Monday, September 28, 2015

Behavioral Biases: How They Influence Investment Decisions

When a stock performs well -- and as just one example Amazon's (AMZN) stock, to say the least, certainly has over the long haul -- it's easy to become convinced, at times incorrectly, what ended up happening was obvious all along.

That's hindsight bias -- the belief, after the fact, that something was more predictable than it actually was -- and is just one among the many biases that impact investor behavior and results (and generally not in a good way).

Now, here's just some examples of those who, more or less, previously expressed a favorable view of Amazon as an investment.*

Amazon 'Undervalued': Portfolio Manager

Analysts Bullish on Amazon

Ken Fisher Still Bullish on Amazon

And some from those with a less favorable point of view...

Not Even Jeff Bezos Would Buy Amazon's Cash Flow

Three Reasons Why Amazon's Cash Flow Is No Comfort

Don't Be Fooled by Amazon's Cash Flow

There are, of course, many more examples of thoughtful but opposing views to be found. The same stock but very different views. For those with an open mind this can and should be a good thing. Unfortunately, it's easy to make the mistake of only seeking information that's consistent with one's own thinking.

Of course, investment decisions should never be based upon what someone else thinks. Ultimately, each investor needs to come to his/her own conclusions. Yet it's important to avoid making the mistake of only giving consideration to information that reinforces a particular view -- however flawed or biased it might be -- while mostly ignoring contrary facts and logic.

Keep in mind I'm simply using Amazon as an example. The same thing, in general, can be applied to other stocks though naturally the specific circumstances will always be unique.

Personally, I respect and admire Amazon and Jeff Bezos** but have never considered owning the stock for a simple reason:

I just don't know how to value it within a narrow enough range.

That doesn't necessarily mean I'll be surprised if the company proves to be very valuable over the long run.

In fact I won't be at all.

It simply means I don't understand it well enough especially when compared to alternatives; it means my estimate (within a range) of likely future returns can't be compared in a meaningful way to those things I think I do understand better; it means that if I can't value something with enough warranted confidence, it's by definition impossible to determine what price represents a sufficient margin of safety.

So, as a result, it has never made any sense for me to consider owning Amazon's stock. Behaving otherwise would likely be, at least in my case, a recipe for subpar results or worse in the long run.

Now, lets assume for some reason I had long ago decided to buy Amazon (again, I've always had -- and continue to have -- zero interest in doing so) and it happened to work out well for me. This result would have been mostly, if not entirely, due to pure luck. In other words, not being able recognize when good fortune more so than being right was the reason for the good result will likely lead to future costly mistakes and reduced results.
(Even though, due to luck, the results were favorably impacted by the Amazon investment my view is that the lack of discipline, ultimately, is likely to hurt results.)

It's about knowing and staying within limits.

Those who buy any stock without carefully considering the reasons why things may not go as well as hoped are potentially setting themselves up for permanent capital loss.

Beware of confirmation bias.

Beware of investor overconfidence.

These can prove expensive in the long run.

If not carefully managed these and other biases can lead to big and unnecessary mistakes.

The important thing to remember is that biases are -- in the context of investing -- not just someone else's problem.

For most of us -- if not all of us -- bias blind spot is a real factor.

It's easy to point to what worked well with the benefit of hindsight. For every Amazon -- at least in the real world -- there will be many that seem to have great potential but don't work out nearly so well.

That simply won't be obvious before the fact.

It will only become obvious when looking through the rear-view mirror.

Knowing what to avoid starts with buying only what you understand.

That means, inevitably, sometimes it's necessary to "miss" what after the fact proves to be an excellent opportunity.

Some investors no doubt were able to see Amazon's potential long ago and were rewarded for it.

Still, it's important to try and be objective about the reason something worked out well.

Easier said than done.

Sometimes, an investment might work out well due to brilliant insight and foresight.

Other times, good fortune might have played a significant role.

Knowing the difference can eliminate errors down the road.

Maybe some think Amazon's prospects and intrinsic business value have always been, and remain, plain to see; or maybe that's, at least in part, simply hindsight bias at work.

