Definition of 'Margin Of Safety'
A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.
The term was popularized by Benjamin Graham (known as "the father of value investing") and his followers, most notably Warren Buffett. Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an analyst's judgment. Determining a company's "true" worth (its intrinsic value) is highly subjective. Each investor has a different way of calculating intrinsic value which may or may not be correct. Plus, it's notoriously difficult to predict a company's earnings. Margin of safety provides a cushion against errors in calculation.
Investopedia explains 'Margin Of Safety'
Margin of safety is a concept used in many areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons? Probably not. It would be much more prudent to build the bridge to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying it at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9.
There is no universal standard to determine how wide the "margin" in margin of safety should be. Each investor must come up with his or her own methodology.
http://www.coattailinvestor.com/
Saturday, 30 November 2013
Margin of safety
Margin of safety (safety margin) is the difference between the intrinsic value of a stock and its market price.
Another definition: In Break even analysis (accounting), margin of safety is how much output or sales level can fall before a business reaches its breakeven point.
History
Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, Harper Business Essentials, 2003).
Application to investing
Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.
The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to accurately compute, the margin of safety gives the investor room for investing.
A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).
Application to accounting
In accounting parlance, margin of safety is the difference between the expected (or actual) sales level and the breakeven sales level. It can be expressed in the equation form as follows:
Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)
The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.
Formula
Margin of Safety = Actual Sales - Breakeven Sales
Another definition: In Break even analysis (accounting), margin of safety is how much output or sales level can fall before a business reaches its breakeven point.
History
Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, Harper Business Essentials, 2003).
Application to investing
Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.
The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to accurately compute, the margin of safety gives the investor room for investing.
A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).
Application to accounting
In accounting parlance, margin of safety is the difference between the expected (or actual) sales level and the breakeven sales level. It can be expressed in the equation form as follows:
Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)
The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.
Formula
Margin of Safety = Actual Sales - Breakeven Sales
Reference
- Graham, Benjamin. Dodd, David. Security Analysis: The Classic 1934 Edition. McGraw-Hill. 1996. ISBN 0-07-024496-0.
- http://www.businessweek.com/magazine/content/06_32/b3996085.htm
- http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/
Notes
- ^ Yee, Kenton K. (2008). "Deep-Value Investing, Fundamental Risks, and the Margin of Safety". Journal of Investing 17 (3): 35–46. doi:10.3905/JOI.2009.18.1.027.
- ^ http://www.accountingtools.com/article-metric-margin-of-safet
External links
From Wikipedia, the free encyclopedia
Monday, 25 November 2013
How Emotional Intelligence Can Improve Decision-Making
The secret to making smarter decisions that aren't swayed by your current emotions -- particularly when your emotions are unrelated to the decision at hand -- could lie in emotional intelligence, according to a new study.
For instance, "people are driving and it's frustrating. They get to work and the emotions they felt in their car influences what they do in their offices. Or they invest money based on emotions that stem from things unrelated to their investments," study researcher Stéphane Côté, a professor in the Rotman School of Management at the University of Toronto, said in a statement. "But our investigation reveals that if they have emotional intelligence, they are protected from these biases."
Emotional intelligence is a term used in psychology to signal the ability to identify and control both your and others' emotions, and to apply that ability to certain tasks, according to Psychology Today.
For the study, published in the journal Psychological Science, researchers conducted several experiments to evaluate how different levels of emotional intelligence influence decision-making. In one experiment, researchers found that anxiety's effect on a decision involving risk -- when that anxiety was unrelated to the decision at hand -- seemed to be blocked in people with high emotional intelligence. For people with low emotional intelligence, on the other hand, anxiety seemed to influence the decision-making.
The researchers said that emotional intelligence can likely help you stop any emotions -- not just negative ones, like stress and anxiety, but also good ones, like excitement -- from influencing unrelated decisions.
"People who are emotionally intelligent don't remove all emotions from their decision-making," Côté said in the statement. "They remove emotions that have nothing to do with the decision."
Indeed, a 2008 study published in the Journal of Consumer Research also showed that emotional intelligence could play a role in decision-making by helping people realize their emotions can sway the choices they make.
Thursday, 21 November 2013
Malaysian Airline System (MAS)
No of ordinary shares 16,710.8 million
Market price of MAS RM 0.315 (21.11.2013)
Market capitalization 5,263.9 m
18.11.2013
Income Statement
Latest quarterly result Q3 2013
Revenue 3,782.7 m
Loss -373.2 m
EPS -2.25 sen
Cumulative 9M 2013
Revenue 10,766.0 m
Loss -827.0 m
EPS -6.67 sen
Finance costs -331.5 m
Unrealised foreign exchange loss -175.7 m
Balance Sheet (30.9.2013)
NCA 15,378.6 m
CA 7,446.6 m
CL 8,211.6 m
NCL 10,253.8 m
TL 18,465.4 m
Equity 4,359.6 m
Cash 5,443.4 m
ST Borrowings 1,591.9 m
LT Borrowings 10,253.8 m
Total Borrowings 11,845.7 m
Net assets per share RM 0.26
Cash Flow Statement
CFI
Purchase of aircraft, PPE -3,242.7 m
Disposal of aircraft, PPE 846.5 m
CFF
Proceeds from:
Rights issue 3,074.8 m
Aircraft refinancing 833.0 m
Borrowings 1,910.0 m
Repayment of:
Borrowings -166.2 m
Finance lease -486.3 m
Capital changes
Weighted average number of ordinary shares
30.9.2013 16,710.8 m
30.9.2012 7,102.1 m
Market price of MAS RM 0.315 (21.11.2013)
Market capitalization 5,263.9 m
18.11.2013
Income Statement
Latest quarterly result Q3 2013
Revenue 3,782.7 m
Loss -373.2 m
EPS -2.25 sen
Cumulative 9M 2013
Revenue 10,766.0 m
Loss -827.0 m
EPS -6.67 sen
Finance costs -331.5 m
Unrealised foreign exchange loss -175.7 m
Balance Sheet (30.9.2013)
NCA 15,378.6 m
CA 7,446.6 m
CL 8,211.6 m
NCL 10,253.8 m
TL 18,465.4 m
Equity 4,359.6 m
Cash 5,443.4 m
ST Borrowings 1,591.9 m
LT Borrowings 10,253.8 m
Total Borrowings 11,845.7 m
Net assets per share RM 0.26
Cash Flow Statement
CFI
Purchase of aircraft, PPE -3,242.7 m
Disposal of aircraft, PPE 846.5 m
CFF
Proceeds from:
Rights issue 3,074.8 m
Aircraft refinancing 833.0 m
Borrowings 1,910.0 m
Repayment of:
Borrowings -166.2 m
Finance lease -486.3 m
Capital changes
Weighted average number of ordinary shares
30.9.2013 16,710.8 m
30.9.2012 7,102.1 m
Tuesday, 19 November 2013
Only rich at risk from London’s bubble
Only rich at risk from London’s bubble
Oct 7, 2013 : UK housing bubble fears have been exacerbated by Help to Buy. But Ed Hammond, property correspondent, tells John Authers the bubble is built on equity, not debt, and that the average home price remains below pre-crisis levelsBe cautious, first-timers urged
November 17, 2013
With a threat of mortgage interest rate rises in the near future, home buyers are asked to tread carefully.
Read more: http://www.smh.com.au/money/borrowing/be-cautious-firsttimers-urged-20131116-2xnn8.html#ixzz2l4qnver1
The unfortunate truth about investing
1. Saying "I'll be greedy when others are fearful" is much easier than actually doing it.
2. The gulf between a great company and a great investment can be extraordinary.
3. Markets go through at least one big pullback every year, and one massive one every decade. Get used to it. It's just what they do.
4. As Erik Falkenstein says: "In expert tennis, 80 per cent of the points are won, while in amateur tennis, 80 per cent are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves."
5. Time-saving tip: Instead of trading penny stocks, just light your money on fire. Same for leveraged ETFs.
6. Not a single person in the world knows what the market will do in the short run. End of story.
7. The analyst who talks about his mistakes is the guy you want to listen to. Avoid the guy who doesn't – his are much bigger.
8. You don't understand a big bank's balance sheet. The people running the place and their accountants don't, either.
9. There will be seven to 10 recessions over the next 50 years. Don't act surprised when they come.
10. Most of what is taught about investing in school is theoretical nonsense. There are very few rich professors.
11. The market doesn't care how much you paid for a stock. Or your house. Or what you think is a "fair" price.
12. The majority of market news is not only useless, but also harmful to your financial health.
13. Professional investors have better information and faster computers than you do. You will never beat them short-term trading. Don't even try.
14. The decline of trading costs is one of the worst things to happen to investors, as it made frequent trading possible. High transaction costs used to cause people to think hard before they acted.
15. Most IPOs will burn you. People with more information than you have want to sell. Think about that.
16. When someone mentions charts, moving averages, head-and-shoulders patterns, or resistance levels, walk away. Or run.
17. The book "Where Are the Customers' Yachts?" was written in 1940, and most still haven't figured out that financial advisors don't have their best interest at heart.
18. The low-cost index fund is one of the most useful financial inventions in history. Boring but beautiful.
19. The best investors in the world have more of an edge in psychology than in finance.
20. What markets do day to day is overwhelmingly driven by random chance. Ascribing explanations to short-term moves is like trying to explain lottery numbers.
21. For most, finding ways to save more money is more important than finding great investments.
22. If you have credit card debt and are thinking about investing in anything, stop. You will never beat 20% annual interest.
23. A large portion of share buybacks are just offsetting shares issued to management as compensation. Managers still tout the buybacks as "returning money to shareholders."
24. The odds that at least one well-known company is insolvent and hiding behind fraudulent accounting are high.
25. Twenty years from now the ASX 200 will look nothing like it does today. Companies die and new ones emerge.
26. The government has much less influence over the economy than people think.
27. However much money you think you'll need for retirement, double it. Now you're closer to reality.
28. The next recession is never like the last one.
29. Remember what Mark Twain says about truth: "A lie can travel halfway around the world while truth is putting on its shoes."
30. Investments that offer little upside and big downside outnumber those with the opposite characteristics at least 10-to-1.
Foolish takeaway
The best investors are cleverer than they think – the worst think they are cleverer than they are. The same applies to their temperaments and behaviour.
