Lessons from Charlie Munger-XII

Mar 30, 2012

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


Contrast Misreaction tendency

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

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

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


Contrast misreaction tendency in the stock markets 

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


Expensive at 140, attractive at 300!

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

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

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

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

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

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

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Lessons from Charlie Munger-XI

Mar 1, 2012

In the previous article, we discussed the social proof tendency in day-to-day life and also explained why corruption in India is so deeply rooted. Today, we shall discuss the social proof tendency in the context of business and finance. 


The Institutional Imperative

Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions. Even the legendary investor Warren Buffett had the same notion when he entered the world of business. But through time and experience, he realised that more often than not, despite all the qualifications and experience, it was not the case. A deadly force which he calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses. 

What does institutional imperative mean? The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. A simpler term that comes to mind is peer pressure. However surprising it may seem, even CEOs are subject to this pressure which forces them to make stupid mistakes. 

The evidence is almost everywhere. Say for instance, if some companies in a certain sector go on a capacity expansion spree, others are quite likely to follow, even though the overall economic situation may be hinting otherwise. What is the excuse such companies provide when the initiative goes for a toss? It's not difficult to guess- 'Everybody was doing that'. 

From his own mistakes, Buffett realised how important it was to not fall victim to this force. As an antidote to this problem, he introduced a technique at Berkshire Hathaway that has been quite effective in dealing with institutional imperative. To idea is simple- Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake. 

The tendency to fall prey to the social proof tendency is also seen among investors. Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. What should investors do to avoid such mistakes? Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency. 

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

https://www.equitymaster.com/detail.asp?date=03/01/2012&story=8&title=Lessons-from-Charlie-Munger-XI

Lessons from Charlie Munger-X

Jan 5, 2012

In the previous article, we had discussed how our tendency to be over-optimistic distorts our view of reality and as a result, we often end up making wrong investment decisions. Today, we shall discuss a very important human tendency which is prevalent in all walks of our social life and has a tremendous influence on how we think and behave. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.


Social proof tendency 

We would like you to contemplate a bit about the below questions before we share our views on them:

• Have you ever commuted on Mumbai's local trains? If you have, you will most certainly agree about how a harmless looking gentleman can so quickly transform into a savage beast to plough his way into the train and onto a seat.
  
  
• What causes riots? How are terrorists created? What do you think prompts an otherwise normal person to pick up weapons and brutalise unarmed strangers?
• What was the reason for the success of Anna Hazare's movement against corruption? Why did an otherwise indifferent middle class go all out in support of Team Anna, sometimes even referring to the episode as India's second freedom struggle?
• Why are Indians cleaner and more disciplined abroad than at home?

Though there may be other reasons as well, but the one important common thread among all these is the social proof tendency. What is social proof tendency? Well, it is an automatic tendency to think and act the way people around you are thinking and acting. 

In the first instance, an otherwise gentleman turns rash in a Mumbai local train. Since everyone is doing the same, it seems socially acceptable to him. While he may not display that kind of behaviour in most other places, pushing and suffocating others in a local train appears pardonable to him. At least that is what it seems to him from the behaviour of others. Meaning, there is social proof. 

The social proof tendency works in both positive and negative situations. Be it riots and terrorists. Or be it the massive support that came in for Anna Hazare. This tendency most readily occurs in the presence of puzzlement or stress, or both. 


Social proof tendency and corruption in India

Charlie Munger points out one interesting aspect of the social proof tendency which very well explains why corruption in India is so deeply rooted. The "Serpico Syndrome" is named in the memory of Frank Serpico who once entered a highly corrupt New York police division. Unlike others, he resisted to be consumed by the contagion of corruption. And for that resistance, he was almost about to lose his life. Isn't this reminiscent of the many Indian films wherein the protagonist is the honest police officer who challenges the corrupt system? In the film, of course, the good cop reigns over his adversaries. In real life, however, that is seldom the case. As it is evident, the evil of corruption continues to persist in our country because of this very Serpico Syndrome, which is created by the social proof tendency and the power of incentives. 

Akin to the other spheres of life, social proof tendency is present in overwhelming proportions in the world of business and finance. It dominates how investors behave in stock markets, how company managements do business and so on. We will discuss this is more detail in the next article of this series. 


https://www.equitymaster.com/detail.asp?date=01/05/2012&story=4&title=Lessons-from-Charlie-Munger-X

Lessons from Charlie Munger-IX

Dec 29, 2011

In the previous article, we had discussed how a simple emotion like jealousy could prompt you into making irrational investment decisions. Today, we shall discuss our innate tendency to be over-optimistic and how it affects our view of the economy and the stock markets. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments. 


