Stock market corrections and panics are easy to spot and usually the safest because they don't tend to change the earnings of the underlying business. That is, unless the company is somehow tied to the investment business, in which case a market downturn tends to reduce general market trading activity, which means brokerage firms and investment banks lose money. Otherwise the underlying economics of most businesses stay the same. During stock market corrections and panics, stock prices drop for reasons having nothing to do with the underlyng economics of their respective companies.
This is the easiest kind of situation to invest in because there is no real business problem for the company to overcome. If you let the price of the security, as Buffett does, determine whether or not the investment gets bought, then this is possibly the safest "buy" situation there is. Buffett began buying The Washington Post during the stock market crash of '73 - '74 and Coca-Cola during the crash of '87. While everyone else was caught in a state of panic, Buffett began buying these companies' shares like a man possessed with a deep thirst for value. He eventually acquired 1,727,765 shares of The Washington Post and 200,000,000 shares of Coca-Cola.
A market correction or panic will more than likely drive all stock prices down, but it will really hammer those that have recently announced bad news, like a recent decline in earnings. Remember, a market panic accents the effect that bad news has on stock price. Buffett believes that the perfect buying situation can be created when there is a stock market panic coupled with bad news about the company.
Any company with a strong consumer monopoly will eventually recover after a market correction or panic. But beware: In a really high market, in which stock prices are trading in excess of fourty times earnings, it may take a considerable amount of time for things to recover after a major correction or panic. Companies of the commodity type may never again see their bull market highs, which means investors can suffer a very real and permanent loss of capital.
After a market correction or panic, stock prices of the consumer monopoly type company will usually rebound withn a year or two. This bounce effect will often provide an investor an opportunity to pick up a great price on an exception business and see a dramatic profit within a year or two of purchasing the stock. Stock market corrections and panics have made Buffett a very happy and a very rich man.
Thursday, 9 October 2008
One success can wipe out 10,000 failures.
Harness the stunning power of financial regret
Regret over past financial decisions can have a powerful hold on you.
At 23, you may regret running up $20,000 in credit card debt during college. At 35, you may regret never having gone to college. At 45, you may regret having never started that consulting business you always dreamed of pursing. And at 65, you may regret not having saved more for retirement. In recent days, many financial chickens have come home to roost.
Regret, financial or otherwise, can have a powerful grip on your life. For most, the question is not whether you have financial regret. The question is how you harness the power of that regret to make sound financial decisions today that you will not regret tomorrow.
Here are some ideas to help you do just that:
We all have made stupid financial decisions. Even Warren Buffett has made dumb investments, which he readily admits. We can spend a lot of time and energy lamenting those past decisions, but it will not help us make better decisions today. We need to stop obsessing about the past and, instead, use the lessons it can teach us to make better decisions today.
It is better to look ahead and prepare than to look back and regret. -- Jackie Joyner-Kersee
Regret for wasted time is more wasted time. -- Mason Cooley
Learn from that which you regret. If regret has any positive value, it comes from evaluating the decisions you made that caused the regret. Take out a piece of paper and write down your financial regrets in as much detail as possible. Think about not only regrets from things you did, but also regrets from things you chose not to do. It is the things we did not do that often cause the most pain. We will use this list of regrets to make new and fresh decisions today that can at least keep the regretful decisions from continuing.
Never regret. If it's good, it's wonderful. If it's bad, it's experience. -- Victoria Holt
Regret for the things we did can be tempered by time; it is regret for the things we did not do that is inconsolable. -- Sidney J. Harris
To regret deeply is to live afresh. -- Henry David Thoreau
It is never too late. Reread the quote from Sidney Harris above. Does it describe any of the financial regrets you wrote down on the piece of paper? In most cases, our most profound regrets come from things we were too scared or busy or distracted to do. Whether it was going into business, going to college, or investing in the stock market, what we chose not to do can be a major source of regret.
If you are reading this article, it is not too late. Many go to college during retirement, or start investing in their 50s (or later), or start a business only after retiring from a career. Sometimes we convince ourselves that it is too late to accomplish this or that because it eases the pain of regret. But it is a lie. Believing that it is too late to change may make us feel better, but it also causes us to repeat the same inaction that caused the regret in the first place. Look at it this way. If you are 45 and considering getting a college degree, you have two choices: turn 50 with a college degree, or turn 50 without one.
There is no old age. There is, as there always was, just you. -- Carol Matthau
Do not go gentle into that good night,
Old age should burn and rave at close of day;
Rage, rage against the dying of the light. -- Dylan Thomas
Change the bad habits. Many regrets are born out of a lifetime of small, insignificant bad money-management decisions. You may have lived for years spending just a little more than you make. But after a lifetime of such living, you find yourself in unimaginable debt, with little or no savings. It wasn't one big mistake, it was thousands of small financial missteps. If that describes some of the regrets you have written down, changing those bad habits will be much like breaking free from addiction.
