price, would I like to own this business?’ or ‘would I approve if my daughter wants to marry the executive of the company’ or ‘Is this opportunity better than, say, most of the opportunities I can invest my capital in?’... This way, I think, it allows us to make better use of information available at hand and make a calculated guess, weighing the pros and cons more efficiently...

Conclusion:
As I sit down here reflecting on my answer to the problem of misperceiving reality, I wonder if I have done justice at perceiving the problem at hand. I shall continue to reflect if I have I become a victim of selective perception, man with a hammer tendency, confirmation bias, and all those sort of stuff.

Having said that, I would like to add what Prof. Sanjay Bakshi once said–A tiny edge is all you need... (as compounding will magnify the impact of the edge as time goes by...). And I wish that this reflection has helped me (and, hopefully, the reader as well) gain a tiny edge in a certain way...

4 Comments:

Blogger Mohit Kumra said...

Do find the time to check out my new Value Investment blog kumrainvestmentcompany.blogspot.com. Your critical comments would be most appreciated.

10:03 PM  
Anonymous Mahendra Naik said...

Hi Arpit,

Great post on the quandry facing an investor. I feel that investing is essentially simple (not easy)
and you have to be broadly right on your investment call rather than fine tuning all possible indicators. If an investor would look to get better return on his equity investments as compared to other alternatives, he would be better served rather than trying to beat the best performing stock out there.

2:29 PM  
Anonymous Sandy said...

Do you really think it is a zero sum game?

12:04 PM  
Blogger Arpit Ranka said...

Sandy:

Shareholders as a group cannot better the return earned on equity by the underlying businesses over the long run...

Moreover, the transaction cost and taxes would eat away into it. But lets keep this aside.

This implies, that if an investor A earns above average return (vis-a-vis the underlying business), then there has to be an investor B, who has underperformed the same.

That is, the game is zero sum game, when the opportunity cost is considered as the return earned by the underlying asset/equity...

If you think I have missed something critical in reaching the conclusion above, please do share your thoughts.

Best,
- Arpit

12:22 PM  

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