Over-optimism tendency 

It is indeed commendable how humans and other creatures have evolved and survived over millions of years of evolution. Forget millions of years. Just look at all that has happened in the last 100 years, a period which saw two major world wars and a series of economic and political crises across the globe. Yet we continue to look forward to a better future. What is it that allows man to endure the many trials and tribulations that life presents? Hope, isn't it? 

Charlie Munger shares a very interesting perspective in this regard. He opines that an excess of optimism is the normal human condition. And this tendency to be over-optimistic not only manifests when man is in pain, but also when he is doing well and there is no threat of pain whatsoever. A famous Greek orator by the name of Demosthenes is known to have said these very fitting lines more than 2,000 years ago-"What a man wishes, that also will he believe." 


Over-optimism tendency in stock markets

It is not at all difficult to understand how this tendency drives not just stock markets but the entire world of finance and economics. Why otherwise would we have booms and bubbles with such amazing regularity? Why do people continue to flock to the financial markets despite the regular crises and busts that torment the markets? In fact, all the malaise troubling the global economy today, from the debt crises in the developed economies to the high inflation and slowing growth in emerging economies like India, do have roots in excessive optimism. The problem is that when things are good, we expect them to get better and better in a linear fashion. And even when things are bad and getting worse, we often expect that the situation will turn good again sometime in the future. 

This tendency is so often displayed by company managements. 

• During good times, they tend to get over-optimistic and take up massive debt-funded expansion plans by way of capacity additions or wasteful mergers and acquisitions. When the cycle turns and things turn sour, you see red ink all over their financial statements. 
• What is surprising is that even in bad times, a lot of companies are extremely shy to admit that things are not going too well. They tend to project and hope only what they wish to see and not what there is really. 

As investors, the best way to deal with this bias is to acknowledge that it exists in the first place. That is half solution done because most of the times we are not aware of our own biases. Then a very effective antidote to over-optimism is to challenge your views by asking yourself as many questions as possible. If your views cannot stand the attack of reason, you know which tendency is to be blamed. 

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

https://www.equitymaster.com/detail.asp?date=12/29/2011&story=4&title=Lessons-from-Charlie-Munger-IX

Lessons from Charlie Munger-VIII

Dec 15, 2011

In the previous article, we had discussed how you can make consistent stock returns by understanding and avoiding the trap of inconsistency-avoidance tendency. Today, we shall discuss a very basic tendency that often drives our thoughts and actions and is very relevant to our behaviour in stock markets. And in doing so, our aim is to help you identify dysfunctional behaviour patterns and thinking errors that may be hampering your stock market investments. 


Envy / jealousy tendency 

What do the words envy and jealousy bring to mind? Whatever they bring to mind, we often try our best to dissociate ourselves from them. Such is the taboo attached to these emotions that we do not want to link our behaviour and actions with them. Yet these very emotions are so innate to human nature that it is almost impossible to get rid of them. More importantly, given the crucial role that these emotions play in the human world, you could risk ignoring them at your own peril. 
So let's ponder a bit about the roots of envy and jealousy. Charlie Munger gives a very interesting evolutionary perspective on this, "A member of a species designed through evolutionary process to want often-scarce food is going to be driven strongly toward getting food when it first sees food. And this is going to occur often and tend to create some conflict when the food is seen in the possession of another member of the same species. This is probably the evolutionary origin of the envy/jealousy tendency that lies so deep in human nature." If these lines sound very geeky and clinical, let us elaborate in simple words. Food is very basic to the survival of any life-form. Without nutrition, no life can exist. So the chief life-long struggle of any creature is about securing the supply of food. Throughout history, the availability of food has dictated the survival or extinction of species. Given the utmost importance of this vital resource, a creature will be instinctively driven to possess the food the moment it notices it. The conflict arises when it sees food in the possession of another creature. This explanation, though difficult to verify accurately, does broadly explain the origin of envy and jealousy. And it extends to all other things other than food as well.