Investing Foolishly (with a capital F!) is all about getting rich slowly. As the saying goes, there's no shortcut to any place worth going. Trying to take shortcuts is much more likely to end up in pain. And no, you're very unlikely to be the exception to that rule.
November 16, 2012
Read more: http://www.smh.com.au/business/motley-fool/the-unfortunate-truth-about-investing-20121116-29gew.html#ixzz2l3VJz9lS
2. The gulf between a great company and a great investment can be extraordinary.
3. Markets go through at least one big pullback every year, and one massive one every decade. Get used to it. It's just what they do.
4. As Erik Falkenstein says: "In expert tennis, 80 per cent of the points are won, while in amateur tennis, 80 per cent are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves."
5. Time-saving tip: Instead of trading penny stocks, just light your money on fire. Same for leveraged ETFs.
6. Not a single person in the world knows what the market will do in the short run. End of story.
7. The analyst who talks about his mistakes is the guy you want to listen to. Avoid the guy who doesn't – his are much bigger.
8. You don't understand a big bank's balance sheet. The people running the place and their accountants don't, either.
9. There will be seven to 10 recessions over the next 50 years. Don't act surprised when they come.
10. Most of what is taught about investing in school is theoretical nonsense. There are very few rich professors.
11. The market doesn't care how much you paid for a stock. Or your house. Or what you think is a "fair" price.
12. The majority of market news is not only useless, but also harmful to your financial health.
13. Professional investors have better information and faster computers than you do. You will never beat them short-term trading. Don't even try.
14. The decline of trading costs is one of the worst things to happen to investors, as it made frequent trading possible. High transaction costs used to cause people to think hard before they acted.
15. Most IPOs will burn you. People with more information than you have want to sell. Think about that.
16. When someone mentions charts, moving averages, head-and-shoulders patterns, or resistance levels, walk away. Or run.
17. The book "Where Are the Customers' Yachts?" was written in 1940, and most still haven't figured out that financial advisors don't have their best interest at heart.
18. The low-cost index fund is one of the most useful financial inventions in history. Boring but beautiful.
19. The best investors in the world have more of an edge in psychology than in finance.
20. What markets do day to day is overwhelmingly driven by random chance. Ascribing explanations to short-term moves is like trying to explain lottery numbers.
21. For most, finding ways to save more money is more important than finding great investments.
22. If you have credit card debt and are thinking about investing in anything, stop. You will never beat 20% annual interest.
23. A large portion of share buybacks are just offsetting shares issued to management as compensation. Managers still tout the buybacks as "returning money to shareholders."
24. The odds that at least one well-known company is insolvent and hiding behind fraudulent accounting are high.
25. Twenty years from now the ASX 200 will look nothing like it does today. Companies die and new ones emerge.
26. The government has much less influence over the economy than people think.
27. However much money you think you'll need for retirement, double it. Now you're closer to reality.
28. The next recession is never like the last one.
29. Remember what Mark Twain says about truth: "A lie can travel halfway around the world while truth is putting on its shoes."
30. Investments that offer little upside and big downside outnumber those with the opposite characteristics at least 10-to-1.
Foolish takeaway
The best investors are cleverer than they think – the worst think they are cleverer than they are. The same applies to their temperaments and behaviour.
Investing Foolishly (with a capital F!) is all about getting rich slowly. As the saying goes, there's no shortcut to any place worth going. Trying to take shortcuts is much more likely to end up in pain. And no, you're very unlikely to be the exception to that rule.
November 16, 2012
Read more: http://www.smh.com.au/business/motley-fool/the-unfortunate-truth-about-investing-20121116-29gew.html#ixzz2l3VJz9lS
Monday, 18 November 2013
Buffett's Investing Wisdom - The Best Holding Period
When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. -- Warren Buffett
What do Procter & Gamble (NYSE: PG), Coca-Cola, and Wal-Mart (NYSE: WMT) have in common? If you said that all three are in Berkshire Hathaway’s portfolio, you’d be correct. If you said all three are up more than 1,000% over the past three decades, you’d also be correct. Finally, if you said that at some point during that 30-year span, each of the stocks lost more than 30% of its value in a relatively short period of time… well, you’d be correct there, too.
Although the attraction of fast riches in the stock market can have a strong pull, real investing wealth is built over decades, not months or even years. And if you’re curious what “real investing wealth” means, consider that a $10,000 investment in Wal-Mart 30 years ago would be worth roughly $600,000 today. But there were at least five periods over that stretch when Wal-Mart’s stock fell more than 20% over the course of a year. An investor with a quick trigger finger and a lack of long-term focus might have been shaken out at any one of those times and missed out on the truly great gains made possible from owning for the whole period.
If we look at the stocks in Berkshire Hathaway’s portfolio today, it’d be hard to argue that Coca-Cola is anything but a company worth owning for that “forever” timeframe. Sure, the stock isn’t particularly cheap (see the previous quote if that concerns you), and it’s faced headwinds lately in the form of a lousy European economy and a lackluster soda market in the U.S. But when you think bigger picture in the form of the company’s brand -- it was ranked the No. 1 global brand in 2012 by brand expert Interbrand -- its strong market position in its established markets, and continued growth opportunity in emerging markets, it’s obvious there’s still good reason to own Coke stock for the next year, five years from now, and 20 years from now.
When it comes to finding an outstanding business with outstanding managers, Berkshire Hathaway itself would almost certainly need to make the list of companies worth owning for forever. To be sure, Warren Buffett won’t always be the CEO of the company, but the way he’s built the business has ensured that there are many great managers running its many wholly-owned businesses. And with a highly diversified and high-quality business mix that includes everything from The Pampered Chef and Dairy Queen to GEICO and NetJets, the company has many avenues for growth the casual observer may not appreciate. If that’s not enough, consider that there’s a team of investors -- not only Warren Buffett, but his hand-selected protégés Todd Combs and Ted Weschler -- that is expertly investing in publicly-traded stocks using all of the wisdom just discussed here.
Ref: Warren Buffett's Greatest Wisdom
What do Procter & Gamble (NYSE: PG), Coca-Cola, and Wal-Mart (NYSE: WMT) have in common? If you said that all three are in Berkshire Hathaway’s portfolio, you’d be correct. If you said all three are up more than 1,000% over the past three decades, you’d also be correct. Finally, if you said that at some point during that 30-year span, each of the stocks lost more than 30% of its value in a relatively short period of time… well, you’d be correct there, too.
Although the attraction of fast riches in the stock market can have a strong pull, real investing wealth is built over decades, not months or even years. And if you’re curious what “real investing wealth” means, consider that a $10,000 investment in Wal-Mart 30 years ago would be worth roughly $600,000 today. But there were at least five periods over that stretch when Wal-Mart’s stock fell more than 20% over the course of a year. An investor with a quick trigger finger and a lack of long-term focus might have been shaken out at any one of those times and missed out on the truly great gains made possible from owning for the whole period.
If we look at the stocks in Berkshire Hathaway’s portfolio today, it’d be hard to argue that Coca-Cola is anything but a company worth owning for that “forever” timeframe. Sure, the stock isn’t particularly cheap (see the previous quote if that concerns you), and it’s faced headwinds lately in the form of a lousy European economy and a lackluster soda market in the U.S. But when you think bigger picture in the form of the company’s brand -- it was ranked the No. 1 global brand in 2012 by brand expert Interbrand -- its strong market position in its established markets, and continued growth opportunity in emerging markets, it’s obvious there’s still good reason to own Coke stock for the next year, five years from now, and 20 years from now.
When it comes to finding an outstanding business with outstanding managers, Berkshire Hathaway itself would almost certainly need to make the list of companies worth owning for forever. To be sure, Warren Buffett won’t always be the CEO of the company, but the way he’s built the business has ensured that there are many great managers running its many wholly-owned businesses. And with a highly diversified and high-quality business mix that includes everything from The Pampered Chef and Dairy Queen to GEICO and NetJets, the company has many avenues for growth the casual observer may not appreciate. If that’s not enough, consider that there’s a team of investors -- not only Warren Buffett, but his hand-selected protégés Todd Combs and Ted Weschler -- that is expertly investing in publicly-traded stocks using all of the wisdom just discussed here.
Ref: Warren Buffett's Greatest Wisdom
Buffett's Investing Wisdom - Buy Wonderful Companies
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. – Warren Buffett
Interestingly enough, Buffett’s mentor, Benjamin Graham, was quite fond of jumping at fair companies trading at wonderful prices. Graham termed this “cigar butt” investing -- as in, he was looking for discarded cigars that still had a few good puffs left in them. In Buffett’s pre-Berkshire days, he ran with this page from Graham’s book. To be sure, Berkshire Hathaway itself looked a lot like a cigar butt when Buffett bought it -- at the time it was a bedraggled textile business that was markedly unprofitable.
Through his career, though, Buffett realized that the real money wasn’t in puffing on dirty cigar butts. Instead, the big profits in investing come from finding well-run companies that dominate their industries and hanging onto those companies for a long time. Of course, Buffett isn’t one to pay any crazy price for a stock, though, so part of the investment process is determining what a fair price is for the stock and looking for an opportunity to buy the stock at that price.
Costco (Nasdaq: COST) is a great example of a company that dominates its industry. Sure, there are other warehouse-shopping clubs out there, but in terms of quality of operations and management, none stack up. And Buffett -- and even more so his right-hand man, Charlie Munger -- are not shy about professing their admiration for the low-price giant. The problem for investors is that it’s highly unlikely we’ll see shares of Costco trade at true bargain levels unless something dramatically changes the quality and outlook for the company.
In a similar vein, Visa (NYSE: V) and MasterCard (NYSE: MA) are among a very small, very dominant group in the growing and highly profitable credit card industry. As the nature of the global payment system continues to move rapidly away from cash and toward cards and electronic payments, both of these payment-network operators stand to rake it in. Just like Costco, though, investors looking for a “blue light” special on Visa or MasterCard shares will likely find themselves with their hands in their pockets as long as the major growth and success continue.
It’s not just academic to say that investors who balk at a premium price for these companies missed out. Over the past five years, the S&P 500 is up 35%. Costco is up 93%. As for Visa and MasterCard, they’ve tacked on an amazing 162% and 127%, respectively. And investors that bought those companies five years ago weren’t buying on the cheap. In 2008, Costco fetched an average price-to-earnings multiple of 23.5, while Visa and MasterCard sported respective multiples of 53 and 45.