People are addicted to eating out. They are addicting to shopping. They are addicted to their gadgets. Of course, nothing is wrong with any of these things if you are properly managing your money. But if you are not, these are some of the daily, weekly and monthly decisions you make that have added up over a lifetime to create the financial regret you now experience.
As a starting point, wipe your financial slate clean. Put your past financial decisions where they belong, in the past. The question now is what financial decisions are you going to make today. If regret is born out of uncontrollable shopping, put something else in your life to take the place of the shopping. Ask a friend to hold you accountable. Give your spouse your cash and credit cards to hold for you. Do whatever it takes so that tomorrow you will not regret the decisions you make today.
My one regret in life is that I am not someone else. -- Woody Allen
Focus on today and tomorrow, not yesterday. Take another look at that piece of paper that lists all of your financial regrets. That paper represents the past. Take stock of the regrets, and make decisions today so that those regrets do not repeat themselves. And once you have done that, throw the paper away. Make decisions today so that tomorrow you will look back without regret.
When one door closes, another door opens; but we often look so long and so regretfully upon the closed door that we do not see the ones which open for us. -- Alexander Graham Bell
All saints have a past; all sinners have a future. -- Warren Buffett
Regret is a stunningly powerful emotion. Allowed to run amok, regret can ruin a life and even a family. With some honest introspection, however, you can turn that powerful emotion into a motivator that helps you make better choices today. Whatever your past, make today great, so tomorrow can be even better.
One success can wipe out 10,000 failures. -- The Dough Roller
http://blogs.moneycentral.msn.com/smartspending/archive/2008/10/08/harness-the-stunning-power-of-financial-regret.aspx
Regret over past financial decisions can have a powerful hold on you.
At 23, you may regret running up $20,000 in credit card debt during college. At 35, you may regret never having gone to college. At 45, you may regret having never started that consulting business you always dreamed of pursing. And at 65, you may regret not having saved more for retirement. In recent days, many financial chickens have come home to roost.
Regret, financial or otherwise, can have a powerful grip on your life. For most, the question is not whether you have financial regret. The question is how you harness the power of that regret to make sound financial decisions today that you will not regret tomorrow.
Here are some ideas to help you do just that:
We all have made stupid financial decisions. Even Warren Buffett has made dumb investments, which he readily admits. We can spend a lot of time and energy lamenting those past decisions, but it will not help us make better decisions today. We need to stop obsessing about the past and, instead, use the lessons it can teach us to make better decisions today.
It is better to look ahead and prepare than to look back and regret. -- Jackie Joyner-Kersee
Regret for wasted time is more wasted time. -- Mason Cooley
Learn from that which you regret. If regret has any positive value, it comes from evaluating the decisions you made that caused the regret. Take out a piece of paper and write down your financial regrets in as much detail as possible. Think about not only regrets from things you did, but also regrets from things you chose not to do. It is the things we did not do that often cause the most pain. We will use this list of regrets to make new and fresh decisions today that can at least keep the regretful decisions from continuing.
Never regret. If it's good, it's wonderful. If it's bad, it's experience. -- Victoria Holt
Regret for the things we did can be tempered by time; it is regret for the things we did not do that is inconsolable. -- Sidney J. Harris
To regret deeply is to live afresh. -- Henry David Thoreau
It is never too late. Reread the quote from Sidney Harris above. Does it describe any of the financial regrets you wrote down on the piece of paper? In most cases, our most profound regrets come from things we were too scared or busy or distracted to do. Whether it was going into business, going to college, or investing in the stock market, what we chose not to do can be a major source of regret.
If you are reading this article, it is not too late. Many go to college during retirement, or start investing in their 50s (or later), or start a business only after retiring from a career. Sometimes we convince ourselves that it is too late to accomplish this or that because it eases the pain of regret. But it is a lie. Believing that it is too late to change may make us feel better, but it also causes us to repeat the same inaction that caused the regret in the first place. Look at it this way. If you are 45 and considering getting a college degree, you have two choices: turn 50 with a college degree, or turn 50 without one.
There is no old age. There is, as there always was, just you. -- Carol Matthau
Do not go gentle into that good night,
Old age should burn and rave at close of day;
Rage, rage against the dying of the light. -- Dylan Thomas
Change the bad habits. Many regrets are born out of a lifetime of small, insignificant bad money-management decisions. You may have lived for years spending just a little more than you make. But after a lifetime of such living, you find yourself in unimaginable debt, with little or no savings. It wasn't one big mistake, it was thousands of small financial missteps. If that describes some of the regrets you have written down, changing those bad habits will be much like breaking free from addiction.
People are addicted to eating out. They are addicting to shopping. They are addicted to their gadgets. Of course, nothing is wrong with any of these things if you are properly managing your money. But if you are not, these are some of the daily, weekly and monthly decisions you make that have added up over a lifetime to create the financial regret you now experience.