Envy and jealousy tendency in stock markets

It is often said that stock markets are driven by greed and fear. Sounds pretty neat, isn't it? But legendary investor and Charlie Munger's 'Siamese twin,' Warren Buffett, has an important interruption to make here. He very wisely points out, "It is not greed that drives the world, but envy."A patient contemplation of this sentence will reveal to you its utmost significance. While 'greed' refers to an excessive desire to possess something, 'envy' is a desire to possess what the other person is possessing. And more often than not, greed is fuelled by envy. A lot of times, we desire something simply because we see someone else enjoying it. Such human tendency of envy and jealousy is very well orchestrated in the stock markets, albeit in overwhelming proportions. Everyone is here not just to make money, but to make more money than what the next person is making. Comparison and competition is intense, creating a perfect recipe for jealousy tendency. Let us give you a couple of examples to elaborate our point:

a) Mr Gupta made 25% annual gain on his stock portfolio in 2007. He is quite satisfied. But then he learns that his colleague Mr Agarwal made a whopping gain of 300% that same here. Now Mr Gupta is distressed and feeling left out. His 25% gain now looks paltry in comparison to Mr Agarwal's triple-digit gains. He gets desperate to replicate his friend's success. In his frenzy, he ends up playing some stupid bets and loses quite a lot of money. 

b) Mr Rao has made a lot of money on certain stocks in recent times. Mr Desai, whose portfolio hasn't fared too well, is secretly disturbed, or in other words, jealous of his friend's prosperity. He decides to do exactly as his friend does, so that he would be as successful as him. Around this time, Mr Trivedi is extremely bullish on silver and places big bets on silver futures. Mr Sharma is tempted to copy. Despite not being in a very sound financial position, he jumps on the bandwagon and ends up burning his fingers. 

It is clear that it was jealousy that motivated wrong behaviour in both these cases. The list of such cases is long. The important point to take home is to not let such negative emotions affect your investment decisions. But isn't it a little too difficult to not feel bad if your friends and colleagues make a lot more money than you do? It is indeed difficult. So the best antidote in such a case is to avoid discussions that would trigger feelings of jealousy. In fact, some of the best investors in the world keep extremely low profile and keep their discussions limited to stock ideas and business fundamentals. In the absence of such external disturbances, they are able to make more rational investment decisions. 
We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=12/15/2011&story=1&title=Lessons-from-Charlie-Munger-VIII

Lessons from Charlie Munger-VII

Dec 8, 2011

In the previous article, we had discussed the roots and the consequences of the 'doubt-avoidance' tendency. Today, we shall discuss another extremely important human tendency that every serious investor should be well aware of.

Inconsistency-avoidance tendency 

Imagine what it would be like if you woke up every day and had to learn all the physical and mental tasks from scratch. It's impossible to even imagine such a situation. Thanks to the human brain, we don't have to bother about most tasks every single day. Through countless sets of programs, the human brain ensures our smooth and consistent functioning. Habits, which are patterns of behaviour which routinely repeat themselves subconsciously, are also a result of this process. While habits can be good, and good habits doubly so, there are several disadvantages as well. Habits often come in the way of any kind of change or transformation. As Charlie Munger puts it very aptly, "People tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong." 

This brings us to the inconsistency-avoidance tendency which is very rampant amongst human beings. In simple words, we filter away any piece of information which may be inconsistent to our ideas and beliefs. You may have read as students how many great scientists and discoverers were often discredited and ridiculed for their so-called lunacies. Many were acknowledged for their great work only after their death. Do you see how the inconsistency-avoidance tendency works? Not just history, even our day-to-day life is filled with such stories.


Inconsistency-avoidance tendency in stock markets

Our aim is not to profess psychology for its own sake but to attempt to relate it to human behaviour in the stock markets. Stock markets are largely driven by sentiment. So you must do your best to be as objective as you can and guard yourself from the lures of greed and fear. 

Getting back to inconsistency-avoidance tendency, can you remember instances when you have used this tendency to your own peril? We'll point out a few for your benefit:

Have you lost money on your favourite stock that had once been an outperformer? The company's prospects may have changed, it may no longer be worth putting your money into, but you still couldn't let go of it. Why? Because letting go of it would be inconsistent with your original beliefs about it. So you did everything to console and convince yourself that nothing was wrong. But your portfolio losses have a different story to say, don't they? 

Each investor will have innumerable such instances to share. Now the more important question, how exactly do you get rid of this tendency? There are several ways to do that, but more than anything else, you need to be very disciplined with your approach. 

• One great way is to play the devil's advocate. If you find a prospective company very compelling, first start with rejecting the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good, then it has passed the bar. 
• You can also take a good lesson from the court of law. Law courts have processes and procedures in place that tend to minimise hasty and biased decision-making, which can cost someone's life. As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in your mind. 

Always remember, stock markets will always keep swinging higher and lower. Investing opportunities will be there. We can assure you that if you can tackle with your inconsistency-avoidance tendency, money will consistently keep pouring into your bank accounts. 

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

https://www.equitymaster.com/detail.asp?date=12/08/2011&story=5&title=Lessons-from-Charlie-Munger-VII

Lessons from Charlie Munger-VI

Sep 29, 2011

In the previous article, we had discussed how the 'disliking and hating' tendency can be a threat to your investments. Today, we shall discuss a very important human tendency that every investor should undoubtedly not avoid.