Today, the stocks of all three of these companies still sport higher-than-average earnings multiples. But all three are also still top-notch businesses with stellar growth and profit potential.
Ref: Warren Buffett's Greatest Wisdom
Interestingly enough, Buffett’s mentor, Benjamin Graham, was quite fond of jumping at fair companies trading at wonderful prices. Graham termed this “cigar butt” investing -- as in, he was looking for discarded cigars that still had a few good puffs left in them. In Buffett’s pre-Berkshire days, he ran with this page from Graham’s book. To be sure, Berkshire Hathaway itself looked a lot like a cigar butt when Buffett bought it -- at the time it was a bedraggled textile business that was markedly unprofitable.
Through his career, though, Buffett realized that the real money wasn’t in puffing on dirty cigar butts. Instead, the big profits in investing come from finding well-run companies that dominate their industries and hanging onto those companies for a long time. Of course, Buffett isn’t one to pay any crazy price for a stock, though, so part of the investment process is determining what a fair price is for the stock and looking for an opportunity to buy the stock at that price.
Costco (Nasdaq: COST) is a great example of a company that dominates its industry. Sure, there are other warehouse-shopping clubs out there, but in terms of quality of operations and management, none stack up. And Buffett -- and even more so his right-hand man, Charlie Munger -- are not shy about professing their admiration for the low-price giant. The problem for investors is that it’s highly unlikely we’ll see shares of Costco trade at true bargain levels unless something dramatically changes the quality and outlook for the company.
In a similar vein, Visa (NYSE: V) and MasterCard (NYSE: MA) are among a very small, very dominant group in the growing and highly profitable credit card industry. As the nature of the global payment system continues to move rapidly away from cash and toward cards and electronic payments, both of these payment-network operators stand to rake it in. Just like Costco, though, investors looking for a “blue light” special on Visa or MasterCard shares will likely find themselves with their hands in their pockets as long as the major growth and success continue.
It’s not just academic to say that investors who balk at a premium price for these companies missed out. Over the past five years, the S&P 500 is up 35%. Costco is up 93%. As for Visa and MasterCard, they’ve tacked on an amazing 162% and 127%, respectively. And investors that bought those companies five years ago weren’t buying on the cheap. In 2008, Costco fetched an average price-to-earnings multiple of 23.5, while Visa and MasterCard sported respective multiples of 53 and 45.
Today, the stocks of all three of these companies still sport higher-than-average earnings multiples. But all three are also still top-notch businesses with stellar growth and profit potential.
Ref: Warren Buffett's Greatest Wisdom
Buffett's Investing Wisdom - Who's Swimming Naked?
You only find out who is swimming naked when the tide goes out. – Warren Buffett
Unwise business plans can often lead to huge profits… over the short term. When the economy is roaring and everything is moving up and to the right, it’s far easier for companies to hide dumb, corner-cutting, or even illegal practices as they rake in profits. Eventually though, the environment changes, those ill-advised practices are exposed, and the companies employing them -- and their shareholders -- get punished.
Thinking back to the dot-com boom, online grocer Webvan is a perfect example. After pricing its 1999 IPO at $15, the stock traded up to nearly $25 -- up 66%! -- on its first day of trading. So what if the company was losing money, it had a questionable business plan, the economy was booming, and internet stocks couldn’t lose!
As we know now, it couldn’t last. As the stock market boom turned to bust and the economy cooled, Webvan’s approach to online retailing -- which only led to mounting losses -- left investors cold. Unable to fund its massive cash bleed, Webvan declared bankruptcy in 2001.
Of course, we have a plethora of even more recent examples of businesses caught swimming naked thanks to the housing bust and financial-market meltdown in 2008. Chief among those examples is Lehman Brothers, which was an investment bank that was raking it in prior to the crash by employing large amounts of ultra-short-term loans to finance risky, complex real-estate investments. When the market turned, Lehman’s lack of swimming trunks was painfully obvious, and in 2008, Lehman filed the U.S.’s largest corporate bankruptcy.
Buffett’s “swimming naked” quote provides us with plenty of cautionary tales and gives us an idea of companies we might want to avoid investing in. If we flip it on its head, though, it also reveals companies that are great investing opportunities.
For example, let’s look at the credit crisis again. Lehman Brothers declared bankruptcy, Fannie Mae (OTC: FNMA) and Freddie Mac (OTC: FMCC) were put into government conservatorship, and Bear Stearns narrowly avoided bankruptcy by agreeing to be bought out by JPMorgan Chase (NYSE: JPM). But Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB) both made it through the crisis without reporting a single unprofitable quarter. Though they both accepted government bailout money, it’s unlikely that either truly needed it. In fact, Wells Fargo’s chief executive at the time argued vociferously against taking bailout money, but regulators overruled the request.
When the tide went out, we saw that both Wells Fargo and U.S. Bancorp not only had their swimming suits on, but were wearing suits of titanium. The washing out that came with the financial crisis revealed both banks as great companies to invest in for the long term. It also just so happens that both are among Buffett’s largest holdings at Berkshire Hathaway -- in fact, Wells Fargo is Berkshire’s single largest stock holding. While neither stock is as cheap as it was circa 2009, both are still reasonably priced for a long-term owner today.
Ref: Warren Buffett's Greatest Wisdom
Unwise business plans can often lead to huge profits… over the short term. When the economy is roaring and everything is moving up and to the right, it’s far easier for companies to hide dumb, corner-cutting, or even illegal practices as they rake in profits. Eventually though, the environment changes, those ill-advised practices are exposed, and the companies employing them -- and their shareholders -- get punished.
Thinking back to the dot-com boom, online grocer Webvan is a perfect example. After pricing its 1999 IPO at $15, the stock traded up to nearly $25 -- up 66%! -- on its first day of trading. So what if the company was losing money, it had a questionable business plan, the economy was booming, and internet stocks couldn’t lose!
As we know now, it couldn’t last. As the stock market boom turned to bust and the economy cooled, Webvan’s approach to online retailing -- which only led to mounting losses -- left investors cold. Unable to fund its massive cash bleed, Webvan declared bankruptcy in 2001.
Of course, we have a plethora of even more recent examples of businesses caught swimming naked thanks to the housing bust and financial-market meltdown in 2008. Chief among those examples is Lehman Brothers, which was an investment bank that was raking it in prior to the crash by employing large amounts of ultra-short-term loans to finance risky, complex real-estate investments. When the market turned, Lehman’s lack of swimming trunks was painfully obvious, and in 2008, Lehman filed the U.S.’s largest corporate bankruptcy.
Buffett’s “swimming naked” quote provides us with plenty of cautionary tales and gives us an idea of companies we might want to avoid investing in. If we flip it on its head, though, it also reveals companies that are great investing opportunities.
For example, let’s look at the credit crisis again. Lehman Brothers declared bankruptcy, Fannie Mae (OTC: FNMA) and Freddie Mac (OTC: FMCC) were put into government conservatorship, and Bear Stearns narrowly avoided bankruptcy by agreeing to be bought out by JPMorgan Chase (NYSE: JPM). But Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB) both made it through the crisis without reporting a single unprofitable quarter. Though they both accepted government bailout money, it’s unlikely that either truly needed it. In fact, Wells Fargo’s chief executive at the time argued vociferously against taking bailout money, but regulators overruled the request.
When the tide went out, we saw that both Wells Fargo and U.S. Bancorp not only had their swimming suits on, but were wearing suits of titanium. The washing out that came with the financial crisis revealed both banks as great companies to invest in for the long term. It also just so happens that both are among Buffett’s largest holdings at Berkshire Hathaway -- in fact, Wells Fargo is Berkshire’s single largest stock holding. While neither stock is as cheap as it was circa 2009, both are still reasonably priced for a long-term owner today.
Ref: Warren Buffett's Greatest Wisdom
Warren Buffett's Greatest Wisdom
According to Forbes' latest list of worldwide billionaires, Warren Buffett is worth more than $50 billion.
The octogenarian’s massive fortune was built through Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), the company he’s been a controlling shareholder of since 1965. Since that time, Berkshire’s stock has appreciated nearly 600,000% (no, that’s not a typo!) versus 7,400% for the S&P 500 index.
At that rate of return, a $1,000 investment in Berkshire would have become roughly $6 million.
Much of the success at Berkshire has been driven by Buffett’s uncanny skill as an investor. During his career as CEO, he’s made billions for the company and its investors by buying top-notch companies like American Express (NYSE: AXP) and Coca-Cola (NYSE: KO) and holding the stocks for decades.
There’s a lot we can learn from Buffett
Fortunately, not only has Buffett been one of the most effective CEOs of the modern age, he’s also been one of the most transparent. For Berkshire, each year is capped by a letter to shareholders from Buffett that not only details the company’s results, but teaches readers general investing lessons in Buffett’s down-to-earth, folksy style. Outside of those letters, Buffett is also known for delivering some of the all-time most concise, elucidating quips about investing.
Ref:
The octogenarian’s massive fortune was built through Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), the company he’s been a controlling shareholder of since 1965. Since that time, Berkshire’s stock has appreciated nearly 600,000% (no, that’s not a typo!) versus 7,400% for the S&P 500 index.
At that rate of return, a $1,000 investment in Berkshire would have become roughly $6 million.
Much of the success at Berkshire has been driven by Buffett’s uncanny skill as an investor. During his career as CEO, he’s made billions for the company and its investors by buying top-notch companies like American Express (NYSE: AXP) and Coca-Cola (NYSE: KO) and holding the stocks for decades.
There’s a lot we can learn from Buffett
Fortunately, not only has Buffett been one of the most effective CEOs of the modern age, he’s also been one of the most transparent. For Berkshire, each year is capped by a letter to shareholders from Buffett that not only details the company’s results, but teaches readers general investing lessons in Buffett’s down-to-earth, folksy style. Outside of those letters, Buffett is also known for delivering some of the all-time most concise, elucidating quips about investing.
Ref:
Warren Buffett's Greatest Wisdom
Sunday, 17 November 2013
'Being human" costs the average investor around 3 - 4% in return every year.
The cost of being human
When it comes to investing, human nature doesn’t help. Our innate need for emotional comfort is estimated to cost the average investor around 3–4% in returns every year.* And for many, the figure can be much greater.This shortfall in returns is partly caused by what is known as the Behaviour Gap. It explains the difference between long-term financial returns (if we were only to stick to sensible and simple rules for investing) and actual returns (which are determined by all our short-term decision-making, often based on our emotional needs).