As a starting point, wipe your financial slate clean. Put your past financial decisions where they belong, in the past. The question now is what financial decisions are you going to make today. If regret is born out of uncontrollable shopping, put something else in your life to take the place of the shopping. Ask a friend to hold you accountable. Give your spouse your cash and credit cards to hold for you. Do whatever it takes so that tomorrow you will not regret the decisions you make today.
My one regret in life is that I am not someone else. -- Woody Allen
Focus on today and tomorrow, not yesterday. Take another look at that piece of paper that lists all of your financial regrets. That paper represents the past. Take stock of the regrets, and make decisions today so that those regrets do not repeat themselves. And once you have done that, throw the paper away. Make decisions today so that tomorrow you will look back without regret.
When one door closes, another door opens; but we often look so long and so regretfully upon the closed door that we do not see the ones which open for us. -- Alexander Graham Bell
All saints have a past; all sinners have a future. -- Warren Buffett
Regret is a stunningly powerful emotion. Allowed to run amok, regret can ruin a life and even a family. With some honest introspection, however, you can turn that powerful emotion into a motivator that helps you make better choices today. Whatever your past, make today great, so tomorrow can be even better.
One success can wipe out 10,000 failures. -- The Dough Roller
http://blogs.moneycentral.msn.com/smartspending/archive/2008/10/08/harness-the-stunning-power-of-financial-regret.aspx
Understanding FEAR and PANIC
October 8, 2008
Forget Logic; Fear Appears to Have Edge
By VIKAS BAJAJ
The technical term for it is “negative feedback loop.” The rest of us just call it a panic.
How else to explain yet another plunge in the stock market Tuesday that sent the Standard & Poor’s 500-stock index to its lowest level in five years — particularly in the absence of another nasty surprise?
If anything, the markets should have been buoyed by the Federal Reserve saying it would shore up another troubled corner of finance by lending money directly to companies. Stocks did open higher, but then quickly tumbled as rumors swirled about the viability of big financial firms like Morgan Stanley and the Royal Bank of Scotland.
Anybody searching for cause-and-effect logic in the daily gyrations of the market will be disappointed — even if the overarching problem of a crisis of confidence in the global economy is now becoming clear.
Instead, the market has become a case study in the psychology of crowds, many experts say. In normal times, it runs on a healthy mix of fear and greed. But fear now seems to rule, with investors often exhibiting a Wall Street version of the fight-or-flight mechanism — they are selling first, and asking questions later.
“What’s happening is people are crawling into a bunker and pulling an iron sheet over their heads because they think the sky is falling,” said William Ackman, a prominent hedge fund manager in New York.
And that bunker is getting very crowded, so much so that some analysts are starting to suggest the markets are showing signs of “capitulation” — another term of art to describe what happens when even the bullish holdouts, the unflagging optimists, throw up their hands and join the stampede out of the market.
Fear can be seen at every turn — in headlines raising questions about another Great Depression, and in the crowds gathered around office televisions to track stocks or to parse the latest pronouncements from the Federal Reserve chairman, Ben S. Bernanke, or the Treasury secretary, Henry M. Paulson Jr.
Even James Cramer, the voluble and long-bullish host of an investing show on CNBC, advised investors to sell some stock during appearances on the “Today” show Monday and Tuesday mornings.
To some, signs of capitulation can be read as an indicator that the bottom may be near. Indeed, Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, is among those who say the market may be close to a bottom.
In addition to his analysis of the market, he was swayed by the numerous telephone calls he has received in recent days from professional acquaintances and his sister-in-law, all saying they are getting out of stocks.
“More and more people are doing that and selling out,” Mr. Stovall said.
The opposite of capitulation, of course, is investing at the height of a bubble. One oft-cited sign of the housing market’s top: when dinner parties are dominated by stories about fast profits on flipped condominiums.
During the dot-com boom in the late 1990s, it seemed everybody and their grandmothers were piling into stocks. Now they are bailing out. Tuesday was the fourth consecutive day that the S.& P. 500-stock index registered a decline of 1 percent or more. The last time that happened was October 2002, when the index reached its lowest point during the bear market that started in 2000. The S.& P. is now down 36 percent from its peak a year ago, almost to the day, on Oct. 9, 2007.
Another barometer of panic: volatility, reflected in the so-called Fear Index (or the VIX), which tracks options trades that investors use to protect against future losses. On Tuesday, it climbed to its highest level since the 1987 stock market crash.
Fear is an immensely powerful force, perhaps more so than greed, said Andrew W. Lo, a professor at the Massachusetts Institute of Technology who has studied investor behavior.
Scientists who have studied the brain function have found that the amygdala, the part of the brain that controls fear, responds faster than the parts of the brain that handle cognitive functions, he said.
“Fear is a much stronger motivational force,” Mr. Lo added. “The loss of $1,000 has a much bigger impact than the gain of a $1,000.”