Doubt-avoidance tendency 

The name itself is quite self-explanatory. Doesn't our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion? It surely does, and at times to our own disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must have developed in humans from their non-human ancestors. He asserts that it would be suicidal for a prey animal threatened by a predator to take a long time to decide what to do. The development of this tendency has come as a survival tactic in times of stress and confusion. Much of religious propaganda has in fact taken advantage of this tendency. How otherwise would you explain the immense faith displayed by people in religious decrees that will otherwise find difficulty to get past the check-post of logic? 
So the evolutionary justification of this tendency is reasonable. But the problem with any kind of psychological tendency or mental programming is that it doesn't work well in all situations. Say, a person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly the opposite.


Doubt-avoidance tendency in stock markets

Have you observed the doubt-avoidance tendency manifesting itself in the stock markets? The answer is a loud 'yes' in our view. How often do you trade on impulse without asking the right questions? How open are you to hear negative things about stocks that you are very optimistic about? When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising. The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided. Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity. 

Without any exaggeration, we strongly believe that if you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor. 

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

https://www.equitymaster.com/detail.asp?date=09/29/2011&story=2&title=Lessons-from-Charlie-Munger-VI

Lessons from Charlie Munger-V

Apr 7, 2011

In the previous article, we had discussed how loving your stocks too much can distort your perception and in turn be a threat to stock investing. Today, we shall discuss the other extreme of the emotional spectrum: how feelings of dislike and hatred too can derail your investments. 


Disliking and hating tendency

Take the recent Cricket World Cup. Rewind back to the semi-final match between India and Pakistan. Was it a cricket match? Or was it war? War it was! The high-voltage match that ended with India beating Pakistan saw our feelings of patriotism and national pride touch the sky. But it's not pride for India alone that makes us so jingoistic. There's also an intense hatred towards Pakistan that equally nourishes that feeling. So we get back to where we started- emotions and biases. 

From the time we are born, we learn to dislike and hate the same way as we develop tendencies to like and love. The history of human evolution boasts of almost continuous wars. Neither religion, nor advancements in civil life have done much to change the basic savage instinct. And wars are not the only way in which hatreds find expression. In more sophisticated societies, hatreds and dislikes find expression in more non-lethal things such as elections, sports and even stock markets. 

Charlie Munger has very aptly explained how the "disliking & hating tendency" acts as a conditioning device:

• We ignore virtues in the object of dislike
• We dislike people, products, and actions merely associated with the object of dislike
• We even tend to distort other facts so as to justify our hatred.

Do you recall a promising stock that you had fallen for faltering miserably? There may have been some unfortunate event or probably a cyclical downturn. Maybe your timing wasn't right. Or maybe, the markets were just too pessimistic and overreacting at that moment. But your instinctive reaction could have been that of disappointment and anger. In your fury, you may have even decided never to put money in such a money-sucking monster.

This kind of biased approach to investing could be very detrimental to your stock portfolio. While negative events should be viewed diligently, you will be better off if you fairly consider the pros and cons of every situation. You never know, your blind dislike for a certain stock or sector could destroy a potential multibagger

https://www.equitymaster.com/detail.asp?date=4/7/2011&story=2&title=Lessons-from-Charlie-Munger-V

Lessons from Charlie Munger- IV

Mar 3, 2011

In the previous article, we had discussed how a wrong set of incentives across the entire economic system was responsible for the US financial crisis. Today, please do not panic, for we are going to talk about love.


Liking and loving tendency

Love is one of the most basic of emotions. The very first manifestation of it is between a mother and the new-born child. For a child, this earliest experience has far reaching effects. The child learns to love and to be loved in return. It becomes a kind of a programming device. And it extends not only towards people, but also towards things, ideas and concepts. Of course, the child learns to dislike and hate as well. But we'll limit this piece to our tendency to love and to like.

This tendency to love has its own set of side effects. It acts as a conditioning device and often distorts our perceptions. To make it simple, think of someone you love- your spouse, your kid, your favourite actor or cricketer. You could also think of any idea or belief that is very dear to you. Now ask yourself these questions:

• Do you tend to ignore their faults? Do you readily comply with their wishes?
  
• Do you favour people, products, and actions merely associated with them?
  
• Do you distort any unpleasant facts about them?

Now why are we talking about all this? Has it got anything to do with investments and stocks? Most certainly yes! We are firmly of the belief that being a successful investor requires discipline and a sound emotional make-up.

