Very often, we see in investing world that a person categorizes a situation based on his/her previous experiences or notion or belief about it rather than any objective assessment. In simple terms this is how we can explain Representative Heuristic which is a cognitive bias. Well, if one makes a short-cut decision, something like a rule of thumb strategy, this can sometimes be useful when faced with uncertainty. But as a process, representative heuristic can be limiting and almost suffering from close-mindedness when we talk about stock-picking.
Cut back to 2002, we had so many software companies claiming to be the next Infosys. A few growth years or financial parameters, and pat came the declaration from the investing community of The Next... It was representativeness without any thorough understanding of their business or management attributes. We know most of them do not exist today, and others failed to make it big.
Cut back to 2007, we had so many engineering and infrastructure companies claimed to be the next L&T. Hefty order books and growing construction work all around and even professional analysts declared arrival of The Next... Again, it was mainly representative heuristic without any objective assessment. I don’t want to name any companies in this league but those who follow the markets would have understood which ones I’m alluding to, and look how they are struggling to keep their head above the water.
Now in 2011, you’ve a urban consumption branded stock that is highly successful in something - shoes, undergarments, pizza, coffee or whatever. Here I’m talking about success of the stock, not necessarily success of the company (my saying so can put off few but I defer that discussion for some other time). Then comes another stock in similar space, through an IPO, re-listing, analyst’s discovery or restructuring. And the analysts declare it as The Next…
The Gambler's Fallacy…
This basically means that if a fair coin is tossed repeatedly and say heads comes up 6 out of 6 times, a gambler may incorrectly believe that in 7th toss the coin is “due” for a tails and the outcome of heads is less likely. When in reality, the probability remains the same 50% no matter how many times the coin is flipped. Likewise, there is a reverse gambler's fallacy where a person may instead decide that heads are more likely since run of events or fate has all this time allowed heads consistently so why change the odds. Either way, memory of past results does not statistically influence future outcome.
To some extent, this fallacy happens in investing while extrapolating the stock trends and performance. When we look at a stock which has historically traded at high PE of 20 times and due to “turn of events” came down to say 10, Investor A will buy thinking how cheap it is, without regard to change in its business dynamics. Investor B will bet that it has now lost favour of the market and sell it.
The Reversion to Mean…
Will returns generated by that evergreen stock over the next 5 years outpace the industry average the way it has done in the last 5 years? This is the moot question. Can it be taken for granted if you do a Rip Van Winkle and come back after many years? Well, mean reversion works until it doesn’t. There have got to be good reasons that it has worked or they did something better than the pack. What needs to be investigated from investment perspective is can this competitive advantage be sustained over a longer period? Stocks that have risen too fast like flash in a pan or beaten the normal trajectory for a short while can revert to the mean faster than one expects.
Most of the Polyfilm stocks gave such an opportunity in 2010 where decent money was made given the disproportionate market demand and fewer players (yours truly also utilized the run and sold out in time), but to have expected that this would last forever was a fallacy.
Representative heuristics affect our stock decisions all the time. Sentiment is an integral part of the market psychology. Not very long ago, you heard your friend saying that 52-week high for this stock is so and so and now it’s available at such a lucrative price. Besides the stock and its underlying, we need to track the real drivers that decide its performance - the competition catching up, the moat melting away, the size becoming an enemy, the macro policy shifting, the hitherto tight cost structures giving away and the customer preferences changing.
We need to be sure that we are looking at the right metrics. I conclude with quote from Peter Bernstein “The fundamental law of investing is the uncertainty of the future”.