He cites a series of groundbreaking experiments in the 1970s by psychologists Daniel Kahneman and Amos Tversky. In one test, they asked students to choose between a sure bet of $3,000, or an 80 percent chance of winning $4,000 (meaning there was a 20 percent chance of winning nothing). Most students said they would take the $3,000.
The same question, framed differently, asked them if they would rather lose $3,000 or accept an 80 percent chance of losing $4,000 (with a 20 percent chance of losing nothing). In this case, they said they would take the riskier bet.
In other words, they were willing to take a bigger risk to avoid losing money than they were when they stood to make more money.
Those instincts seem to be taking over.
At this point, any spreadsheet analysis of underlying and intrinsic values of stocks becomes meaningless, and concern for preserving wealth overrides the desire to grow it — what some may call greed.
“With negative emotions we tend to have a desire to change the situation,” said Ellen Peters, a senior scientist at Decision Research in Eugene, Ore. But “when things are good there is not much desire to change.”
That perhaps explains why investors are willing to earn virtually no return in Treasury bills just to be assured that they will get their money back, rather than investing in short-term corporate debt that offers a better return but carries some risk. Investors were reminded of that risk after Lehman Brothers sought bankruptcy protection last month.
Even banks, which make money by lending to businesses, consumers and each other, are hoarding cash. That is why the Federal Reserve said on Tuesday that it would buy commercial paper, the short-term loans issued by companies and banks.
If the market is indeed close to the bottom, history suggests any rally in the next few weeks will probably be big. Since World War II, Mr. Stovall estimates stocks have recouped about a third of their bear market losses in the first 40 days after the market hits bottom.
But enough investors have to first be persuaded that the economy and housing market will begin recovering soon. Another major test will be third-quarter corporate earnings announcements that will trickle out in the next three weeks.
Perhaps the most important indicator will be the credit markets: Investors will regain confidence when they believe financial firms are adequately capitalized and money is flowing more freely through the financial system.
Mr. Ackman, the hedge fund manager who has been vocal about his bearish views of some financial companies in recent years, said it is hard to precisely time the market. But, he added, “I do think that stocks are getting extremely cheap.”
David Bertocchi, a portfolio manager for Baring Asset Management in London, echoed that sentiment, saying he was beginning to increase his stake in certain companies.
He is taking advantage, he said, of panicked selling by hedge funds that have to pay back loans to their brokers. “That’s what drives markets to attractive levels,” he said.
http://www.nytimes.com/2008/10/08/business/08fear.html?em
__________
A Day (Gasp) Like Any Other
This panic is taking place in such a compressed time frame that it is just astonishing. Mr. Chernow pointed out that while the stock market crash of 1929 took place over three brutal trading days in October 1929, it took nearly three years to reach bottom. By then, stocks had lost a shocking 89 percent of their value.
This crisis, by contrast, seems to be moving at hyper-speed — one day it is Lehman Brothers, the next A.I.G., the day after that Washington Mutual. This crisis doesn’t wear you down over time. It hits you over the head with a two-by-four. On a daily basis.
A third problem, though, is that confidence keeps eroding. The latest wrinkle is that many hedge fund investors, fearing big losses, no longer have confidence in their hedge fund managers. Thus, hedge fund managers are preparing for huge withdrawals at the end of the year, and so they are selling billions of dollars worth of stock preparing to pay redemptions. That is one reason the stock market is under pressure.
“It becomes a self-fulfilling prophecy,” said one hedge fund manager. Firms fearing redemptions sell off stocks, which hurts their performance. Which undermines their investors’ confidence. Which means there are likely to be even more redemptions. Around and around it goes.
Twelve years ago, Alan Greenspan invented the term “irrational exuberance.” That era seems tame compared with this one. What is going on in the markets is anything but exuberant — at this point, though, it is undeniably irrational.
http://www.nytimes.com/2008/10/07/business/07nocera.html?em
Forget Logic; Fear Appears to Have Edge
By VIKAS BAJAJ
The technical term for it is “negative feedback loop.” The rest of us just call it a panic.
How else to explain yet another plunge in the stock market Tuesday that sent the Standard & Poor’s 500-stock index to its lowest level in five years — particularly in the absence of another nasty surprise?
If anything, the markets should have been buoyed by the Federal Reserve saying it would shore up another troubled corner of finance by lending money directly to companies. Stocks did open higher, but then quickly tumbled as rumors swirled about the viability of big financial firms like Morgan Stanley and the Royal Bank of Scotland.
Anybody searching for cause-and-effect logic in the daily gyrations of the market will be disappointed — even if the overarching problem of a crisis of confidence in the global economy is now becoming clear.
Instead, the market has become a case study in the psychology of crowds, many experts say. In normal times, it runs on a healthy mix of fear and greed. But fear now seems to rule, with investors often exhibiting a Wall Street version of the fight-or-flight mechanism — they are selling first, and asking questions later.