Have a look at your stock portfolio. There is one very common error that most investors do with stocks that they own. Once they have bought a stock, they automatically start developing a feeling of affection towards it. Don't we often hear people raving about certain blue chips with an admiration that borders around reverence? Any negative comment about them will either be ignored, dismissed or defended. It almost seems like a marriage brimming with loyalty and affection. Take the so-called "hot" sector stocks. Don't they often cause many a feeble hearts to melt? And what happens to all thoughts about business and valuation? Well, well, well... You know best. We dislike challenging and reasoning with things and ideas that we love.

Our bottom line is this. Do fall in love, but not with your stocks. Love your capital and do the best you can to protect it and to help it grow. And what better of doing that than being a disciplined value investor!

https://www.equitymaster.com/detail.asp?date=3/3/2011&story=6&title=Lessons-from-Charlie-Munger--IV

Lessons from Charlie Munger- III

Jan 13, 2011

In the previous article, we had discussed the influence of incentives at the level of individual firms and some antidotes for investors. In this article, we'll discuss the power of incentives in the context of economic systems. 

We all are part of various systems or groups- from a micro-system like a family to a macro-system like an economy. If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives. They may be in the form of rules, regulations, norms, customs, traditions, mores or ethics. And you see them everywhere, don't you? Be it religion, politics or economics, every system is made up of these elements. 
We'd like to point out to you how the success or failure of any economic system depends on how incentives and disincentives are designed. Let us explain.


What made the free-market economy work?

The success of the free-market system as an economic system comes from its inherent reward-punishment mechanism. Owners have a strong incentive to prevent all waste in operations. Their businesses will perish in the face of brutal competition if they are not efficient. Replace such owners by salaried government employees and you will normally get a substantial reduction in overall efficiency. 

Communism has failed due to the absence of exactly those incentives that have motivated private enterprises to flourish in democracies. The fall of the Soviet communists is a glaring example of wrong system design. But one may also point the knife at the US- the epitome of free-market economy, for bringing in one of the worst financial crises ever. What really went wrong? Well, there is not just one simple answer to this. But we'll restrict our discussion to the main theme of the article.


The US financial crisis: an outcome of wrong incentives and absence of disincentives 
It is fashionable to bash up the US Fed and the big investment banks for all the menace they created. But blaming them alone would do us more harm than good; because the crisis was a failure of the entire system and not the outcome of a few crooks alone. In one part, the financial crisis was a result of a series of incentives that induced unscrupulous behaviour across the entire system. The other major mishap was a complete dearth of penalties for wrong behaviour. Looking back, the evidence comes out pouring, often overwhelming.

Though it is not widely discussed, the original subprime lenders of the 1990s had already gone bust by turn of the century. A child could point and say, "Don't make loans to people who can't repay them." Simple. But amusingly and frighteningly, the lesson learnt was a bit complicated: "Keep making such loans; just don't keep them on your books." The lenders made the loans, and then sold them off to the fixed income departments of big Wall Street investment banks. These investment banks in turn packaged them into bonds and sold them off to investors. So the originator of loans had little incentive to bother at all about creditworthiness. On the other hand, there was hardly any penalty to curb his recklessness. As Mr. Raghuram Rajan, a leading economist who saw the crisis unfolding as early as 2005 noted, "Incentives were horribly skewed in the financial sector, with the workers reaping rich rewards for making money but being only lightly penalized for losses." 

Also, the problem was not that no one warned about the dangers. It was that those who benefited from an over-heated economy- which included a lot of people- had little incentive to listen. So everyone enjoyed this "passing the parcel (read atom bomb)" game as long as the music played. And we all know what happened after the music stopped.

India 2010: A carnival of scams

We just emphasised the omnipotence of incentives and how a flawed reward-punishment mechanism can bring about the collapse of a giant system. It is quite clear that man responds more often and more easily to incentives than to reason and conscience. Didn't we see this axiom crystallizing before our own eyes with the cracking of a series of scams last year? Again, we will not arrive at an effective solution if the issue is not addressed at the most fundamental level. Firstly, we have to accept that man is fallible and corruptible, if the situation so allows. So the solution does not lie in moralising individuals alone, but more importantly, in creating robust systems that reward fair and ethical behaviour and deter deceitful practices. 

https://www.equitymaster.com/detail.asp?date=1/13/2011&story=5&title=Lessons-from-Charlie-Munger--III

Lessons from Charlie Munger- II

Jan 5, 2011

In the previous introductory article, we briefly discussed Charlie Munger's multidisciplinary approach to investing. Starting with this article, we'll discuss his list of "24 Standard Causes of Human Misjudgment" and understand how they have powerful implication for investors.