A good example is how our investment strategy often goes off course in turbulent times. So despite the obvious costs, we can often end up buying high and selling low.
*Source: Barclays Wealth & Investment Management, White Paper - March 2013, ‘Overcoming the Cost of Being Human’.
http://www.investmentphilosophy.com/fpa/
Hesitation can cost you dearly. The average investor foregoes 4–5% in returns each year by leaving their wealth in cash.
Hesitation can cost you dearly
The average investor foregoes 4–5% in returns* each year by leaving their wealth in cash rather than investing in a diversified portfolio.Failing to invest at all is the first way in which we exchange long-term performance for short-term emotional comfort. Here, the comfort factor is very simple – we cannot lose if we don’t get involved. But the potential cost – on average 4–5% in lost returns each year – is very high
Often those prone to reluctance only decide to invest when there is a sustained market boom. But by going in at the top of the market, they may experience the knock-on effects of buying high: a reduction in returns and an increase in anxiety and stress.
Take this Financial Personality Assessment™
*Source: Barclays Wealth & Investment Management, White Paper - March 2013, "Overcoming the Cost of Being Human'.
http://www.investmentphilosophy.com/fpa/
Saturday, 16 November 2013
Will You, Won't You? Staying out of the markets is a costly way of reducing investor anxiety.
For some investors the idea of getting involved in the markets at all is uncomfortable. This investor anxiety is quite common in those people who get the emotional comfort they need by avoiding investing altogether. Yet being too hesitant has large hidden costs.
What if...?
Certain people have greater natural reluctance than others to enter markets in the first place. We call this low Market Engagement, which measures the degree to which you are inclined to avoid or engage in financial markets, usually due to a fear of the unknown or getting the timing wrong. It is a component of risk attitude and is one of the financial personality dimensions one need to understand.
Low Market Engagement can mean you are nervous of investing at the wrong time so you tend to stay out of the markets which is a costly way of reducing anxiety. To overcome this you may opt to invest in a gradual, phased manner, normally starting with the lower risk asset classes. Low Market Engagement investors may also value some protection against large interim capital losses for products in riskier asset classes.
Those with high Market Engagement can find it easier to commit to investments. However this can sometimes lead to damaging enthusiasm where investors appear "trigger happy" with investments, giving them less consideration than is due. Investors are also more likely to invest based on passing recommendations from people they meet.
Ref:
Barclays
Wealth and Investment Management.
What if...?
Certain people have greater natural reluctance than others to enter markets in the first place. We call this low Market Engagement, which measures the degree to which you are inclined to avoid or engage in financial markets, usually due to a fear of the unknown or getting the timing wrong. It is a component of risk attitude and is one of the financial personality dimensions one need to understand.
Low Market Engagement can mean you are nervous of investing at the wrong time so you tend to stay out of the markets which is a costly way of reducing anxiety. To overcome this you may opt to invest in a gradual, phased manner, normally starting with the lower risk asset classes. Low Market Engagement investors may also value some protection against large interim capital losses for products in riskier asset classes.
Those with high Market Engagement can find it easier to commit to investments. However this can sometimes lead to damaging enthusiasm where investors appear "trigger happy" with investments, giving them less consideration than is due. Investors are also more likely to invest based on passing recommendations from people they meet.
Ref:
Barclays
Wealth and Investment Management.
Recency Bias or the Party Effect
Overview
The Party Effect or Recency Bias is where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves. This is a very important concept to understand. Let’s set the stage for an illustration of how this happens.
Examples
A Party Tale
“You’re Right”
One of my favorite life lessons centers around President Franklin Delano Roosevelt, also known as FDR. FDR had many strengths but I think his greatest was his ability to recognize that things are not always black and white. I think his ability to see the big picture as well as discern the subtleties of a situation is what made him such an effective leader and brought out the best in others.
In one well known FDR story, he asks one of his trusted advisors what he thinks about a particular situation and after he listens to the advisor, FDR replies “You’re Right.” Not long after FDR asks another of his trusted advisors for his opinion on the same matter and this advisor gives the exact opposite recommendation from the first advisor to which FDR once again replies “You’re Right.”
At hearing FDR’s reply to the second advisor one of FDR’s closest advisors that had listened to FDR’s response to both advisors, points out the obvious contradiction to which FDR replies “You’re Also Right.”
Much can be learned from what at first appears to be FDR’s flippant and contradictory remarks to his advisors. However, FDR was far wiser. FDR understood that all three advisors were in fact right. They were just right from their perspective. But they didn’t have a view of the big picture. The contrast between FDR’s perspective of the entire situation compared to the trusted advisor’s perspective of a narrow part of the situation is what creates the dichotomy. The stock market works much the same way.
A different example would be the poem about the six blind men and the elephant. Each of the six blind men is asked to describe an elephant. Their perceptions lead to misinterpretation because they each describe the elephant differently depending on which part of the elephant they touch. One touches the side and describes the elephant like a wall. The other the tusk and describes the elephant as a spear. The next touches the trunk and describes a snake. The next the knee and describes a tree. The next an ear and describes a fan. Finally the last touches the tail and describes the elephant like a rope.
This tale is about the stock market and how investors relate to the stock market. The stock market can be viewed as FDR or the elephant while investors or participants in the stock market can be viewed as the advisors or the blind men. When describing the stock market each participant sees their portfolio’s performance from their perspective only and thus they are always “right” which leads to what I call The Party Effect or what Financial Behaviorist call the Recency Bias.
Imagine that you attended a party hosted by your investment advisor and that in addition to you, also in attendance were several other clients. As you go around the room and meet people you learn that everyone at the party owns the exact same S&P 500 index mutual fund. I use the S&P 500 for this tale because by many measures it has historically produce an average rate of return of about 12% and as many people know, and now you know as well, it represents what many investors call “the stock market.” The question then is would everyone have the same rate of return at this party? Of course the answer is, no they would not. If they started at the same time they would but since people invest or come into the life of the investment advisor at different times, the answer is no.
Let’s tighten up the party attendee list and invite only 30 guests. For simplicity, let’s assume that Guest 1 purchased the fund 30 months ago, that Guest 2 purchased it 29 months ago, that Guest 3 purchased it 28 months ago, etc. What would the guests discuss? What would be their perspectives of the stock market?
In order to determine what the guests would discuss and how they would evaluate their performance we need to have some data in the form of monthly rates of return. So we need to develop a monthly rate of return for 30 months to see what they see. Again, for simplicity, assume that for the first 18 months the fund goes up 3% per month and for the next 12 months it goes down 2% per month. Please note that I didn’t pick this sequence of numbers randomly. I have a purpose to this. This particular sequence approximates how the stock market moves in terms of bull and bear market duration and after 30 months returns approximately 12%; 12.28% to be exact. This sequence of numbers is a good sequence to illustrate The Party Effect or Recency Bias. We can characterize the first 18 months as the bull market phase of the 30-month cycle and the last 12 months as the bear market phase of the 30-month cycle.
To illustrate The Party Effect lets focus on 4 guests and see how they describe the stock market. Remember the FDR and elephant example from the start of this tale. Let’s look at guests 1, 10, 19 and 25. I picked these 4 because readers of this tale can relate in some form or another to one of these 4.
- Guest 1 started 30 months ago, at the beginning of the bull market phase, and his rate of return is 12.28% for the entire 30-month cycle. He enjoyed the ride up for 18 months and now the ride down for the last 12.
- Guest 10 started 21 months ago, halfway through the bull market phase, and his rate of return is 1.36% for the 21-month period he has been invested.
- Guest 19 started 12 months ago, at the beginning of the bear market phase, and his rate of return is -21.53% for the 12-month period he has been invested.
- Finally, Guest 25 started 6 months ago, halfway through the bear market phase, and his rate of return is
–11.42 for the 6-month period he has been invested.
These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. All 4 are correct. All 4 are right and yet they couldn’t possibly have more divergent outcomes. If they don’t have a complete picture of the stock market, like the elephant, they can get themselves in trouble. The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point. The point is that stock market investing will always produce different outcomes. One guest started at the worst time possible. Another guest started at the best possible time. How they look at the past determines how they see the present. Most importantly, it will determine how they will act going forward.
The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. They do not see the market as it is but as they are. Without an expert understanding of how the stock market works, this leads to incorrect conclusions that ultimately lead to incorrect decisions. The field of Behavioral Finance (BF) has shown time and time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. All 4 have intellectual access to the events of the last 30 months. All 4 can educate themselves on the stock market. However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally. I have witnessed this irrational behavior throughout my career. No one is immune, even advisors.
There are ways to combat The Party Effect trap but it is the deadliest of all the stock market traps that I know. Few can overcome it. The only sure way to overcome it is to become an expert on the stock market yourself, learn to manage your emotions, and then either manage your own money or hire competent managers that you recognize are expert in their chosen investment discipline. However, if you hire an expert on the stock market you have not solved the problem if you do not have expertise. Let me repeat this sentence and highlight it. If you hire an expert on the stock market you have not solved The Party Effect trap if you do not have expertise yourself. When you hire an expert on the stock market without being an expert yourself all you have done is added complexity to a complex problem. You have inserted another variable between you and the stock market. You now have three variables to worry about, the stock market, your advisor and yourself. Without expertise you have no way of knowing if your advisor is an expert. You are in an endless loop. You are in a recursive situation. Just like we ask, what came first the chicken or the egg? The Party Effect asks, how do I hire an expert without being an expert myself?
If you are unwilling to become an expert on the stock market you must find a way to solve The Party Effect trap? How do you do it? As a first step I suggest you read An Expert Tale to make sure the person you hire is in fact an expert and then hire them. The original intent of my Financial Tales project was to educate my kids and others I love. With that as a backdrop, this means I highly recommend you avoid dealing with any advisor that does not have a fiduciary relationship with you the client. Why, because you are adding a 4th variable to an already complex situation. You are adding the ever present conflict of interest that every non-fiduciary advisor has with their client. This 4th variable makes a successful outcome all but impossible. I recognize that these words are harsh but I believe your odds of success drop dramatically once you introduce the non-fiduciary variable. I don’t know what the future holds, but today you must avoid conflicted advisors at firms such as Merrill Lynch, Smith Barney, Morgan Stanley, etc. I expect that the non-fiduciary model of providing people with investment advice based on the size of the advertising budget will go the way of the dinosaur, but for as long as it exists, you must avoid this ilk of advisors.
