Shailesh Kumar on Risk and Investor Behavior

By Shailesh Kumar of ValueStockGuide.com

The traditional equation of risk with the volatility is a popular myth propagated by academia. It is true that a volatile stock can give you sleepless nights, thereby causing you to believe that your investments are riskier than they may be in reality. For investors, the real risk lies in the possibility that they might suffer a capital loss over the holding period of the security.

Between the time you buy a stock and the time you sell it, the stock may be volatile. However, as long as the business fundamentals are evolving as expected, an investor will do better to ignore the daily fluctuations in the stock price. Short term stock prices are a function of the demand and supply of the shares in the market while over the long term the stock prices reflect the strength in the underlying business.

Easier Said Than Done

As humans we are programmed to react. We react to self-preserve and often make snap judgments that do not turn out to be rational. Add to this the fact that we are normally very bad judges of probabilities, especially when  money and long time frames are involved, and it is easy to see why so many of us end up making irrational investment decisions that are based more on emotions and less on logic.

In multiple studies, subjects were asked to predict which side of a “T-maze” held food for a rat. The maze was rigged such that the food was randomly placed (no pattern), but 60% of the time on one side and 40% on the other. The rat quickly “gets it” and waits at the “60% side” every time and is thus correct 60% of the time. Human observers keep looking for patterns and choose sides in rough proportion to recent results. As a consequence, the humans were right only 52% of the time.

There are a few behaviors wired into our psyche as humans that work against us as investors:

1. Loss Aversion: We want to avoid losses as much as possible and may give up making gains as an alternative. Therefore, avoiding a potential $100 loss becomes more of a priority over making a possible $200 profit. Investors often keep their losing positions in the hopes of something turning around, instead of redeploying the capital in a more promising investment.

2. Sunk Cost Fallacy: When a stock you own becomes cheaper, should you buy more or not? When the stock price has risen, should you sell or buy more? The answer is that we can’t tell with the information provided. The appropriate decision depends on the valuation of the company and the stock price today. It has nothing to do with what we paid for the stock in the past. Still, we regularly see investors trying to “bring their average cost down” without considering the reasons the stock declined in the first place.

3. Hyperbolic Discounting:  Instant gratification colors our judgment. We discount long term rewards and end up making sub optimal decisions. Quick: What would you rather have? $50 now or $52 one week from now? (Hint: $52 a week from now is akin to earning a 1000% annual rate of interest on your $50 deposit, but you will be surprised how many people think of this as the worse choice in this context). Ever own a stock where the long term business prospects have not changed but there has been a temporary setback and the investors sold the stock en masse? Maybe the quarterly earnings were a little light as some deliveries got pushed to the next quarter. This is our “everything now” culture rearing its head.

Now frankly, the fact that most investors exhibit these behaviors in the market is great news for me. It creates opportunities that the Efficient Market Hypothesis insists should not exist. But as long as I keep falling in these same psychological traps, I have no way of identifying or taking advantage of these opportunities, nor a way to realize how others with better control on their emotions may benefit from my behavior.

The Greatest Risk in Investing

The greatest risk in investing does not come from making a mistake in judging the value of a stock. Surely that is a risk, but it is managed simply by insisting on a sufficient margin of safety. Investing is mostly common sense and as long as we exercise good judgment, over time we will prosper.

The greatest risk lies in the fact that we do not exercise good judgment. In the periods of stress, we are wired to choose what feels good at the moment over what is right for the long term. I have had many instances in my practice where one single choice, for example, deciding to purchase more shares when the market panicked and sold the stock, has turned a losing investment into a satisfyingly profitable one. Most of your investment success depends on your capability to make rational decisions in these moments. At first, you might feel sick to your core, since you are over riding your body’s reflexes. With practice, it gets easier.

Ensuring Rational Decisions

I can only give some pointers as every investor has a different risk profile and way of acting. The following system has evolved over the 20 years of my investment career and works well. Following a system with discipline creates objectivity in your decision making that is lacking when you are just reacting from the seat of your pants.

Establish a Value and Risk Exposure

  • Figure out the intrinsic value of the stock that you are buying before you buy it
  • Estimate your level of confidence in the intrinsic value you just calculated – maybe you made certain assumptions that if different in reality can shift the valuation markedly
  • Run through future scenarios that are probable and how they will affect the intrinsic value of the company
  • Determine the upper limit of the price you will pay for the stock given your calculations above

Figure Out the Why

I am not a big fan of buying a stock just because it is cheap or a great value. Yes I have done it and still do it from time to time, but in every case I run through different scenarios that will make my investment profitable (and also the flip side). There has to be some catalyst to unlock the value, if you will.

1. BBRY stock is cheap compared to the value of the cash and other assets on its balance sheet and lack of debt

vs.

2. BBRY stock is cheap compared to the value of its balance sheet and the company has a believable turn around plan to make these assets more productive and return to profitability

There is a difference between the following two statements describing possible investment theses on Blackberry (BBRY)

If #2 is my investment thesis, I am more likely to make correct decisions in the future. I would have studied the turn around plan, would not panic when I see a large restructuring expense in the future quarters as it would be expected, and would be able to put future management actions in the right context. I am unlikely to sell out at the wrong time.

If you do end up investing in a stock where your “why” is not strong, you can still manage your exposure to this increased risk by limiting the allocation, and perhaps breaking up your purchases in chunks that may be executed over time as more of your questions get answered.

Eliminate the Noise

Turn off the TV and uninstall that stock ticker from your computer. The only opinion that matters is yours, and only thing you need to know is any material development in the business. About 98% of what passes as opinions, projections and estimates in the media from the “experts” is wrong (I may be exaggerating here, but not by much)

Final Note

Volatility does not always indicate risk but it might provide opportunities if you remain rational. It is worth watching yourself over time and how you make decisions so you can evolve your investment process over time.

Bio: Shailesh Kumar is a value investor and runs ValueStockGuide.com

Saundra Marcel