Reward and Punishment Super-response Tendency

Why do we do what we do? Why are we tempted to do certain things while refraining from others? Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the same time avoiding or reducing pain. In any given circumstance, we assess the risks and the associated rewards and respond in a way that seems to best serve us. With this premise, it is imperative to understand the role of incentives and disincentives in changing cognition and behaviour. 

The power of incentives

There is this interesting case of the logistics services major FedEx Corporation. The integrity of the FedEx system required that all packages be shifted rapidly among airplanes in one central airport each night. And the system had no integrity for the customers if the night work shift couldn't accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right thing. They tried moral persuasion. They tried everything in the world without luck. Finally, somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. So maybe if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And that solution worked just perfectly. This is a classical case of the power of incentives and how they can be used to produce desirable behavioural changes. 

The abuse of incentives

One of the most important consequences of incentives is what Charlie Munger calls "incentive-caused bias." The following example will explain the same. Early in the history of Xerox, Joseph Wilson, who was then in the government, had to go back to Xerox because he couldn't understand why its new machine was selling so poorly in relation to its older and inferior machine. When he got back to Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse incentive to push the inferior machine on customers. An incentive-caused bias can tempt people into immoral behavior, like the salesmen at Xerox who harmed customers in order to maximize their sales commissions.

The story of mutual funds in India is quite similar to that of the Xerox case. Mutual funds that offer the maximum commission to distributors are the best sold funds. Also, consider your own stockbrokers. There will be seldom one who will not lure you to trade too often. And seldom will a management consultant's report not end with an advice like this one: "This problem needs more management consulting services." Such behavioural biases exist in most places and situations. And human nature, bedeviled by incentive-caused bias, causes a lot of ghastly abuse. 


Some antidotes for investors

For you investors, we believe it is important to understand the motives and incentives of people and organisations you're dealing and investing with. Everyone ranging from the company you're investing in to your stockbroker, your mutual fund agent and your equity advisor (yes, even we) must pass your scrutiny.

Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor. The general antidotes here are:

1. Especially fear professional advice when it is especially good for the advisor.
2. Learn and use the basic elements of your advisor's trade as you deal with your advisor.
3. Double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.

https://www.equitymaster.com/detail.asp?date=01/05/2011&story=5&title=Lessons-from-Charlie-Munger--II

Lessons from Charlie Munger- I

The Multi-disciplinarian

Both men have as many striking differences as similarities. One may typecast Buffett as purely an investor and philanthropist. And quite rightly so, for the man devotes his time almost exclusively to his business. Munger, on the other hand, is a generalist for whom investment is only one of a broad range of interests. In many ways, his personality has traces of his own hero-Benjamin Franklin, who along with being a great scientist and inventor, was also a leading author, statesman and philanthropist, and played four instruments. On similar lines, Munger hops around science, architecture, psychology and philanthropy with as much passion and curiosity as he does with business and investments.

Thinking errors and misjudgements

Munger very aptly follows this multidisciplinary approach in all kind of situations. He draws influences from fields as diverse as physics and psychology to his investment process. For long, he had been interested in standard thinking errors. Without diving much into academic psychology textbooks, he developed his own system of psychology more or less in the self-help style of Ben Franklin. In a series of articles that will follow, we will pick up insights from a speech that Munger gave on "24 Standard Causes of Human Misjudgment". But before we start discussing these thinking errors, let us tell you why these lessons have very powerful implications for investors. 

Do we behave like ants?

We may take great pride in our evolutionary superiority over other creatures. But we also often behave like ants. Strange? Not really. Munger has pointed out some very intriguing observations about the behaviour of these social insects. Each ant, like each human, is composed of a living physical structure plus behavioural algorithms in its nerve cells. Mostly, the ant merely responds to stimuli with a few simple responses programmed into its nervous system by its genes. For instance, one type of ant, when it smells a pheromone given off by a dead ant's body in the hive, immediately responds by co-operating with other ants in carrying the dead body out of the hive. Harvard's great E.O. Wilson performed one of the best psychology experiments ever. He painted dead-ant pheromone on a live ant. Quite naturally, the other ants dragged this useful live ant out of the hive. This despite the poor creature kicked and protested throughout the entire process. Such is the brain of the ant.