What is the second step to avoiding The Party Effect trap? There is no second step. You either develop investment expertise or you learn to recognize experts and hire them. You can’t avoid or abdicate this charge. You must embrace your responsibility or you will suffer or those you love will suffer. It behooves the reader to invest their time in what is one of the most important decisions they will ever make and must make every day.
http://www.wikinvest.com/wiki/Recency_bias
The Party Effect or Recency Bias is where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves. This is a very important concept to understand. Let’s set the stage for an illustration of how this happens.
Examples
A Party Tale
“You’re Right”
One of my favorite life lessons centers around President Franklin Delano Roosevelt, also known as FDR. FDR had many strengths but I think his greatest was his ability to recognize that things are not always black and white. I think his ability to see the big picture as well as discern the subtleties of a situation is what made him such an effective leader and brought out the best in others.
In one well known FDR story, he asks one of his trusted advisors what he thinks about a particular situation and after he listens to the advisor, FDR replies “You’re Right.” Not long after FDR asks another of his trusted advisors for his opinion on the same matter and this advisor gives the exact opposite recommendation from the first advisor to which FDR once again replies “You’re Right.”
At hearing FDR’s reply to the second advisor one of FDR’s closest advisors that had listened to FDR’s response to both advisors, points out the obvious contradiction to which FDR replies “You’re Also Right.”
Much can be learned from what at first appears to be FDR’s flippant and contradictory remarks to his advisors. However, FDR was far wiser. FDR understood that all three advisors were in fact right. They were just right from their perspective. But they didn’t have a view of the big picture. The contrast between FDR’s perspective of the entire situation compared to the trusted advisor’s perspective of a narrow part of the situation is what creates the dichotomy. The stock market works much the same way.
A different example would be the poem about the six blind men and the elephant. Each of the six blind men is asked to describe an elephant. Their perceptions lead to misinterpretation because they each describe the elephant differently depending on which part of the elephant they touch. One touches the side and describes the elephant like a wall. The other the tusk and describes the elephant as a spear. The next touches the trunk and describes a snake. The next the knee and describes a tree. The next an ear and describes a fan. Finally the last touches the tail and describes the elephant like a rope.
This tale is about the stock market and how investors relate to the stock market. The stock market can be viewed as FDR or the elephant while investors or participants in the stock market can be viewed as the advisors or the blind men. When describing the stock market each participant sees their portfolio’s performance from their perspective only and thus they are always “right” which leads to what I call The Party Effect or what Financial Behaviorist call the Recency Bias.
Imagine that you attended a party hosted by your investment advisor and that in addition to you, also in attendance were several other clients. As you go around the room and meet people you learn that everyone at the party owns the exact same S&P 500 index mutual fund. I use the S&P 500 for this tale because by many measures it has historically produce an average rate of return of about 12% and as many people know, and now you know as well, it represents what many investors call “the stock market.” The question then is would everyone have the same rate of return at this party? Of course the answer is, no they would not. If they started at the same time they would but since people invest or come into the life of the investment advisor at different times, the answer is no.
Let’s tighten up the party attendee list and invite only 30 guests. For simplicity, let’s assume that Guest 1 purchased the fund 30 months ago, that Guest 2 purchased it 29 months ago, that Guest 3 purchased it 28 months ago, etc. What would the guests discuss? What would be their perspectives of the stock market?
In order to determine what the guests would discuss and how they would evaluate their performance we need to have some data in the form of monthly rates of return. So we need to develop a monthly rate of return for 30 months to see what they see. Again, for simplicity, assume that for the first 18 months the fund goes up 3% per month and for the next 12 months it goes down 2% per month. Please note that I didn’t pick this sequence of numbers randomly. I have a purpose to this. This particular sequence approximates how the stock market moves in terms of bull and bear market duration and after 30 months returns approximately 12%; 12.28% to be exact. This sequence of numbers is a good sequence to illustrate The Party Effect or Recency Bias. We can characterize the first 18 months as the bull market phase of the 30-month cycle and the last 12 months as the bear market phase of the 30-month cycle.
To illustrate The Party Effect lets focus on 4 guests and see how they describe the stock market. Remember the FDR and elephant example from the start of this tale. Let’s look at guests 1, 10, 19 and 25. I picked these 4 because readers of this tale can relate in some form or another to one of these 4.
- Guest 1 started 30 months ago, at the beginning of the bull market phase, and his rate of return is 12.28% for the entire 30-month cycle. He enjoyed the ride up for 18 months and now the ride down for the last 12.
- Guest 10 started 21 months ago, halfway through the bull market phase, and his rate of return is 1.36% for the 21-month period he has been invested.
- Guest 19 started 12 months ago, at the beginning of the bear market phase, and his rate of return is -21.53% for the 12-month period he has been invested.
- Finally, Guest 25 started 6 months ago, halfway through the bear market phase, and his rate of return is
–11.42 for the 6-month period he has been invested.
These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. All 4 are correct. All 4 are right and yet they couldn’t possibly have more divergent outcomes. If they don’t have a complete picture of the stock market, like the elephant, they can get themselves in trouble. The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point. The point is that stock market investing will always produce different outcomes. One guest started at the worst time possible. Another guest started at the best possible time. How they look at the past determines how they see the present. Most importantly, it will determine how they will act going forward.
The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. They do not see the market as it is but as they are. Without an expert understanding of how the stock market works, this leads to incorrect conclusions that ultimately lead to incorrect decisions. The field of Behavioral Finance (BF) has shown time and time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. All 4 have intellectual access to the events of the last 30 months. All 4 can educate themselves on the stock market. However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally. I have witnessed this irrational behavior throughout my career. No one is immune, even advisors.
There are ways to combat The Party Effect trap but it is the deadliest of all the stock market traps that I know. Few can overcome it. The only sure way to overcome it is to become an expert on the stock market yourself, learn to manage your emotions, and then either manage your own money or hire competent managers that you recognize are expert in their chosen investment discipline. However, if you hire an expert on the stock market you have not solved the problem if you do not have expertise. Let me repeat this sentence and highlight it. If you hire an expert on the stock market you have not solved The Party Effect trap if you do not have expertise yourself. When you hire an expert on the stock market without being an expert yourself all you have done is added complexity to a complex problem. You have inserted another variable between you and the stock market. You now have three variables to worry about, the stock market, your advisor and yourself. Without expertise you have no way of knowing if your advisor is an expert. You are in an endless loop. You are in a recursive situation. Just like we ask, what came first the chicken or the egg? The Party Effect asks, how do I hire an expert without being an expert myself?
If you are unwilling to become an expert on the stock market you must find a way to solve The Party Effect trap? How do you do it? As a first step I suggest you read An Expert Tale to make sure the person you hire is in fact an expert and then hire them. The original intent of my Financial Tales project was to educate my kids and others I love. With that as a backdrop, this means I highly recommend you avoid dealing with any advisor that does not have a fiduciary relationship with you the client. Why, because you are adding a 4th variable to an already complex situation. You are adding the ever present conflict of interest that every non-fiduciary advisor has with their client. This 4th variable makes a successful outcome all but impossible. I recognize that these words are harsh but I believe your odds of success drop dramatically once you introduce the non-fiduciary variable. I don’t know what the future holds, but today you must avoid conflicted advisors at firms such as Merrill Lynch, Smith Barney, Morgan Stanley, etc. I expect that the non-fiduciary model of providing people with investment advice based on the size of the advertising budget will go the way of the dinosaur, but for as long as it exists, you must avoid this ilk of advisors.
What is the second step to avoiding The Party Effect trap? There is no second step. You either develop investment expertise or you learn to recognize experts and hire them. You can’t avoid or abdicate this charge. You must embrace your responsibility or you will suffer or those you love will suffer. It behooves the reader to invest their time in what is one of the most important decisions they will ever make and must make every day.
http://www.wikinvest.com/wiki/Recency_bias
The investment mistakes caused by framing
Behavioural finance: The investment mistakes caused by framing
In this post on behavioural investing, we'll look at the dramatic effects the concept of framing can have in an investment context.
Peoples' personality traits can hugely affect the way they react to the actual performance of their portfolio in the future. For example, consider a situation where two investors (Bob and Brian) have made the same investment. Over one year, the market average rises 10 per cent but the individual investment value increases by 6 per cent.
Bob cares only about the investment return and frames this as a gain of 6 per cent. Brian is concerned with how the investment performs relative to the benchmark of the market average. The investment has lagged behind the market’s performance and Brian frames this as a loss of 4 per cent. Which investor is likely to be happier with the performance of their investment?
Because of the way that individuals feel losses more than gains, Bob is much more likely to be happy with the investment than Brian. Their differing reactions here will frame their future investment decisions. Another problem for investors is the strong tendency for individuals to frame their investments too narrowly – looking at performance over short time periods, even when their investment horizon is long term. People also struggle to consider their portfolio as a whole, focusing too narrowly on the performance of individual components.
Because of the way that individuals feel losses more than gains, Bob is much more likely to be happy with the investment than Brian. Their differing reactions here will frame their future investment decisions. Another problem for investors is the strong tendency for individuals to frame their investments too narrowly – looking at performance over short time periods, even when their investment horizon is long term. People also struggle to consider their portfolio as a whole, focusing too narrowly on the performance of individual components.
The 70% rule
Consider the “70% rule” that advises people to plan on spending about 70 per cent of their current income during their retirement.
For most people, this rule of thumb is intuitively appealing, which could explain why it has become so popular among financial planners. Now let’s use slightly different lenses and reframe the 70 per cent rule as the 30 per cent rule. That is, rather than focusing on the 70 per cent of expenditures someone would sustain through retirement, let’s consider the 30 per cent of expenditures that should be eliminated. Most people find the 30 percent rule unpalatable, even though the 70 per cent and 30 per cent rules are mathematically identical.
Investors hate losses
Individuals are extremely sensitive to the way in which decisions are presented or ‘framed’ – simply changing the wording or adding irrelevant background detail can dramatically change peoples' perceptions of the alternatives available to them, even where there is no reason for their underlying preferences to have changed. When individuals make investment decisions, emotion and reason work together, but they produce very different emotional results depending on whether the investment made or lost money. For example, according to Shefrin, people tend to feel losses much more strongly than the pleasure of making a comparable gain.