Adam

No position in AMZN

* Naturally, views such as these are not necessarily static, may have changed, or at some point may change.
** Some concerns and criticisms have also been previously highlighted.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, September 15, 2015

Bogle on Speculation

John "Jack" Bogle recently said the following on CNBC about volatility in the capital markets:

"It's just speculators not speculating on what they think is going to happen but what they think other speculators think is going to happen..."

So it's too much focus on trying to guess how other market participants might behave, along with other near-term events (fed action or inaction, earnings reports, GDP growth), instead of gauging the intrinsic values of businesses.

"This speculative binge that we're seeing here … has nothing to do with the fundamentals behind the long-term value of equities in particular, which are created by the values of corporations, earnings and dividends, and reinvestment in the business."

Estimating intrinsic business values is challenging enough; guessing what the market -- or any individual security -- is going to do is if not impossible, for most of us at least, a fool's game.

The idea that since a little speculation in markets is a good thing then unlimited amounts must become a wonderful thing is a fallacy. The petrol engine in my car likes roughly the right amount of air relative to fuel in order for the combustion process to work. So that means, at some point, too much -- or too little -- air compared to fuel will actually hinder performance.

It's about optimization. The same is true for capital markets. I'd argue there's way too much activity geared toward what's going to happen in the next minute, hour, day, week, month -- and even a year or two. Too much air; not enough fuel.

All of those time frames are way too short to be considered investment activity. It's speculation and even pure gambling (there's a difference between the two) over investment.

There are important reasons for the capital markets to exist and the focus should be mostly on what's the optimal way to makes sure it serves the real economy instead of itself.

Adam

Related posts:
Zero-Sum Games
On Speculation and Investment
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, September 4, 2015

Buffett on Value vs Growth

Warren Buffett, in an interview on CNBC back in March of this year, said the following:

"I always say if you aren't investing for value, what are you investing for? And the idea that value and growth are two different things makes no sense. I mean, growth is part of the value equation and a company that grows and uses little capital in doing it...is obviously worth more money than one that doesn't grow. That doesn't make the one that doesn't grow valueless though." - Warren Buffett on CNBC

Growth can be a good thing if the price is right (i.e. price paid comfortably less than est. per share intrinsic value). Unfortunately, exciting growth prospects sometimes attracts more than its fair share of attention leading to market prices more than reflecting intrinsic value.

Too little margin of safety if future business performance disappoints.

In fact, growth isn't necessarily even always a good thing:

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter

Some seem to treat all growth as good growth. Well, that's just not the case.

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth." - Warren Buffett in the 1992 Berkshire Letter

What matters is buying a good business -- whether it happens to have growth prospects or not -- at a discount and warranted confidence that the core business economics are attractive and will remain so.

Some businesses produce high returns on existing capital but can't do the same on incremental capital. These can still prove to be sound investments (again, at the right price) but growth prospects -- at least the kind of growth that produces satisfactory or better returns -- will usually be modest. The fact is putting incremental capital to work in such a business can actually end up hurting investors. So excess capital needs to be intelligently allocated elsewhere* (outside the business) or, otherwise, returned to shareholders.

One problem that sometimes arises with higher growth businesses is simply that investors pay too much for the privilege of ownership. In other words, due to the excitement about the upside potential, what could go wrong doesn't get fair consideration. The end result being investors pay a price that doesn't protect them sufficiently if things don't go quite as well as hoped.

A price biased toward things going well can increase the risk of permanent capital loss. In fact, an optimistic price might lead to insufficient rewards even if things do go well.

More risk.

Less reward.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
High Returns on Capital vs High Returns on Incremental Capital - Jan 2015
Altria: Timing Isn't Everything, Part II - Jul 2014
Aesop's Investment Axiom Revisited - Jul 2014
Altria: Timing Isn't Everything - Jul 2014
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Technology Stocks - May 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* Berkshire has the luxury of being able to move excess capital from where it can't produce high returns to where it can.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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