“What’s happening is people are crawling into a bunker and pulling an iron sheet over their heads because they think the sky is falling,” said William Ackman, a prominent hedge fund manager in New York.
And that bunker is getting very crowded, so much so that some analysts are starting to suggest the markets are showing signs of “capitulation” — another term of art to describe what happens when even the bullish holdouts, the unflagging optimists, throw up their hands and join the stampede out of the market.
Fear can be seen at every turn — in headlines raising questions about another Great Depression, and in the crowds gathered around office televisions to track stocks or to parse the latest pronouncements from the Federal Reserve chairman, Ben S. Bernanke, or the Treasury secretary, Henry M. Paulson Jr.
Even James Cramer, the voluble and long-bullish host of an investing show on CNBC, advised investors to sell some stock during appearances on the “Today” show Monday and Tuesday mornings.
To some, signs of capitulation can be read as an indicator that the bottom may be near. Indeed, Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, is among those who say the market may be close to a bottom.
In addition to his analysis of the market, he was swayed by the numerous telephone calls he has received in recent days from professional acquaintances and his sister-in-law, all saying they are getting out of stocks.
“More and more people are doing that and selling out,” Mr. Stovall said.
The opposite of capitulation, of course, is investing at the height of a bubble. One oft-cited sign of the housing market’s top: when dinner parties are dominated by stories about fast profits on flipped condominiums.
During the dot-com boom in the late 1990s, it seemed everybody and their grandmothers were piling into stocks. Now they are bailing out. Tuesday was the fourth consecutive day that the S.& P. 500-stock index registered a decline of 1 percent or more. The last time that happened was October 2002, when the index reached its lowest point during the bear market that started in 2000. The S.& P. is now down 36 percent from its peak a year ago, almost to the day, on Oct. 9, 2007.
Another barometer of panic: volatility, reflected in the so-called Fear Index (or the VIX), which tracks options trades that investors use to protect against future losses. On Tuesday, it climbed to its highest level since the 1987 stock market crash.
Fear is an immensely powerful force, perhaps more so than greed, said Andrew W. Lo, a professor at the Massachusetts Institute of Technology who has studied investor behavior.
Scientists who have studied the brain function have found that the amygdala, the part of the brain that controls fear, responds faster than the parts of the brain that handle cognitive functions, he said.
“Fear is a much stronger motivational force,” Mr. Lo added. “The loss of $1,000 has a much bigger impact than the gain of a $1,000.”
He cites a series of groundbreaking experiments in the 1970s by psychologists Daniel Kahneman and Amos Tversky. In one test, they asked students to choose between a sure bet of $3,000, or an 80 percent chance of winning $4,000 (meaning there was a 20 percent chance of winning nothing). Most students said they would take the $3,000.
The same question, framed differently, asked them if they would rather lose $3,000 or accept an 80 percent chance of losing $4,000 (with a 20 percent chance of losing nothing). In this case, they said they would take the riskier bet.
In other words, they were willing to take a bigger risk to avoid losing money than they were when they stood to make more money.
Those instincts seem to be taking over.
At this point, any spreadsheet analysis of underlying and intrinsic values of stocks becomes meaningless, and concern for preserving wealth overrides the desire to grow it — what some may call greed.
“With negative emotions we tend to have a desire to change the situation,” said Ellen Peters, a senior scientist at Decision Research in Eugene, Ore. But “when things are good there is not much desire to change.”
That perhaps explains why investors are willing to earn virtually no return in Treasury bills just to be assured that they will get their money back, rather than investing in short-term corporate debt that offers a better return but carries some risk. Investors were reminded of that risk after Lehman Brothers sought bankruptcy protection last month.
Even banks, which make money by lending to businesses, consumers and each other, are hoarding cash. That is why the Federal Reserve said on Tuesday that it would buy commercial paper, the short-term loans issued by companies and banks.
If the market is indeed close to the bottom, history suggests any rally in the next few weeks will probably be big. Since World War II, Mr. Stovall estimates stocks have recouped about a third of their bear market losses in the first 40 days after the market hits bottom.
But enough investors have to first be persuaded that the economy and housing market will begin recovering soon. Another major test will be third-quarter corporate earnings announcements that will trickle out in the next three weeks.
Perhaps the most important indicator will be the credit markets: Investors will regain confidence when they believe financial firms are adequately capitalized and money is flowing more freely through the financial system.
Mr. Ackman, the hedge fund manager who has been vocal about his bearish views of some financial companies in recent years, said it is hard to precisely time the market. But, he added, “I do think that stocks are getting extremely cheap.”
David Bertocchi, a portfolio manager for Baring Asset Management in London, echoed that sentiment, saying he was beginning to increase his stake in certain companies.