This emotional strain is magnified when the person assumes responsibility for the loss. This guilt feeling then produces an aversion to risk. But this level of guilt can be changed depending on how a financial decision is framed. For example, if an adventurous investor seeking attractive returns over the long-term made close to 100 per cent over two years and then lost 20 per cent in year three, the investor could justify the year three loss by saying that even though they suffered a hefty loss over a twelve month period, the fact remains that they had made an annual return over the three years of 21.6 per cent which would be classed by many as impressive performance.
Myopic thinking can lead to investment mistakes
Behavioral finance's answer to the equity premium puzzle revolves around the tendency for people to have "myopic loss aversion", a situation in which investors - overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains – take a very short-term view on an investment. What happens is that investors are paying too much attention to the short-term volatility of their portfolios.
While it's not uncommon for an average stock or fund to fluctuate a few percentage points in a very short period of time, a myopic (i.e. shortsighted) investor may not react too favourably to the downside changes. Therefore, it is believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss.
Over-monitoring performance
How frequently you monitor your portfolio’s performance can bias your perception of it. Suppose you were investing over a 5-year investment horizon in a high-risk equity portfolio. The table below presents how you would perceive the portfolio depending on the monitoring period. Over the appropriate 5-year time frame, equity performance has been positive 90 per cent of the time, and so risky investments do not lose money more than 10 per cent of the time. However, if you were to monitor the performance of the same portfolio on a month-by-month basis, you would observe a loss 38 per cent of the time!*
Once again, because of our inherent aversion to loss, monitoring your portfolio more frequently will cause you to observe more periods of loss, making it likely you'll feel more emotional stress and take on less risk than is appropriate for your long-term investment objectives.
Observing short-term fluctuations in the value of an investment is likely to cause more discomfort for investors who are particularly sensitive to losses. This may prevent them from investing in such a portfolio and thus lose out on the higher potential returns that they would get by taking on appropriate levels of risk.
* Source: Kahneman and Riepe, 1998.
http://web.isaco.co.uk/blog/bid/147855/Behavioural-finance-The-investment-mistakes-caused-by-framing
Friday, 15 November 2013
Availability Bias
AVAILABILITY BIAS
The next cognitive illusion is known as availability bias. When confronted with a decision, humans’ thinking is influenced by what is personally relevant, salient, recent or dramatic. Put another way, humans estimate the probability of an outcome based on how easy that outcome is to imagine.
Consider the following example. In the months after the September 11 terrorist attacks, travelers made the decision that travelling to their destination by car was a far safer way than by air. In light of the very recent (at the time), salient and dramatic events of September 11, this decision seemed an obvious and wise one. The probability of danger when travelling by air seemed much greater than travelling by car… when you think about it, at that time, it was far easier to imagine something bad happening when travelling by air.
However, this was the availability heuristic at work. The truth of the matter was that firstly, air travel had never been safer than in the months following September 11, on account of the massively increased security. And secondly, on account of far more people hitting the roads come holiday time, there were inevitably many more fatal accidents. Upon examination of the statistics, it was far more dangerous to drive than to fly (US road fatalities in October-December 2001 were well above average) and yet, the availability bias humans suffer from made many feel that driving was the smarter choice… this decision-making error cost some people their lives.
We also apply this bias in the world of investing. For instance, availability bias can result in our paying more attention to stocks covered heavily by the media, while the availability of information on a stock influences our tendency to invest in a stock. The dot.com boom of 1999/2000 is a great example. The availability of information and media coverage of internet stocks was such that people were more inclined to invest in them than they would have otherwise been.
Be wary of following the latest market fad simply because of the availability of information. If you have read it in the newspaper, you may well be amongst the last in the market to know!!
http://stockmarketinvesting.com.au/Availability-Bias.html
Tuesday, 12 November 2013
The seven simple habits of the best investors
While bad habits get all the press, it's really their beneficial flip side we should focus on. Good habits are like super powers that people forget they can have. Somewhere in our subconscious lurk automations - mental patterns and rhythms that we execute regularly - but few people realise just how significant those are.
A 2007 study out of Duke University concluded that as many as 40 per cent of our daily actions are deeply ingrained habits, not conscious decisions. Yes, 40 per cent.
When it comes to investing, it pays to look to those who have done it right before. Here are seven common habits I've identified among the world's best investors.
1. They read. And read, and read, and read ...
If you follow Warren Buffett and Berkshire Hathaway (NYSE: BRK-A, BRK-B), you've probably stumbled across his witty and equally brilliant first mate, Charlie Munger. He's a legend for his insights into successful investing, thought processes, and habits. He nailed a crucial one here: “In my whole life, I have known no wise people who didn't read all the time - none, zero. You'd be amazed at how much Warren reads - at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out.”
2. They seek and demonstrate humility
Koch Industries may not command the recognition of its phonetic relative Coke, but it should. Koch is the second-largest private company in the United States and rakes in more than twice the revenue of the more familiar beverage-maker.
Koch Industries chief financial officer Steve Feilmeier is in charge of deploying the company's massive capital at a reasonable rate of return. When discussing what he looks for in a valuable acquisition for Koch, he said: "There is one in particular that I pay attention to when we're looking at another company, and that is humility."
Humility can be a rare virtue in an industry controlled by animal spirits, but it pays off.
3. They fail
Peter Lynch, the legendary manager of Fidelity's Magellan Fund, absolutely stomped the market over his career, averaging annual returns of 29 per cent. Here's what he had to say on picking winners: "In this business, if you're good, you're right six times out of 10. You're never going to be right nine times out of 10."
That's right. If you're king of the investing mountain, you may narrowly beat a coin toss in the long run.
4. They steal
Maybe "steal" isn't the best word for it. In investing it's called "cloning", or basically borrowing already great investment ideas and making them your own.
When it comes to cloning, no one is a bigger advocate than fund manager Mohnish Pabrai - and few are so successful at it. After managing his fund for more than 18 years and weathering two recessions, his average annual return is 25.7 per cent.
Pabrai breaks his approach down to three strategies, and one of them is, indeed, cloning. It's no coincidence that he has had this idea affirmed by someone else too: Charlie Munger.
5. They evaluate internally
A lot of investors are aware of the need to go against the grain to find success, but the judgment and evaluation of others can be a big psychological weight. It can cause doubt and insecurity in your approach.
Buffett knows this best. He was chastised for trailing the moonshot returns of the tech bubble while he stuck with boring insurance and paint manufacturers. His advice for weathering the storm? An "inner scorecard". As he said in The Snowball, a book about his life: “The big question about how people behave is whether they've got an Inner Scorecard or an Outer Scorecard. It helps if you can be satisfied with an Inner Scorecard ... If all the emphasis is on what the world's going to think about you, forgetting about how you really behave, you'll wind up with an Outer Scorecard.”
6. They practise patience
We got a wonderful reminder of the power of patience here at Fool HQ when co-founder David Gardner's 1997 recommendation of Amazon.com (Nasdaq: AMZN) became a 100-bagger. That return – a gain of 100 times the original investment – is absolutely stunning, but even more impressive is that David was an owner the whole way through.
In his original Amazon recommendation, David wrote: "We're patient investors who buy with the idea of holding on to our latest pick for at least a year or two - if not indefinitely."
He's still holding.
7. They're decisive
Don't confuse patience with indecision. The best investors are poised to act when the right opportunity comes across their radars.
John Paulson and Michael Burry didn't participate in The Greatest Trade Ever by sitting on their hands. When they saw a clear opportunity, they backed up the truck. For Burry, that often meant battling his own investors' anxiety. His fund Scion Capital returned nearly 500 per cent in less than eight years.
Foolish takeaway
Taking the time to cultivate good habits will yield incredible results. As one popular saying goes:
Your actions become your habits,
Your habits become your values,
Your values become your destiny.
Read more: http://www.smh.com.au/business/the-seven-simple-habits-of-the-best-investors-20131112-2xe2o.html#ixzz2kQj29J7f
A 2007 study out of Duke University concluded that as many as 40 per cent of our daily actions are deeply ingrained habits, not conscious decisions. Yes, 40 per cent.
When it comes to investing, it pays to look to those who have done it right before. Here are seven common habits I've identified among the world's best investors.
1. They read. And read, and read, and read ...
If you follow Warren Buffett and Berkshire Hathaway (NYSE: BRK-A, BRK-B), you've probably stumbled across his witty and equally brilliant first mate, Charlie Munger. He's a legend for his insights into successful investing, thought processes, and habits. He nailed a crucial one here: “In my whole life, I have known no wise people who didn't read all the time - none, zero. You'd be amazed at how much Warren reads - at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out.”
2. They seek and demonstrate humility
Koch Industries may not command the recognition of its phonetic relative Coke, but it should. Koch is the second-largest private company in the United States and rakes in more than twice the revenue of the more familiar beverage-maker.
Koch Industries chief financial officer Steve Feilmeier is in charge of deploying the company's massive capital at a reasonable rate of return. When discussing what he looks for in a valuable acquisition for Koch, he said: "There is one in particular that I pay attention to when we're looking at another company, and that is humility."
Humility can be a rare virtue in an industry controlled by animal spirits, but it pays off.
3. They fail
Peter Lynch, the legendary manager of Fidelity's Magellan Fund, absolutely stomped the market over his career, averaging annual returns of 29 per cent. Here's what he had to say on picking winners: "In this business, if you're good, you're right six times out of 10. You're never going to be right nine times out of 10."
That's right. If you're king of the investing mountain, you may narrowly beat a coin toss in the long run.
4. They steal
Maybe "steal" isn't the best word for it. In investing it's called "cloning", or basically borrowing already great investment ideas and making them your own.
When it comes to cloning, no one is a bigger advocate than fund manager Mohnish Pabrai - and few are so successful at it. After managing his fund for more than 18 years and weathering two recessions, his average annual return is 25.7 per cent.
Pabrai breaks his approach down to three strategies, and one of them is, indeed, cloning. It's no coincidence that he has had this idea affirmed by someone else too: Charlie Munger.
5. They evaluate internally
A lot of investors are aware of the need to go against the grain to find success, but the judgment and evaluation of others can be a big psychological weight. It can cause doubt and insecurity in your approach.