Of course, our brain is far more complex and advanced. Ants don't design and fly airplanes. But under complex circumstances, don't we also find ourselves behaving counterproductively just like ants? And aren't stock markets a perfect playground for this kind of behaviour? We'll discuss this and a lot more in the forthcoming articles. 

https://www.equitymaster.com/detail.asp?date=12/29/2010&story=6&title=Lessons-from-Charlie-Munger--I&utm_source=archive-page&utm_medium=website&utm_campaign=sector-info&utm_content=story

Charlie Munger - Conservative investing with steady savings without expecting miracles is the way to go.

Charlie Munger

Charles Thomas Munger (born January 1, 1924, in Omaha, Nebraska) is an American business magnate, lawyer, investor, and philanthropist. 

He is Vice-Chairman of Berkshire Hathaway Corporation, the diversified investment corporation chaired by Warren Buffett; in that capacity, Buffett describes Munger as "my partner." 

Munger served as chairman of Wesco Financial Corporation from 1984 through 2011 (Wesco was approximately 80%-owned by Berkshire-Hathaway during that time). He is also the chairman of the Daily Journal Corporation, based in Los Angeles, California, and a director of Costco Wholesale Corporation. 

Like Buffett, Munger is a native of Omaha, Nebraska. After studies in mathematics at the University of Michigan, and service in the U.S. Army Air Corps as a meteorologist, trained at Caltech, he entered Harvard Law School, where he was a member of the Harvard Legal Aid Bureau, without an undergraduate degree. - Wikipedia 

"It's in the nature of stock markets to go way down from time to time. There's no system to avoid bad markets. You can't do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go." - Charlie Munger

https://www.equitymaster.com/outlook/charlie-munger/charlie-munger-value-investing.asp

Stay Rational in the Downturn

By Emil Lee 
January 22, 2008 

There's been a bloodbath in the markets lately. Investors, banks, and investment banks are all trying to stay afloat in a sea of red ink.

Forgetting about the happier, more bullish times is easy to do when circumstances turn against us, but we must do our best to stay calm. To keep your cool as a rational investor, here are a few wise words to remember when dealing with the stock market's ups and downs.

It happens, even to the best investorsYou can easily feel isolated when you're handed huge losses, but even the best investors falter.

Charlie Munger, now vice chairman of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , ran an investment partnership called Wheeler, Munger & Co. back in the '60s and '70s. Munger's partnership performed admirably and trounced the indexes. However, in the brutal bear markets of 1973 and 1974, it recorded back-to-back annual losses of 31.9% and 31.5%, compared with losses of 13.1% and 23.1% for the Dow.

Wheeler, Munger & Co. persevered. It returned 73.2% in 1975, and Munger went on to become a billionaire with Berkshire Hathaway. I'm skipping the interim details, but the moral of the story is: Just because you're sitting on a big loss doesn't make you a horrible investor.

Some losses are temporaryAn article in the latest issue of Barron's noted that private-equity firm Warburg Pincus remains committed to its capital infusion of $500 million into besieged bond insurer MBIA (NYSE: MBI  ) , even though its cost basis will be about $31 per share, compared with the current trading price of around $11.43 per share.

In the article, a Warburg spokesperson pointed out that the firm's early '90s investment in Mellon Bank -- now part of the Bank of New York Mellon (NYSE: BK  ) -- also rang up a sharp loss before it turned into a huge gain.

Time will tell whether Warburg's patience will be rewarded. It's worth noting that successful firms and investors draw a sharp distinction between temporary and permanent losses of capital.

Bill Ackman, a prominent bear on the other side of MBIA trade, feels the same way about differentiating between temporary and permanent losses. His large stake in Target (NYSE:TGT  ) plummeted as investors dumped recession-prone stocks.

However, Ackman pegs Target's worth, given its valuable underlying real estate, credit card receivables, and strong cash flows, at $120 per share, and on Bloomberg.com he said that Target "is a case actually where I think a mark-to-market loss is not a real loss." In other words, as long as an investment thesis remains intact, Ackman doesn't consider a stock that's down because of short-term market movements is a permanent loss.

Look for buying opportunitiesIf the stock market will make us suffer huge losses, the least we can do is take advantage of the great prices. If you've ever wondered how Warren Buffett does what he does, one crucial factor is when he does it.

During the banking crisis of the early '90s, when everyone else was running for the exits, investors such as Buffett and Prince Alwaleed made fortunes buying huge stakes in ailing banks, including Wells Fargo (NYSE: WFC  ) and Citigroup (NYSE: C  ) . When everyone else was dumping stock, the smart guys were looking to buy.

Foolish thoughtsKeeping your composure isn't easy when the stock market plummets. However, Fools need to stay rational and composed to make the most of a temporarily bad situation.

http://www.fool.com/investing/value/2008/01/22/stay-rational-in-the-downturn.aspx

Comment:  Warren Buffett "timed" his buying of the market during the Global Financial Crisis.  He asked the public to buy in October 2008 when the Lehman collapsed.