He is taking advantage, he said, of panicked selling by hedge funds that have to pay back loans to their brokers. “That’s what drives markets to attractive levels,” he said.
http://www.nytimes.com/2008/10/08/business/08fear.html?em
__________
A Day (Gasp) Like Any Other
This panic is taking place in such a compressed time frame that it is just astonishing. Mr. Chernow pointed out that while the stock market crash of 1929 took place over three brutal trading days in October 1929, it took nearly three years to reach bottom. By then, stocks had lost a shocking 89 percent of their value.
This crisis, by contrast, seems to be moving at hyper-speed — one day it is Lehman Brothers, the next A.I.G., the day after that Washington Mutual. This crisis doesn’t wear you down over time. It hits you over the head with a two-by-four. On a daily basis.
A third problem, though, is that confidence keeps eroding. The latest wrinkle is that many hedge fund investors, fearing big losses, no longer have confidence in their hedge fund managers. Thus, hedge fund managers are preparing for huge withdrawals at the end of the year, and so they are selling billions of dollars worth of stock preparing to pay redemptions. That is one reason the stock market is under pressure.
“It becomes a self-fulfilling prophecy,” said one hedge fund manager. Firms fearing redemptions sell off stocks, which hurts their performance. Which undermines their investors’ confidence. Which means there are likely to be even more redemptions. Around and around it goes.
Twelve years ago, Alan Greenspan invented the term “irrational exuberance.” That era seems tame compared with this one. What is going on in the markets is anything but exuberant — at this point, though, it is undeniably irrational.
http://www.nytimes.com/2008/10/07/business/07nocera.html?em
Wednesday, 8 October 2008
The Gifts that Keep on Giving
Short-Sightedness and the Bad News Phenomenon.
Warren Buffett discovered that everyone from mutual fund managers to Internet day traders are stuck playing the short-term game. It is the nature of the stock market.
The bad news phenomenon is a constant - people sell on bad news.
Companies that have consumer monopolies have the economic power to pull themselves out of most bad news situations.
Warren Buffett made all his big money investing in consumer monopolies.
Warren Buffett discovered that everyone from mutual fund managers to Internet day traders are stuck playing the short-term game. It is the nature of the stock market.
The bad news phenomenon is a constant - people sell on bad news.
Companies that have consumer monopolies have the economic power to pull themselves out of most bad news situations.
Warren Buffett made all his big money investing in consumer monopolies.
The Bad News that Creates a Buying Situation
Bad news situations come in four basic flavours:
The perfect buying situation is created when a stock market correction or panic is coupled with an industry recession or individual business calamity.
- Stock market correction or panic
- Industry recession
- Individual business calamity, and,
- Structural changes.
The perfect buying situation is created when a stock market correction or panic is coupled with an industry recession or individual business calamity.
Where to Look for a Consumer Monopoly
Warren Buffett has discovered that there are basically four types of consumer monopolies:
1. Businesses that make products that wear out fast or are used up quickly, that have brand name appeal, and that merchants have to carry or use to stay in business.
2. Communications businesses that provide a repetitive service that manufacturers must use to persuade the public to buy their products.
3. Businesses that provide repetitive consumer services that people and business are consistently in need of.
4. Retail stores that have acquired a quasi-monopoly position selling such items as jewelry and furniture.
1. Businesses that make products that wear out fast or are used up quickly, that have brand name appeal, and that merchants have to carry or use to stay in business.
2. Communications businesses that provide a repetitive service that manufacturers must use to persuade the public to buy their products.
3. Businesses that provide repetitive consumer services that people and business are consistently in need of.
4. Retail stores that have acquired a quasi-monopoly position selling such items as jewelry and furniture.
Determining if the Business Has a Consumer Monopoly
A consumer monopoly is usually evidenced by a brand name product or key service.
Warren Buffett looks for the consumer monopoly to produce earnings that are strong and show an upward trend.
A company that benefits from the high profits that a consumer monopoly produces will usually be conservatively financed. Often it carries no debt at all, which means that it has considerable financial punch to solve problems and to take advantage of new business prospects.
Warren Buffett believes that in order for a company to make shareholders rich over the long run it must earn high rates of return on shareholders' equity.
He also believes that the company must be able to retain its earnings and not have to spend it all on maintaining current operations.
Warren Buffett looks for the consumer monopoly to produce earnings that are strong and show an upward trend.
A company that benefits from the high profits that a consumer monopoly produces will usually be conservatively financed. Often it carries no debt at all, which means that it has considerable financial punch to solve problems and to take advantage of new business prospects.
Warren Buffett believes that in order for a company to make shareholders rich over the long run it must earn high rates of return on shareholders' equity.
He also believes that the company must be able to retain its earnings and not have to spend it all on maintaining current operations.
The Healthy Business: The Consumer Monopoly (Where Warren Finds all the Money)
A consumer monopoly is a type of toll bridge business. If you want to buy a certain product you have to purchase it from that one company and no one else.
Warren Buffett's test for a consumer monopoly is to ask himself whether it would be possible to create a competing business even if one didn't care about losing money.