Buffett knows this best. He was chastised for trailing the moonshot returns of the tech bubble while he stuck with boring insurance and paint manufacturers. His advice for weathering the storm? An "inner scorecard". As he said in The Snowball, a book about his life: “The big question about how people behave is whether they've got an Inner Scorecard or an Outer Scorecard. It helps if you can be satisfied with an Inner Scorecard ... If all the emphasis is on what the world's going to think about you, forgetting about how you really behave, you'll wind up with an Outer Scorecard.”
6. They practise patience
We got a wonderful reminder of the power of patience here at Fool HQ when co-founder David Gardner's 1997 recommendation of Amazon.com (Nasdaq: AMZN) became a 100-bagger. That return – a gain of 100 times the original investment – is absolutely stunning, but even more impressive is that David was an owner the whole way through.
In his original Amazon recommendation, David wrote: "We're patient investors who buy with the idea of holding on to our latest pick for at least a year or two - if not indefinitely."
He's still holding.
7. They're decisive
Don't confuse patience with indecision. The best investors are poised to act when the right opportunity comes across their radars.
John Paulson and Michael Burry didn't participate in The Greatest Trade Ever by sitting on their hands. When they saw a clear opportunity, they backed up the truck. For Burry, that often meant battling his own investors' anxiety. His fund Scion Capital returned nearly 500 per cent in less than eight years.
Foolish takeaway
Taking the time to cultivate good habits will yield incredible results. As one popular saying goes:
Your actions become your habits,
Your habits become your values,
Your values become your destiny.
Read more: http://www.smh.com.au/business/the-seven-simple-habits-of-the-best-investors-20131112-2xe2o.html#ixzz2kQj29J7f
Monday, 11 November 2013
Sunday, 10 November 2013
Legg Mason’s Miller fades away. Onetime superstar manager leaves a tarnished legacy
Nov. 17, 2011
By MarketWatch
BOSTON (MarketWatch) — The forthcoming retirement of legendary mutual fund manager Bill Miller will stop the clock on his track record, but the real question is whether the lasting image will be his legendary successes or his epic failures.
Legg Mason's Bill Miller steps down
After running Legg Mason Value Trust mutual fund for nearly 30 years, Bill Miller is stepping down at the end of April and will be succeeded by Sam Peters, WSJ's Mark Gongloff reports on Markets Hub. Photo: AP.
Over almost three decades at the helm of Legg Mason Value TrustLMVTX +1.72% , Miller made his mark with a 15-year steak of beating the Standard & Poor’s 500 index SPX +1.34% . It’s not that Miller’s fund made money every year from 1991 through 2005, but he was the anomaly, the active manager who did better than an index fund in all conditions. As mutual funds became mainstream investments through the 1990s, investors flocked to him.
Even as the Internet bubble burst, Miller was able to top the index despite big bets made on Enron and other troubled stocks, convincing investors that he had enough star power to overcome his mistakes.
Legg Mason said Thursday that Miller will retire from fund management in April, 30 years after he started running Value Trust. But in fact, most people wondered what had taken Miller so long.
When his market-beating streak ended, Miller went from the guy who could do no wrong to one who did no right. In 2007, when the market was up, Miller was down; in 2008, Legg Mason Value Trust lost a stunning 55% of its value. (His other fund, Legg Mason Opportunity LMOPX +2.21% lost 65.5% that year.)
The mutual-fund press made him the poster boy for star managers letting their egos take over while their performance suffers, believing that they can somehow bend the market to the power of their will and their investment style.
It doesn’t work that way.
Miller’s 2009 gains of more than 40% for the Value Trust (and 83% for Opportunity) were too late; in four of the last five calendar years, Value Trust finished in the bottom 2% of its peer group, according to investment researcher Morningstar Inc.
While the fund still has $2.8 billion in assets, you’d be hard-pressed to find anyone who would buy it now; new helmsman Sam Peters has been Miller’s co-manager for about a year now, but expecting him to be “the next Bill Miller” is unrealistic, if you are pegging that hope to Miller’s stretch run. No one who followed Fidelity Magellan legend Peter Lynch ever truly proved to be “the next Peter Lynch,” and the number of top managers who have been succeeded by bright stars is tiny.
End of an era
While Miller won’t be the last star manager, he will be the guy known for killing off the genre. The next time someone has a hot streak or a run of great performance, it will be Miller’s heyday they are compared to, and Miller’s fall from grace that is the cautionary tale used to scare investors away.
That’s not entirely fair. A $10,000 investment in Legg Mason Value Trust from when Miller took over in April 1982 is worth $235,089 today, a cumulative return of 2,251%, an annualized average return of 11.26%. The fund was one of just 14 large-blend funds to beat the S&P 500 over Miller’s management tenure (from April 1982 until now), tying for 10th place in the category over that time.
By comparison, a $10,000 investment in the Vanguard Index 500 VFINX +1.34% is up 10.97% annualized (turning $10,000 into $217,457), and an investment in the average large-cap blend fund gained 9.76% over the last 30 years, according to Morningstar, turning $10,000 into $157,175.
The sad problem is that few people enjoyed that long record of performance. Instead, they bought in after Miller’s reputation was made, and lost money while he lost his edge. Over the last 15 years, the fund ranks in the bottom 30% of its Morningstar peer group, despite the fact that it beat the market in roughly half of those calendar years.
Evaluated by his long-term track record, Miller’s departure represents the end of an era of success that few managers have ever enjoyed. Few investors will remember him that way; instead, he’s the guy they were told was great who wound up disappointing them perhaps more than any star manager in history.
Saturday, 9 November 2013
Thinking, Fast and Slow (Daniel Kahneman)
Thinking, Fast and Slow is a 2011 book by Nobel Memorial Prize winner in Economics Daniel Kahneman which summarizes research that he conducted over decades, often in collaboration with Amos Tversky. It covers all three phases of his career:
- his early days working on cognitive bias,
- his work on prospect theory, and
- his later work on happiness.
The book's central thesis is a dichotomy between two modes of thought :
- System 1 is fast, instinctive and emotional;
- System 2 is slower, more deliberative, and more logical.
The book delineates cognitive biases associated with each type of thinking, starting with Kahneman's own research on loss aversion. From framing choices to substitution, the book highlights several decades of academic research to suggest that people place too much confidence in human judgment.
Contents
1 Prospect theory
2 Two systems
3 Heuristics and biases
3.1 Anchoring
3.2 Availability
3.3 Substitution
3.4 Optimism and loss aversion
3.5 Framing
3.6 Sunk-cost
4 Choices
5 Rationality and happiness
5.1 Two selves
The basis for his Nobel prize, Kahneman developed prospect theory to account for experimental errors he noticed in Daniel Bernoulli's traditional utility theory. This theory makes logical assumptions of economic rationality that do not reflect people’s actual choices, and does not take into account behavioral biases.
One example is that people are loss-averse: they are more likely to act to avert a loss than to achieve a gain. Another example is that the value people place on a change in probability (e.g. of winning something) depends on the reference point: people appear to place greater value on a change from 90% to 100% (going from high probability to certainty) than from, say, 45% to 55%, and place the greatest value of all on a change from 0% to 10% (going to a chance of winning from no chance). This despite that all three changes give the same increase in utility. Consistent with loss-aversity, the order of the first and third of those is reversed when the event is presented as losing rather than winning something: there, the greatest value is placed on eliminating the probability of a loss to 0.
Two systems
In the book's first section, Kahneman describes the two different ways the brain forms thoughts:
System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious
System 2: Slow, effortful, infrequent, logical, calculating, conscious
Kahneman covers a number of experiments which purport to highlight the differences between these two thought processes, and how they arrive at different results even given the same inputs. Terms and concepts include coherence, attention, laziness, association, jumping to conclusions and how one forms judgments.
Heuristics and biases
The second section offers explanations for why humans struggle to think statistically. It begins by documenting a variety of situations in which we either arrive at binary decisions or fail to precisely associate reasonable probabilities to outcomes. Kahneman explains this phenomenon using the theory of heuristics.
Kahneman uses heuristics to assert that System 1 thinking involves associating new information with existing patterns, or thoughts, rather than creating new patterns for each new experience. For example, a child who has only seen shapes with straight edges would experience an octagon rather than a triangle when first viewing a circle. In a legal metaphor, a judge limited to heuristic thinking would only be able to think of similar historical cases when presented with a new dispute, rather than seeing the unique aspects of that case. In addition to offering an explanation for the statistical problem, the theory also offers an explanation for human biases.
Anchoring
The “anchoring effect” names our tendency to be influenced by irrelevant numbers. Shown higher/lower numbers, experimental subjects gave higher/lower responses. Experiment: experienced German judges proposed longer sentences if they had just rolled a pair of dice loaded to give a high number.
Availability
The availability heuristic is a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples. The availability heuristic operates on the notion that, "if you can think of it, it must be important." The availability of consequences associated with an action is positively related to perceptions of the magnitude of the consequences of that action. In other words, the easier it is to recall the consequences of something, the greater we perceive these consequences to be. Sometimes, this heuristic is beneficial, but the frequencies that events come to mind are usually not accurate reflections of the probabilities of such events in real life.
Substitution
System 1 is prone to substituting a simple question for a more difficult one. In what Kahneman calls their “best-known and most controversial” experiment, “the Linda problem.” Subjects were told about an imaginary Linda, young, single, outspoken and very bright, who, as a student, was deeply concerned with discrimination and social justice. They asked whether it was more probable that Linda is a bank teller or that she is a bank teller and an active feminist. The overwhelming response was that “feminist bank teller” was more likely than “bank teller,” violating the laws of probability. (Every feminist bank teller is a bank teller.) In this case System 1 substituted the easier question, "Is Linda a feminist?" dropping the occupation qualifier. An alternative view is that the subjects added an unstated implicature to the effect that the other answer implied that Linda was not a feminist.
Optimism and loss aversion
Kahneman writes of a "pervasive optimistic bias", which “may well be the most significant of the cognitive biases.” This bias generates the illusion of control, that we have substantial control of our lives. This bias may be usefully adaptive. Optimists are more psychologically resilient, have stronger immune systems, and live longer on average than more reality-based opposites. Optimism protects from loss aversion: people's tendency to fear losses more than we value gains.