How to analyze real estate developers

How to analyze real estate developers

Real estate stocks make up a significant number of companies in Asian stock exchanges and many of them are among the the most volatile stocks. Whether the real estate developer is listed or not, they are influenced by a host of cyclical factors ranging from government policies, interest rates, unemployment rates, affordability, etc. Hence, it is important to understand how real estate companies can be analyzed.


Profit Model

Real estate industry can be separated into the following sub-industries or types of real estate developers:

1. Residential real estate developers
2. Commercial and mixed use real estate developers
3. Industrial real estate developers

Profit model of residential real estate developers

Residential real estate developers are more dependent on economies of scale than ever because of increasing land prices and declining rate of increase in residential property prices. In many developing countries, developers used to be able to acquire land at cheap prices and hope for rapid increase in home prices to make huge profits. In developed countries, land prices are higher, and price increases are more muted. Hence, brands and good management are playing an increasingly important role.


Profit model of commercial real estate developers

As prime real estate for commercial developments become more scare, commercial real estate developers tend to prefer to have rental incomes rather than selling units so that they can have consistent income and manage the properties. These developers are also more likely to sell their commercial properties to real estate investment trusts to free up capital and many are REITs that also develop properties.


Profit model of industrial real estate developers

Industrial real estate developers operate more like commercial real estate developers as they seek to have stable rental incomes and also sometimes selling their properties. Some industrial estate developers might even have a fund to invest in promising industrial companies so as to achieve higher profits.



Factors that Affect Value

1.  Land bank - the value of a real estate developer is directly influenced by its land bank. As the larger the land bank, usually means the developer can make more profits from developing the land banks later. Hence, the land bank that a real estate company has is always disclosed in detail in the listed companies' reports.

2.  Inventories - Real estate inventories can be separated into a few categories. Usually increasing values of construction-in-progress and land held for development will translate to higher future earnings for the company:

• Completed developments - properties whose construction has been completed
• Construction-in-progress - means the value of properties under construction.
• Land held for development - value of land help for future developments.
• Investment properties - properties held for rent or sale

3.  Customers deposits - for residential projects, it is often that developers will collect customers deposits or even prepayments of entire houses prior to completion of the units. As these properties are pre-sold and their profit and loss have yet to be recognized in the income statement, growing customer deposits could signal increasing revenue and most likely profits in the coming years ahead.

4.  Housing prices - the profits from real estate developers that primarily sell their developments come from selling the units at above costs. Hence, the moving of housing prices have direct impact on the profitability of residential real estate developers. Usually the stock price of real estate developers have high correlation with the anticipated housing price direction.

5.  Rental rates - Rental rates are especially important for commercial and industrial real estate developers as most of them do not sell all the units that they developed but they keep these units for rental returns. Rental rates have direct bearing on stock prices of such developers and REITs.

6.  Industry consolidation - as economic difficulties mount and economies of scale becomes more important, mergers and acquisition activities will also drive prices of real estate companies as the merged entities might be more efficient given a larger land bank.

7.  Macro economic factors - government policies play a huge role in controlling property prices as the following factors will determine the direction of property prices. We have listed

Factor                 Movement      Likely Effects
Interest rates         Up                Negative
Land supply          Down            Positive on short term price but will affect future
                                                  profitability if land bank dries up
Loan Quantum      Up                 Positive
Reserve ratio         Up                Negative
GDP                     Up                Positive
Unemployment      Up                       Negative




Valuing Real Estate Developers

A common method to value real estate developers is using the Revalued Net Asset Value ("RNAV") approach which basically determines the net asset value of a real estate developer by adding up

• the change in value of the investment properties held by the company, 
• the surplus value of properties held for development using Discounted Cash Flow method and 
• the net asset value of the company with any other adjustments that are deemed necessary.

Usually a discount or premium percentage is multiplied with the RNAV base on the developers other qualities such as management capabiltiies, branding, track record, etc. A smaller developer with poor record of continuously generating consistent income is usually given a significant discount to its RNAV.

Using the RNAV approach only takes into account of what the developer can earn with the assets that it has in its books at the time of the valuation. If properly applied, it is usually more conservative than the market approach such as P/E multiples.

However, to use this method, it requires a lot of work in revaluing the properties held by the developer, making it difficult to implement by most people as information needed to determine RNAV needs some skill in obtaining.

The price earnings ratio method could also be useful to cross check the RNAV method.

Source: http://roccapitalholdings.com/content/how-analyze-real-estate-developers