GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Are You Right Because the Stock Moved Up?

June 01, 2014 | About:
Grahamites

Grahamites

112 followers
"The prices on the market are the ultimate form of social proof, reflecting what other people think."

- Charlie Munger (Trades, Portfolio)

Do you ever ask yourself this question – how do I judge the success of failure of my investment decision making? In other words, how I know whether my investment thesis is right or wrong? If you do, what is your rational answer and is your practice consistent with the theoretically correct answer?

From my observation, most market participants judge the quality of an investment decision by one single factor – the price movement (especially) of the underlying security. If someone pitched a long idea and the price of the stock moved up say 30% during the next few weeks for whatever reason, he or she will be rewarded with credibility and respect. Conversely, when Bill Ackman (Trades, Portfolio) pitched the case against MBIA and the price kept going up and up and up for years, he looked like an idiot during these years.

I think this predictable irrationality caused by a combination of reinforcement and social proof is one of the most under-appreciated concepts in the investing world. We talk about how to sharpen our analytical skills and how to value a business very often but we don’t talk enough about how to avoid the folly of being misled by the powerful irrational movement caused by social proof. This predictable irrationality is almost ubiquitous. I’ve known investors from all over the world and we exchange ideas on a regular basis. For a while I was befuddled by the following behavioral pattern: I would receive congratulatory emails from my friends because the stock I wrote about moved up but very few of them wrote me congratulatory emails when the thesis of my investment was gradually holding water yet the stock price remained tamed.

Such is the human side of investing. We are subconsciously subject to a super powerful lollapalooza effect – the availability bias, the consistency and commitment bias and the social proof bias. Very often the price of a stock is readily available whereas other data may take a while to find. Then we are inclined to pound in what we shout out. Ultimately we feel secure and comfortable when the whole investment community agrees with us and insecure and horrified when the herd is against us.

There are many great examples of how we can minimize the impact, or even overcome the aforementioned lollapalooza effect. My favorite examples are given by David Einhorn (Trades, Portfolio) and Bill Ackman (Trades, Portfolio). Readers can read the book “Fooling Some of the People All of the Time” and "Confidence Game: How Hedge Fund Manager Bill Ackman (Trades, Portfolio) Called Wall Street's Bluff.” Whatever bias you may hold against Mr.Einhorn or Mr. Ackman, don’t let them stand in the way of appreciating the remarkable battle they had against the herd and human nature in their short bets against Allied Capital and MBIA.

Another great example that is still developing is Warren Buffett (Trades, Portfolio)’s investment in IBM. I’ve laid out my simple case for IBM in one of my previous articles. As IBM’s stock price has been stagnant during the past few years, Buffett and Munger are facing a growing amount of criticism and doubts. Obviously Buffett and Munger have their way to handle the tremendous power of social proof and commitment and consistency tendencies. Their approach is simple- pay attention to the fundamentals of the business and ignores the price movement. I encourage the readers to adopt this simple approach. Let me illustrate this point with the help of Value Line’s IBM report:



As we can tell, on a per share basis, both revenue and net income have been increasing consistently since Buffett took a stake. The profit margin is expanding. IBM continues to shrink its share count, giving Berkshire a higher ownership%. Its return on equity is still enviable. In short, the fundamentals of the business look very healthy despite the much discussed challenges faced by IBM.

I suspect this is why Buffett and Munger are not swayed by the nay-sayers and critics, who most probably focus on the easily available and social proofable stock prices. The wiser men focus on rationality and sound investment thesis supported by quantifiable evidences.

Ok, I have done my part of preaching. Fully aware of the limpidness of my thinking and experiences, I look forward to thoughtful comments from fellow intelligent readers.


Rating: 5.0/5 (7 votes)

Voters:

Comments

m.siddiquee
M.siddiquee - 1 month ago

Excellent article. I think part of the problem is also due to outcome bias - we judge people by the outcome of their work, not by the process the followed. Thanks.

Grahamites
Grahamites premium member - 1 month ago

You are right, M.Siddiquee. The outcome bias in this case is related to the availability bias in my opinion. Imagine what would happen if we close the stock market for 3 years:)

Thanks for commenting.

vgm
Vgm - 1 month ago

Great question. I think one answer is embodied in Ben Graham's observation that "In the short term, markets behave like a voting machine, but in the long term like a weighing machine." If we've bought a good company with a margin of safety in the price we paid, then we should expect that the price rises to meet intrinsic value over time, assuming the company continues on a positive business trajectory.