A consumer monopoly sells a product where quality and uniqueness are the most important factors in the consumer's decision to buy.
Consumer monopolies, though excellent businesses, are still subject to the ups and downs of the business cycle and the occasional business calamity.
Warren Buffett's test for a consumer monopoly is to ask himself whether it would be possible to create a competing business even if one didn't care about losing money.
A consumer monopoly sells a product where quality and uniqueness are the most important factors in the consumer's decision to buy.
Consumer monopolies, though excellent businesses, are still subject to the ups and downs of the business cycle and the occasional business calamity.
Identifying the Commodity Type Businesses
Commodity type businesses have the following characteristics:
- Low profit margins on sales coupled with low inventory turnover
- Low returns on shareholders' equity
- Absence of any brand loyalty
- Presence of multiple producers
- Existence of substantial excess production capacity in the industry
- Erratic profits
- Profitability that is almost entirely dependent upon management's abilities to efficiently utilise tangible assets.
The Economic Engine Buffett Wants to Own
Warren Buffett has separated the world of business into two different categories:
A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly.
A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell.
Warren Buffett believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market.
- the healthy consumer monopoly type business and
- the sick commodity type business.
A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly.
A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell.
Warren Buffett believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market.
Tuesday, 7 October 2008
Stick to it
If you have got a formula that could make money, STICK TO IT.
No one can make all the money, let others make some.
Generally, any tactic that results in profits in terms of shares investment should be followed consistently. Unfortunately, rarely does one stick to sound investment tactics. This is because we are often swayed by others who claim that their tactics are better. However, the truth is that these persons may have only told you about the profitable side of their story and not the losses they have incurred.
Therefore, if you have found a certain strategy which enables you to make money, you should continue to use it. The bottom line is not to be greedy as it can be costly.
As such, the most important thing that you must remember is to follow a strategy that consistently gives you profits. The size of the profit is not as important as the method because with the correct method, you can improve on the amount of profits eventually.
No one can make all the money, let others make some.
Generally, any tactic that results in profits in terms of shares investment should be followed consistently. Unfortunately, rarely does one stick to sound investment tactics. This is because we are often swayed by others who claim that their tactics are better. However, the truth is that these persons may have only told you about the profitable side of their story and not the losses they have incurred.
Therefore, if you have found a certain strategy which enables you to make money, you should continue to use it. The bottom line is not to be greedy as it can be costly.
As such, the most important thing that you must remember is to follow a strategy that consistently gives you profits. The size of the profit is not as important as the method because with the correct method, you can improve on the amount of profits eventually.
Monday, 8 September 2008
Heuristic-driven biases: 5. Innumeracy
5. Innumeracy
People have difficulty with numbers.
Trouble with numbers is reflected in the folowing:
People confuse between "nominal" changes (greater or lesser numbers of actual dollars) and "real" changes (greater or lesser purchasing power). Economists call this "money illusion".
People have difficulty in figuring out the "true" probabilities. Put differently, the odds are that they don't know what the odds are. To illustrate this point, consider an example. In a lottery in which six numbers are selected out of fifty, what are the chances that the six numbers will be 1, 2, 3, 4, 5, and 6? Most people think that such an outcome is virtually impossible. The reality, of course, is that the probabiliy of selecting 1 through 6 is the same as the probability of selecting any six numbers.
People tend to pay more attention to big numbers and give less weight to small figures.
People estimate the likelihood of an event on the basis of how vivid the past examples are and not on the basis of how frequently the event has actually occurred.
People tend to ignore the "base rate" which represents the normal experience and go more by the "case rate", which reflects the most recent experience.
People have difficulty with numbers.
Trouble with numbers is reflected in the folowing:
People confuse between "nominal" changes (greater or lesser numbers of actual dollars) and "real" changes (greater or lesser purchasing power). Economists call this "money illusion".
People have difficulty in figuring out the "true" probabilities. Put differently, the odds are that they don't know what the odds are. To illustrate this point, consider an example. In a lottery in which six numbers are selected out of fifty, what are the chances that the six numbers will be 1, 2, 3, 4, 5, and 6? Most people think that such an outcome is virtually impossible. The reality, of course, is that the probabiliy of selecting 1 through 6 is the same as the probability of selecting any six numbers.
People tend to pay more attention to big numbers and give less weight to small figures.
People estimate the likelihood of an event on the basis of how vivid the past examples are and not on the basis of how frequently the event has actually occurred.
People tend to ignore the "base rate" which represents the normal experience and go more by the "case rate", which reflects the most recent experience.
Heuristic-driven biases: 4. Aversion to Ambiguity
4. Aversion to Ambiguity
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes.
In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar.
This is manifested in home country bias (investors prefer stocks of their country), local company bias (investors prefer stocks of their local area), and own company bias (employees of a company have a preference for their own company's stock).
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes.
In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar.
