Wednesday, 7 September 2016

Lessons from Charlie Munger-XII

Mar 30, 2012

In the previous article, we discussed the social proof tendency and explained how often company managements and investors get bitten by the bug of' institutional imperative'. Today we shall discuss another important psychological tendency that often causes massive misjudgments and bad investment decisions.

Contrast Misreaction tendency

How do we really perceive things? For instance, how does our brain figure that an elephant is a big fat creature? Or, how do we know that a tortoise is very slow? The answer to both these questions is relative comparison. We perceive everything in relative terms. That is, an elephant seems big in comparison to our own selves and most other creatures. A tortoise seems to be moving slower when compared to a hare. Of course, this mode of perception is not just restricted to how we look at animals. But it extends to all things in life, and very evidently in investments and stock markets. It influences how we think about economic news and information, corporate performance, stock prices, and so on. 

The reason why we tend to perceive things in relative terms is that it is impossible for the human nervous system to measure everything in absolute scientific units. So we use our senses to identify things by comparing them with other things. It is the relative contrast that gives things their specific characteristics. This is a simple program that the human mind follows. But like all psychological processes, if a mental program is allowed to run without due diligence, it can cause thinking errors and misjudgements. In this specific case, it can lead to contrast misreaction tendency. 

What is contrast misreaction tendency? Contrast misreaction causes people to make wrong judgments based on misleading contrasts between two or more things and situations. Charlie Munger cites an interesting example where this tendency is often misused- A person is shifting to another city and looking for a new house for his family. To get some quick help, he goes to a real estate broker. First, the salesman takes him around and shows him some really terrible homes for insanely high prices. Then, he takes the person to a merely bad house at a slightly lower price. Need we mention what happens next! What exactly went amiss in this case? How did the home buyer fall into the saleman's psychological trap? Blame it on the contrast misreaction tendency. When the person was shown the last property, he compared the house and its price to the horrible ones he saw before. Because of this comparison, he was ready to buy the not-so-good-house at a pretty high price. 

Contrast misreaction tendency in the stock markets 

Do investors also make wrong investment decisions because of the contrast misreaction tendency? The answer is yes, very often. The following instance will explain how investors enter this psychological trap.

Expensive at 140, attractive at 300!

Mr Chandra was an active investor. He was suggested by a friend to buy shares of XYZ Ltd when the stock price was Rs 90 per share. Instead of buying immediately, he decided to wait for some time. But in just a matter of few weeks the stock price mounted to Rs 140 per share. That was a whopping rise of nearly 56%. Obviously, Mr Chandra was very distressed. He cursed himself for not buying when the stock was trading at Rs 90. But now, he couldn't get himself to invest in the stock. It's way too expensive, he thought.

In the meanwhile, the stock continued to rally. In just a few months, the stock price was hovering around Rs 400. Mr Chandra had never felt so miserable. He had missed such a big opportunity. But then the stock price faced some selling pressure and corrected by about 25%. At Rs 300, what do you think Mr Chandra must have done? He invested heavily into the stock. 

Why did he not buy the stock at Rs 140? What forced him to buy the same stock at Rs 300? The answer in both cases is contrast misreaction tendency. Rs 140 seemed very expensive in contrast to Rs 90, the price at which his friend had suggested. However, Rs 300 seemed cheaper relative to the high of Rs 400 that the stock had witnessed.

A similar mistake also occurs with valuation multiples. For instance, if a stock has commanded a price to earnings (P/E) multiple of 50 times in the past, it doesn't mean that a P/E of 30 times is a lucrative buying opportunity. 

How can investors avoid such thinking errors? We believe the principles of value investing are a perfect antidote for the contrast misreaction tendency. Never judge the value of a company based on its past stock price performance or P/E multiples. Look at the company's business fundamentals and its past financial track record. How are the future growth prospects? What are the risks and opportunities to the business? Do the company's managers behave like owners? Valuing the company based on such important parameters will help you avoid false comparisons.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

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