Ask the right questions

One of the most important life skills lies in asking the right questions, and like most other important ones, it is not taught in schools. This idea lies at the very heart of critical thinking, and thus when you see this…

best-delusion

..you can’t help but shake your head feeling both amused and frustrated at the same time.

The existence of the Internet, Google and Social Media has had a far reaching impact on modern society, but have also provided a platform for two very strong psychological biases: social proof and confirmation bias. People not only seek out validation from groups, but are looking for the sort of validation that confirms their pre-conceived notions. You like gold? You’ll find a dozen blogs that extol its virtues. Think that the earth is flat and there is a conspiracy to cover it up? There’s a society for that too. Every strategy, every stock, every asset class has an advocacy group that will defend it till kingdom come.

In a way, the search for the best whatever reminds me of the story of El Dorado. In the 16th and 17th centuries, countless lives were lost searching for a mythical city were precious stones and gold were as bountiful as common rocks. If it seems far-fetched, consider that there was a grain of truth to the existence of great wealth in the New World. Both the Inca and Aztec civilizations were proof of that, which brought in waves of Spanish conquistadors seeking to make a fortune. History is littered with similar examples were the blurring of the lines between truth and fantasy have led to obsessive, futile quests. The Fountain of Youth. Shangri-La. The Philosopher’s Stone.

There is no such thing as a best stock!

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system”

– Charlie Munger

What Charlie wants to illustrate through this analogy is that, all things being equal, a superior business will outperform an inferior business over time. However, when you change the price paid, suddenly the odds can shift. At a certain price, a superior business may become a bad investment and an inferior business may still work out to be a superior investment.

Think of it as pitting Usain Bolt up against an ordinary individual. If they ran a fair race, Usain Bolt would win hands down. However, lets say you handicapped Usain by giving him a delayed start. He would eventually overtake the average runner, but it would take longer. This is what makes investing so difficult – it’s not always clear what will necessarily make the highest returns, and you can only estimate what the odds are and try and put together a portfolio where risk-reward is in your favour.

For something to be mis-priced, someone (the buyer or the seller) has to be wrong. So instead ask, why am I or my counter-party wrong?

Buffett famously likened investing to playing at a poker table, saying that if in 30 minutes you don’t know who the patsy is, it’s you. You have to think about the possible reasons why someone would want to trade with you in the first place.

  1. Underestimation of the competitive advantage / growth period: the prime reason why certain quality businesses tend to continue to outperform the markets as a while. Usually while someone is looking for the next star, they would be better off just buying this.
  2. Short term time horizon / recency bias: A good business has a bad quarter, negative news pushes down the stock price, business with fixable problems.
  3. Baby thrown out with the bathwater: The markets as a whole go down significantly, or an industry goes out of favour, dragging down the prices of both good and bad companies at the same time.
  4. Institutional / Regulatory selling: A spinoff situation where institutions sell the shares they receive of the spinoff because it doesn’t fit their mandate (covered in well in Joel Greenblatt’s book “You can be a stock market genius”)
  5. Cyclically depressed business: A combination of 2 and 3, where a cyclical business at the bottom of a business cycle tends to become very cheap on the basis of normalized earning power (what the business makes during a more normal period). Caveat: the business should have the financial strength to survive, here is where low debt, low cost efficient producers with strong balance sheets have the advantage.
  6. Genuine Turnarounds: Since the market is taking it’s cues from past performance, which is terrible, it can take time for the new business and financial position to be recognized.
  7. Hidden / Unrecognized Assets: There may be cases where the holding structure of a company or accounting methodology is complicated enough to be obfuscate the value of assets held by the company.
  8. Misunderstood companies: A secular growth story in a cyclical industry / brand in a commodity industry.
  9. High uncertainty – people tend not to like uncertainty, hence they might jump ship in favour for calmer seas. A possible case could be an event such as a pending court case / regulatory body outcome.

This is by no means an exhaustive list, just me thinking out loud off the top of my head at 12 am, so I’m fairly sure I’m missing a whole lot. You get the point though, there’s a ton of better, more meaningful questions you could be asking. Ask questions where the answer makes you a better fisherman.

 

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