This is manifested in home country bias (investors prefer stocks of their country), local company bias (investors prefer stocks of their local area), and own company bias (employees of a company have a preference for their own company's stock).
Heuristic-driven biases: 3. Anchoring
3. Anchoring
After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.
Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.
Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.
Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.
After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.
Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.
Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.
Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.
Heuristic-driven biases: 2. Overconfidence
2. Overconfidence
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.
The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.
Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.
Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.
Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?
People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.
Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.
Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.
The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.
Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.
Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.
Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?
People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.
Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.
Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.
Heuristic-driven biases: 1. Representativeness
1. Representativeness
Representativeness refers to the tendency to form judgements based on stereotypes.
For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.
For example: Investors may be too quick to detect patterns in data that are in fact random.
Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.
Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.
Investors may become overly optimistic about past winners and overly pessimistic about past losers.
Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.
Representativeness refers to the tendency to form judgements based on stereotypes.
For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.
For example: Investors may be too quick to detect patterns in data that are in fact random.
Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.
Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.
Investors may become overly optimistic about past winners and overly pessimistic about past losers.
Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.
Tuesday, 2 September 2008
Behavioural Finance: Heuristic-Driven Biases
The important heuristic-driven biases and cogniive errors that impair judgement are:
- Representativeness
- Overconfidence
- Anchoring
- Aversion to ambiguity
- Innumeracy
1. Representativeness
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases.html
Representativeness refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school
2. Overconfidence
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-2.html
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.
3. Anchoring
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-3-anchoring.html
After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.
4. Aversion to Ambiguity
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-4-aversion-to.html
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
5. Innumeracy
http://myinvestingnotes.blogspot.com/2008/09/heuristic-driven-biases-5-innumeracy.html
People have difficulty with numbers.
Strategies for Overcoming Psychological Biases
The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making. Here are some strategies for overcoming the psychological biases:
1. Understanding the Biases.
Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, "We have met the enemy - and it's us". So, understand your biases (the enemy within) as this is an important step in avoiding them.
2. Focus on the Big Picture.
Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.
3. Follow a Set of Quantitative Investment Criteria.
It is helpful to use a set of quantitative criteria such as
4. Diversify
If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.
5. Control Your Investment Environment
If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:
1. Understanding the Biases.
Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, "We have met the enemy - and it's us". So, understand your biases (the enemy within) as this is an important step in avoiding them.
2. Focus on the Big Picture.
Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.
3. Follow a Set of Quantitative Investment Criteria.
It is helpful to use a set of quantitative criteria such as
- the price-earnings ratio being not more than 15,
- the price to book ratio not more than 5,
- the growth rate of earnings being at least 12%, and so on.
4. Diversify
If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.
5. Control Your Investment Environment
If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:
- Check your stocks only once every month.
- Trade only once every month and preferably on the same day of the month.
- Review your portfolio once or twice a year.
6. Strive to Earn Market Returns
Seek to earn returns in line with what the market offers. If you strive to outperform the market, you are likely to succumb to psychological biases.
7. Review Your Biases Periodically
Once in a year, review your psychological biases. This will throw up pointers to contain such biases in the future.
Behavioural finance - The Irrational Influences
From the mid-1950s, the field of finance has been dominated by the traditional finance model (also referred to as the standard finance model) developed primarily by the economists of the University of Chicago. The central assumption of the traditional finance model is that people are rational.
However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.
The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.
Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.
Key differences
The key differences between "traditional finance" and "behavioural finance" are as follows:
However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.
The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.
Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.
Key differences
The key differences between "traditional finance" and "behavioural finance" are as follows:
1. Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioural finance recognises that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their beliefs and predisposes them to commit errors.
2. Traditional finance presupposes that people view all decisions throgh the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioural finance postulates that perceptions of risk and return are significantly influence by how decision problems are framed. In other words, behavioural finance assumes frame dependence.
3. Traditional finance assumes that people are guided by reason and logic and independent judgment. Behavioural finance, on the other hand, recognises that emotions and herd instincts play an important role in influencing decisions.
4. Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance contends that heuristic-driven biases and errors, frame dependence, and effects of emotions and social influence often lead to discrepancy between market price and fundamental value, thus market inefficiencies.
Types of Risk (Total risk = Unique risk + Market risk)
Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:
Total risk = Unique risk + Market risk
Unique risk (Diversifiable risk or Unsystematic risk)
The unique risk of security represents that portion of its total risk which stems from firm-specific factors like
Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.
Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.
Market risk (Non-diversifiable risk or Systematic risk)
The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like
Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.
Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.
Total risk = Unique risk + Market risk
Unique risk (Diversifiable risk or Unsystematic risk)
The unique risk of security represents that portion of its total risk which stems from firm-specific factors like
- the development of a new product,
- a labour strike, or
- the emergence of a new competitor.
Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.
Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.
Market risk (Non-diversifiable risk or Systematic risk)
The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like
- the growth rate of GDP,
- the level of government spending,
- money supply,
- interest rate structure, and
- inflation rate.
Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.
Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.
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