In the short term (less than 3 years?) anything is possible with Mr Market - the price may remain flat or fluctuate, and if we are confident we should buy more if it goes down significantly. IBM may be an example here. But in the long(er) term (3-5+ years?) we should expect our thesis to work out. And in Buffett's case, he has superior ability in picking companies which he can hold 'for ever'.

Value investors like Bill Nygren (Trades, Portfolio) and the folks at Longleaf tend have target prices at which they intend to sell stocks - Nygren talks about how he sells when something gets to about 90% of his estimated intrinsic value. Intrinsic value is a moving target and could rise or fall with the business.

Another Graham quote is relevant to this discussion I think: "You are neither right nor wrong because the crowd disagrees with you. You're right because your data and reasoning are correct." To me this is where the best differentiate themselves from the rest (of us). It ties in with the comments on 'process' above.

Thanks for the stimulation!

japeel
Japeel - 1 month ago

Great article and thanks for posting it. As someone who has been through the full spectrum of “pseudo-investor (speculator)” to “Investor” (with occasional lapses in judgement/skill). I’ve found over the years that the more I’ve talked to people, family and friends, or commented on website discussion boards about individual stocks the more I had a tendency to judge myself by people’s reactions to what I was saying. By that I mean, it could cause me to be more “contrarian” in my investment theses when I should have been more cautious or less enthusiastic in purchasing when a fine business’ stock price has finally started its long climb out of the doldrums.

This can result in providing a huge stick to your audience, with which they can beat you when things aren’t going so well; instead of allowing you the calm to re-examining your investment thesis and take decisions based on the hard facts. For those who haven’t taken the time and effort to build a disciplined investment approach, they don’t have the first idea what you’re talking about anyway, so you’re bumping your gums for nothing and at the end of conversation look at you like you’re an idiot (it’s hard to say "Well obviously I’m right", when you haven’t made enough money to stop working…. yet).

In fact, the less I comment on/discuss my personal investment performance or stock picks, the better both have become, I now just alternate between a smug grin and grimace and try to build a library of “I won’t do that again”, errors in the grimace case.

Monish Pabrai refers to the fact that he doesn’t discuss his share purchasing theses whilst holding an equity for the simple reason that saying something in public about a holding can almost oblige him to keep it, even when the time to sell has long since passed.

Grahamites
Grahamites premium member - 1 month ago
Vgm - Thanks for the comments and thanks for reminding me of one of my all time favorites Graham's quote. It sounds so easy and so logical. But in practice it's nowhere near being easy. That's why I think we need objective fundamental evidence backing up our thesis and we should track the fundamentals, not the stock prices. It's also harder if you are managing other people's money. Imagine what Bill Ackman (Trades, Portfolio) had to say about his Herbalife short to his investors when it tripled from the low. I really think Ackman and Einhorn provided us with the best in class examples.

Grahamites
Grahamites premium member - 1 month ago

Japeel: First of all, thanks for your thoughtful comments. You are very wise to have realized the committment and consistency, and the social proof tendency you subject to when you tell an investment idea to your friends or family. You pound in what you shout out and you pound in what other people agree. That's why Mohnish doesn't discuss his current holdings. Why expose yourself to unnecessary noise and pressure when they don't even matter? Why not eliminate the conditions that will make you more vulnerable to human biases? So you are absolutely right in your comments below:

In fact, the less I comment on/discuss my personal investment performance or stock picks, the better both have become, I now just alternate between a smug grin and grimace and try to build a library of “I won’t do that again”, errors in the grimace case.

Thanks for your great feedback and thought-provoking comments.

snowballbuilder
Snowballbuilder - 1 month ago

good article and fully agree with VGM.

In the short term any stock can go up , down or no where...

but in the long term , if you have buyed a great company at a good price , the stock should go up.

if is not ... the company wasnt probably so great or the price wasnt probably so good...

look at berkowitz with AIG , ubben with MSF , berkshire and djco with WFC ecc ... some short term pain but a lot of long term gain .

"You have to have the courage of your convictions. That’s what you are getting paid for. This is the time when I really earn my money." Berkowitz

vgm
Vgm - 1 month ago

Grahamites -- thanks, fully agree that it can sometimes sound easy or obvious in theory. But successful practice over a sustained period is challenging to say the least. Munger said it best: "None of this is easy and anyone who thinks it's easy is stupid."

Grahamites
Grahamites premium member - 1 month ago

Snowballbuilder - You have a good point. I would only add that if you don't overpay too much, you should do well with a great company. Examples of overpaying are countless, including Coca Cola and Walmart in the late 1990s. And thanks for the Berkowitz quote.

Grahamites
Grahamites premium member - 1 month ago

Vgm: Good reminder from Munger. Lesson learned: all we need to do is to avoid excessive stupidity:)

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Email Hide