Representativeness: Does this heuristic affect your Stock-picking?

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.

The Next….

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.

Sum up

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”.

Bye Bye Bias–Key to successful investing

Fundamental analysis and technical levels are all fine. But those who have been in the markets for any length of time understand one important dimension of successful investing, and that is – Behavioural aspects of investing. Overcoming investing bias is key to superior results in the investment process.

Making mistakes is acceptable because they are the best teachers. But the problem is unless one understands behavioural side of investing, it is difficult to figure out the primary mistake itself. With this background, I intend to discuss some of the investing biases in this post which often lead to mistakes on the part of the investor.

Human mind is wired to fixed tendencies, and takes decisions according to emotions and those mind patterns. Self-control over impulses is generally difficult to exercise for ordinary investors. Hard wired to herd and inability to look beyond the obvious (however silly that may be) can often be undoing a good investment decision.

Bias # 1 : Thirst for Agreement

We also know this as confirmatory bias. In simple words, we form a view and then spend rest of the day or week looking for information that agrees with that view, howsoever wrong that view or hypothesis may be. As humans, it feels good to hear the same opinion as ours. In investing, it can be a huge disadvantage if we can't accept refutation. Another manifestation of this "thirst for agreement" bias is that any media source, TV channel or information that disagrees with our view, we label that as biased.

Bias # 2 : Price Anchoring

Let me explain anchoring bias with an example psychologists and experts give on this factorial calculation. What is the value of 8! This is asked to participants in 2 different surveys, one as 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 and another as 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8.

Surprisingly, median result of both surveys was not found the same. Under first scenario, median answer was 2250. In second scenario where smaller numbers are appearing first, median answer was 512. What's your guess? Want to know the correct answer, without troubling your excels and calc. Well, it's 40,320.

Coming to stocks, we see the price tape and screens for so long that we are "anchored" to a particular price point, and anything optically different is not readily accepted even if that valuation may be more realistic. People have become so used to Reliance quoting in range of Rs 950 to 1050, that if I say I want to buy it at Rs 750, most would grin or frown at me depending on which side of the position you're.

Bias # 3 : Heads my skill, Tails bad luck

Remember the period - October 2008 to March 2009 in markets when anything we touched turned gold, well almost. But smart folks say it was entirely their skill to have got those stocks right (Heads). I can give them credit for courage and timing because those were gloomy days, but for skill…no. It was nothing great to create multi-baggers in one year for anyone who invested then. On the other hand, poor stock selection (Tails) whatever may be the month or year, is called by us as bad luck. At this time, we don't bring our bad skill set on to the fore. After all, it hurts self-esteem to admit so. This self attribution bias, is a big hurdle to recognizing mistakes and learning from them.

We have discussed only 3 biases in this post, they are many more…will continue some other time.

Good thing is these mind patterns can be attuned or set right with a little bit of mind re-training and self-regulation. It's not without reason old timers stress upon discipline and patience for success in all walks of life, investing included. Give it a try and share your experiences.

I conclude with gem of a quote attributed to WB:

"You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right- and that’s the only thing that makes you right."