At a glance
We’re swayed much more by good stories than by factual evidence – In investing, a compelling story backed by anecdotal evidence is much more likely to get us to act than graphs or numbers – There are hundreds of stories about what works in the stock markets – While some are mere flash-in-the-pan, others are more resilient and bear scrutiny – As investors, we should first identify the kind of stories that appeal to us and then examine them closely to determine their validity before clicking ‘Buy’
Missed opportunity or Distraction
I saw this tweet on my feed a few days ago:
Wonderla has nearly doubled after its IPO. I added much more on the listing date at 160 and it’s at 241 now.
— Deepak Shenoy (@deepakshenoy) July 4, 2014
I follow the tweeter, Deepak Shenoy, for his erudite and analytical views on the general economy and it’s impact on investments, mainly stocks, bonds and real estate. These he publishes on his excellent website, Capital Mind. Interestingly, in spite of the preponderance of economic views in his twitter feed, his investment philosophy, or what is evident from his tweets and his website, largely relies on technical and momentum indicators.
If I had to guess, his trades, probably are largely short-term, with his positions lasting weeks, if not days. Nothing notable about that given there are millions who trade in the markets with similar philosophies, except maybe Deepak is one of the most noted and skilled practitioners around. Nor is the tweet notable, except for the reference to a 50% gain on a stock that listed in May, a little over two months. Add to that the IPO price was around ₹120, which meant a 32% premium on listing day. Great going!
What is notable (to me), is the way it made me pause for a few seconds (and few seconds only), and wonder to myself, “Should I have considered buying that stock in the IPO?”. This, a few weeks after I published a post titled ‘IPO: Imaginary Profits Only?‘ where I essentially rule out the idea of buying shares from promoters at prices he/she decides, with scant visibility into the underlying business save for the dubiously named ‘Red Herring prospectus‘ Note that just because I believe IPOs are strict no-no’s doesn’t mean they are not a viable investment avenue, for others.
What’s your investment story?
As investors, we’re all susceptible to certain stories about what “works” when it comes to making money in the stock market. And there is no dearth of stories. Consider a few:
- Buy stocks in good companies and the returns will follow…
- Buy after bad news…
- Buy after good news…
- Follow the insiders…
- Buy stocks with big dividends…
- Buy stocks that have gone down the most…
- Go with stocks that have gone up the most…
I’m not saying that these and other stories are false, in fact, the opposite. All the stories that one hears have definitely worked at some time or the other, some more than others. Which is what makes them irresistible, just like the Wonderla IPO and it’s 100% return in two months.
When in doubt, it’s time to go to the experts. Easier said than done in this field where faxperts (fake experts?) outnumber the true practitioners probably by a thousand to 1.
In his book, ‘Investment Fables‘, he beautifully categorizes the different kinds of stories we come across and then proceeds to tease apart the validity of each by analyzing what the results of adopting said strategy would be. His approach is refreshingly, not to debunk a host of stories and to point to “the one true approach” but to recognize that our investment choices, much like all choices, are driven by our personalities and experiences. He identifies the weaknesses of some of the stories and why they might cause more harm than good. Not only that, he also points out the more resilient stories, that have delivered consistent, sometimes unspectacular and sometimes exceptional returns.
According to Prof. Damodaran, all investor stories fall into one of four categories based on the kind of audience they appeal to: Risk Averse, Hopeful, Greedy or Risk Seeking. And every story can therefore be classified as having a rationale that’s meant to attract one of those four kinds of investors.
The Risk Averse Investor
By birth or made so by prolonged bear markets or past disasters in the market. Seeks low-risk strategies that offer higher returns than safe investments like fixed deposits
Stories they prefer
- High Dividend Stocks – they resemble bonds by generating income, with the added bonus of price appreciation
- Low Price-Earnings Ratios – Safe because they are cheap
- Trading at less than Book Value – at less than liquidation value, have to be underpriced!
- Stable earnings – Typically conglomerates, showing consistent earnings irrespective of business cycle
The Hopeful Investor
Eternally optimistic in spite of past debacles, believes in the “silver bullet” approach that will beat average investors. The challenge for them is find that right investment ‘expert’
Stories they prefer
- Follow the experts – offer welcome solace from the noise and cacophany in the markets
- Stocks always win – if you can get in and out at the right times, especially with long time horizons
The Greedy Investor
The fuel that drives financial markets. Holds the firm belief that you can get something for nothing.
Stories they prefer
- Fast track investing – companies that short circuit the long grind to growing big by making high-profile acquisitions
- No Risk, Big Profits! – arbitrage from improperly valued assets, including but not limited to derivatives
- Momentum – stocks that are going up keep going up and the opposite too. Chartists and technical analysts rule
The Risk Seeking Investor
How else can one make big returns? Does not believe in anything that looks like a bond, instead seek companies with most “upside” potential
Stories they prefer
- “Great” companies – what Steve Jobs did for Apple, superior management will find ways to turn threats into opportunities
- Growth stocks – high earnings growth can lead to far beyond average price appreciation
- Loser stocks – companies that are currently out of favour due to missteps like too much debt, misplaced strategy but will come back strong
- Hidden bargains – find the next Infosys or Microsoft before they become household names
What Prof. Damodaran exhorts us to do, is to first understand the kind of stories you’re most likely to be convinced by, test them for longevity and resilience, and to then embark on that investment style.