A natural experiment reveals the prevalence of one kind of unwarranted optimism. The planning fallacy is the tendency to overestimate benefits and underestimate costs, impelling people to take on risky projects. In 2002, American kitchen remodeling was expected on average to cost $18,658, but actually cost $38,769.
To explain overconfidence, Kahneman introduces the concept he labels What You See Is All There Is (WYSIATI). This theory states that when the mind makes decisions, it deals primarily with Known Knowns, phenomena it has already observed. It rarely considers Known Unknowns, phenomena that it knows to be relevant but about which it has no information. Finally it appears oblivious to the possibility of Unknown Unknowns, unknown phenomena of unknown relevance.
He explains that humans fail to take into account complexity and that their understanding of the world consists of a small and not necessarily representative set of observations. Furthermore, the mind generally does not account for the role of chance and therefore falsely assumes that a future event will mirror a past event.
Framing
Framing is the context in which choices are presented. Experiment: subjects were asked whether they would opt for surgery if the “survival” rate is 90 percent, while others were told that the mortality rate is 10 percent. The first framing increased acceptance, even though the situation was no different.
Sunk-cost
Rather than consider the odds that an incremental investment would produce a positive return, people tend to "throw good money after bad" and continue investing in projects with poor prospects that have already consumed significant resources. In part this is to avoid feelings of regret.
Choices
In this section Kahneman returns to economics and expands his seminal work on Prospect Theory. He discusses the tendency for problems to be addressed in isolation and how, when other reference points are considered, the choice of that reference point (called a frame) has a disproportionate impact on the outcome. This section also offers advice on how some of the shortcomings of System 1 thinking can be avoided.
Rationality and happiness
Evolution teaches that traits persist and develop because they increase fitness. One possible hypothesis is that our conceptual biases are adaptive, as are our rational faculties. Kahneman offers happiness as one quality that our thinking process nurtures. Kahneman first took up this question in the 1990s. At the time most happiness research relied on polls about life satisfaction.
Two selves
Kahneman proposed an alternate measure that assessed pleasure or pain sampled from moment to moment, and then summed over time. Kahneman called this “experienced” well-being and attached it to a separate "self". He distinguished this from the “remembered” well-being that the polls had attempted to measure. He found that these two measures of happiness diverged. His major discovery was that the remembering self does not care about the duration of a pleasant or unpleasant experience. Rather, it retrospectively rates an experience by the peak (or valley) of the experience, and by the way it ends. Further, the remembering self dominated the patient's ultimate conclusion.
Kahneman demonstrated the principle using two groups of patients undergoing painful colonoscopies. Group A got the normal procedure. Group B, unknowingly received a few extra minutes of less painful discomfort after the end of the examination, i.e., more total discomfort. However, since Group B’s procedure ended less painfully, the patients in this group retrospectively minded the whole affair less.
“Odd as it may seem,” Kahneman writes, “I am my remembering self, and the experiencing self, who does my living, is like a stranger to me.”
http://en.wikipedia.org/wiki/Thinking,_Fast_and_Slow
- his early days working on cognitive bias,
- his work on prospect theory, and
- his later work on happiness.
The book's central thesis is a dichotomy between two modes of thought :
- System 1 is fast, instinctive and emotional;
- System 2 is slower, more deliberative, and more logical.
The book delineates cognitive biases associated with each type of thinking, starting with Kahneman's own research on loss aversion. From framing choices to substitution, the book highlights several decades of academic research to suggest that people place too much confidence in human judgment.
Contents
1 Prospect theory
2 Two systems
3 Heuristics and biases
3.1 Anchoring
3.2 Availability
3.3 Substitution
3.4 Optimism and loss aversion
3.5 Framing
3.6 Sunk-cost
4 Choices
5 Rationality and happiness
5.1 Two selves
The basis for his Nobel prize, Kahneman developed prospect theory to account for experimental errors he noticed in Daniel Bernoulli's traditional utility theory. This theory makes logical assumptions of economic rationality that do not reflect people’s actual choices, and does not take into account behavioral biases.
One example is that people are loss-averse: they are more likely to act to avert a loss than to achieve a gain. Another example is that the value people place on a change in probability (e.g. of winning something) depends on the reference point: people appear to place greater value on a change from 90% to 100% (going from high probability to certainty) than from, say, 45% to 55%, and place the greatest value of all on a change from 0% to 10% (going to a chance of winning from no chance). This despite that all three changes give the same increase in utility. Consistent with loss-aversity, the order of the first and third of those is reversed when the event is presented as losing rather than winning something: there, the greatest value is placed on eliminating the probability of a loss to 0.
Two systems
In the book's first section, Kahneman describes the two different ways the brain forms thoughts:
System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious
System 2: Slow, effortful, infrequent, logical, calculating, conscious
Kahneman covers a number of experiments which purport to highlight the differences between these two thought processes, and how they arrive at different results even given the same inputs. Terms and concepts include coherence, attention, laziness, association, jumping to conclusions and how one forms judgments.
Heuristics and biases
The second section offers explanations for why humans struggle to think statistically. It begins by documenting a variety of situations in which we either arrive at binary decisions or fail to precisely associate reasonable probabilities to outcomes. Kahneman explains this phenomenon using the theory of heuristics.
Kahneman uses heuristics to assert that System 1 thinking involves associating new information with existing patterns, or thoughts, rather than creating new patterns for each new experience. For example, a child who has only seen shapes with straight edges would experience an octagon rather than a triangle when first viewing a circle. In a legal metaphor, a judge limited to heuristic thinking would only be able to think of similar historical cases when presented with a new dispute, rather than seeing the unique aspects of that case. In addition to offering an explanation for the statistical problem, the theory also offers an explanation for human biases.
Anchoring
The “anchoring effect” names our tendency to be influenced by irrelevant numbers. Shown higher/lower numbers, experimental subjects gave higher/lower responses. Experiment: experienced German judges proposed longer sentences if they had just rolled a pair of dice loaded to give a high number.
Availability
The availability heuristic is a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples. The availability heuristic operates on the notion that, "if you can think of it, it must be important." The availability of consequences associated with an action is positively related to perceptions of the magnitude of the consequences of that action. In other words, the easier it is to recall the consequences of something, the greater we perceive these consequences to be. Sometimes, this heuristic is beneficial, but the frequencies that events come to mind are usually not accurate reflections of the probabilities of such events in real life.
Substitution
System 1 is prone to substituting a simple question for a more difficult one. In what Kahneman calls their “best-known and most controversial” experiment, “the Linda problem.” Subjects were told about an imaginary Linda, young, single, outspoken and very bright, who, as a student, was deeply concerned with discrimination and social justice. They asked whether it was more probable that Linda is a bank teller or that she is a bank teller and an active feminist. The overwhelming response was that “feminist bank teller” was more likely than “bank teller,” violating the laws of probability. (Every feminist bank teller is a bank teller.) In this case System 1 substituted the easier question, "Is Linda a feminist?" dropping the occupation qualifier. An alternative view is that the subjects added an unstated implicature to the effect that the other answer implied that Linda was not a feminist.
Optimism and loss aversion
Kahneman writes of a "pervasive optimistic bias", which “may well be the most significant of the cognitive biases.” This bias generates the illusion of control, that we have substantial control of our lives. This bias may be usefully adaptive. Optimists are more psychologically resilient, have stronger immune systems, and live longer on average than more reality-based opposites. Optimism protects from loss aversion: people's tendency to fear losses more than we value gains.
A natural experiment reveals the prevalence of one kind of unwarranted optimism. The planning fallacy is the tendency to overestimate benefits and underestimate costs, impelling people to take on risky projects. In 2002, American kitchen remodeling was expected on average to cost $18,658, but actually cost $38,769.
To explain overconfidence, Kahneman introduces the concept he labels What You See Is All There Is (WYSIATI). This theory states that when the mind makes decisions, it deals primarily with Known Knowns, phenomena it has already observed. It rarely considers Known Unknowns, phenomena that it knows to be relevant but about which it has no information. Finally it appears oblivious to the possibility of Unknown Unknowns, unknown phenomena of unknown relevance.
He explains that humans fail to take into account complexity and that their understanding of the world consists of a small and not necessarily representative set of observations. Furthermore, the mind generally does not account for the role of chance and therefore falsely assumes that a future event will mirror a past event.
Framing
Framing is the context in which choices are presented. Experiment: subjects were asked whether they would opt for surgery if the “survival” rate is 90 percent, while others were told that the mortality rate is 10 percent. The first framing increased acceptance, even though the situation was no different.
Sunk-cost
Rather than consider the odds that an incremental investment would produce a positive return, people tend to "throw good money after bad" and continue investing in projects with poor prospects that have already consumed significant resources. In part this is to avoid feelings of regret.
Choices
In this section Kahneman returns to economics and expands his seminal work on Prospect Theory. He discusses the tendency for problems to be addressed in isolation and how, when other reference points are considered, the choice of that reference point (called a frame) has a disproportionate impact on the outcome. This section also offers advice on how some of the shortcomings of System 1 thinking can be avoided.
Rationality and happiness
Evolution teaches that traits persist and develop because they increase fitness. One possible hypothesis is that our conceptual biases are adaptive, as are our rational faculties. Kahneman offers happiness as one quality that our thinking process nurtures. Kahneman first took up this question in the 1990s. At the time most happiness research relied on polls about life satisfaction.
Two selves
Kahneman proposed an alternate measure that assessed pleasure or pain sampled from moment to moment, and then summed over time. Kahneman called this “experienced” well-being and attached it to a separate "self". He distinguished this from the “remembered” well-being that the polls had attempted to measure. He found that these two measures of happiness diverged. His major discovery was that the remembering self does not care about the duration of a pleasant or unpleasant experience. Rather, it retrospectively rates an experience by the peak (or valley) of the experience, and by the way it ends. Further, the remembering self dominated the patient's ultimate conclusion.
Kahneman demonstrated the principle using two groups of patients undergoing painful colonoscopies. Group A got the normal procedure. Group B, unknowingly received a few extra minutes of less painful discomfort after the end of the examination, i.e., more total discomfort. However, since Group B’s procedure ended less painfully, the patients in this group retrospectively minded the whole affair less.
“Odd as it may seem,” Kahneman writes, “I am my remembering self, and the experiencing self, who does my living, is like a stranger to me.”
http://en.wikipedia.org/wiki/Thinking,_Fast_and_Slow
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