Ignorance In Investing – It is funny how people never ever learn from their mistakes. This is something I see over and over and over again. While fools say that they learn from experience, the wise say that they’d rather learn from the experience of others. To that, I say Amen! I would rather learn vicariously through the eyes of another. As a value investor, my vulnerable persona and esteem takes a royal drubbing whenever I lose money. And I can tell you, losing money is not something that I can smile at. And I believe that this is the same for many investors out there. But unlike many investors out there, I believe that I am well aware of my limitations as an investor. Coupled with some real world experience, this gives me an edge over others. This is not meant to be a self inflating article but sincerely, I hope to impart some these lessons that I have learnt with as much candour as I can possibly muster.
So the question is why in the world do retail investors keep making the same mistakes over again and again? I can attribute this really to a lack of education.
This lack of education in turn leads to mistakes of commission which fall broadly into several categories.
- Behavioural mistakes
- Mistakes on valuation
- Mistakes on diversification. Technically, this could be a subset of the 1st category
- Mistakes on believing management
- Mistakes on ideology
This list here is not meant to be exhaustive.
With regards to behavioural mistakes in the stock market, I believe that Charlie Munger has done us a great service by elaborating on how us humans make decisions, affected in part by the various biases we hold in our system. I can do no better than that interview. Do read and reread the psychology on human misjudgement.
Let me just say one thing about psychology. If you understand human psychology, you could very well be a billionaire.
Let us take the example of Ikea Singapore.
They force you to walk through that maze of furnishings and at the end of that maze, you are greeted with ….. drum roll please….. Ice cream and a whole lot of other feel good snacks!
And you buy it. Subconsciously, you remember that experience!
And you come back again and again! And you do the same thing again and again! And if you understand psychology, you understand that that is nothing more than classic pavlov conditioning.
Think about it! That is just brilliant isn’t it?
Mistakes On Valuation
Then we have mistakes on valuation. Valuation is really part art and part science. The valuation of a corporate entity, as taught by corporate finance, involves the discounting of cash flows from the future to the present day. With those comes projections of the future of free cash flows, projections of capital expenditures etc , all of which could go drastically wrong even if a finance professor like Aswath Damodaran were to value the company. As such, valuation by discounted cash flow and prove to be an onerous task, fraud with an enormous rate of inaccuracy. A good way to go about this is to be conservative and not overoptimistic. Intrinsic value can be taught of as a value in a certain range. This approach to valuing a company requires skill sets way beyond that of just numbers. Again, let me repeat this. Read Charlie Munger’s Psychology On Human Misjudgement. Also read another article of mine : Paying Up For Growth : You’d Better Know What You Are Doing
The other way to value a company is simply not to do it at all but to instead look for statistical cut off points that one can jump over easily. For example, a company is trading at less than its net tangible assets because of industry wide concerns but has huge cash generating abilities with an ability to increase its dividends paid. This company is likely to be undervalued. The cutoff points in this case refer to a low price in relation to assets combined with a other factors that can cause the price of a stock to appreciate. This takes some experience on the investors part as well.
Mistakes On Diversification
Investors can be overoptimistic and bet too much on too few companies. This can lead to overconcentration. A glaring example of this is a friend I knew who put his entire life’s savings of $200 000 into Bank Of America during the subprime financial crisis. He bought it at under $20 and it went down to $3. It proved too much for him mentally. He was lucky to get out at near his cost with some losses. An investor who does not understand the fundamentals of a company and bets big is a gambler who is not in control.
Being Overtrusting In Management
A lot of the mistakes committed by investors are due largely to ignorance, with the kind of attitude that says “Let management take care of it. They will find a way out.” Retail investors in general have an automatically trusting attitude towards management. Management is not some benign, compassionate celestial being, ever ready to bestow one with blessings! Management is largely human and self serving which means that given a choice, they would rather look after their interests before they look after yours. On the other hand, if you are an enlightened investor and you understand what management is doing to your company, you may choose to act on it and be an activist or you could sell off your stake in the company.
Be wise. Trust only yourself. Validate what management is saying versus what management is doing.
Mistakes on Ideology
A lot of times, investors try to emulate other investors without knowing the pros and the cons of a certain style of investing. For example, short term trading is an activity that requires much time and effort but results in lacklustre results. This is not suited to many investors. And yet, due to the allure of quick money, trading is an activity that many want to dip their hands into. The idea of trading is just an idea which has turned many people poor. It is simply not worth pursuing as the odds may suggest.
Herd investing is also another activity that one should avoid. What is herd investing? Herd investing is : if other people buy, I will get in on it too. This activity, I suggest, one should stay far away from. Another example of herd investing is this. If the analysts say buy, I will. For more on this, read : beat the herd mentality.
Hence, I put it to the readers that education is a must when it comes to investing. Read, read, read as much as you can. Assimilate and learn. Repeat the process again. This is your shot at beating ignorance.
To have that “ignoramus” attitude when it comes to investing, now, that is a dangerous attitude to have. To have that kind of a mindset, that kind of a framework, makes for disastrous results in the long run when it comes to investing. And the truth is, people are going to continue investing with that laissez faire attitude now and in the future.
Think education is expensive? Try ignorance.