The Successful Stock Investor

Imagine a world where everyone was equally intelligent, with identical psychological traits and access to the same information. What purpose would the stock markets serve then?

I’ll answer that – None.

The business of stock Investing thrives on these 3 things – Intelligence, Psychology and Information. After closely observing many successful stock investors, I have realized that having ‘only one’ of these traits could actually do a lot more harm to your portfolio than you can imagine. You need at least ‘two of the above traits to formulate your style of making money in the markets. Of course, if you manage to master all three, then I see no reason why you could not be the next ________ (fill in the name of who you think has been the most successful stock investor of all times).

Nevertheless, of these, Intelligence I believe is the easiest to acquire and you don’t need more than what it takes to do basic numbers and read indexed content. Information is purely incidental to one’s closeness and familiarities with those who may be better placed or better aware of certain realities. By all means, you should try to spend more time with such people. In contrast, human psychology is something which is hard to adjust to a desired state of being. Those who are able to discipline their minds need to do little more to succeed in stocks, as indeed in life. Again something I learnt by years of digging deep into the way of being of those who have been successful at making money in stocks.

Later in the course you will read many things about ‘financial ratios’, ‘value’, ‘fundamentals’ and what not. Understanding those concepts will help you make good investments and avoiding the bad ones. Let me state upfront, all that knowledge put together will not stand a chance against psychological traits like greed, envy, fear etc.

You will buy stocks because everyone is buying them and sell them for the same reason. You will often look at a friend who made a fortune in the stock markets and envy him. Oftentimes, you will start buying and selling based on how that friend does things in future. Each of which could have tragic consequences. No matter how much I try to convince you of this, there is all likelihood that you will commit these very mistakes in future. Please don’t!

Don’t believe me? Let’s conduct an experiment.
People often ask me about my investment rationale. I find it difficult to answer this question. Mostly because I try to come up with a better answer every time, while knowing full well how ridiculously difficult it is to come up with an inspiring answer to that question. Depending on how much time the inquirer has I could nevertheless come up with a very lengthy answer – I research; I look for well managed companies; I look for strong financials; I look for businesses which are likely to grow in future; all of the above. Repeat using different terminology and all of the above again. Basically, write it in a million different ways. I have seen many successful stock investors who write a well defined investment rationale ranging from half a page to a few pages. I like reading them all but I never strictly follow one of my own. This is because, besides these basics which are absolutely essential to me, I am myself not sure about what may get my attention. If I find “a young company operating in a niche growing market” of course I will research further. Just that, how many such situations may get me excited is hard to write down. Besides, it’s futile for I can’t cover for every possible situation which may merit further investigation.

Now then, I have always bought and sold (mostly bought) shares based on my estimation of future growth. Like every single investor, my estimations have been right and wrong. The fact that I have managed to consistently grow my portfolio, despite operating in the slowest years (2008-2013) of stock markets, has assured me that it may not be too ambitious of me to aim for higher returns in future.

I often look back at my stock picks to evaluate my decisions after passage of some time (never more frequently than 3 months unless something screamingly irregular happens). Every time I do that exercise, I realize how picky I am with most of my investable fund, about 60% of which at any given point is allocated towards long term investing (with at least a 3-5 year time horizon in mind).

In all, I have made 5 big share purchase decisions over the last 6 years. When the markets crashed in 2008-09, I invested a lot of my money in Yes Bank share, which was still a young and upcoming bank back then. I bought it at Rs. 77 for a share in April of 2009 and sold my entire holding at Rs. 449 in December of 2012. I bought United Spirits share at Rs. 883 in late 2011 (after which it declined to below Rs. 500). I am still strongly holding on to my entire holding. Just at the beginning of this year, I purchased a lesser known company, First source Solutions, when it was trading below Rs. 10; I even released a marketing video for it (you can watch it here if you are still keen on it). Again, I am still holding on to it with conviction.

At the same time, I did not buy an ITC when it traded at Rs. 194, in late 2012, despite many hours of debate with those who racked up on it. For those who have followed my research and writings will see how much research and experimentation has been put out on ITC stock and yet I did not buy it.

Our website is embarrassingly filled with ITC examples, search for ‘DCF sana’, or ‘BCG matrix sana’ on Google and you will find that it’s all performed using ITC financials. The research then is a proof of how close I got to buying it.

ITC stock has nearly doubled since then.

Anyways, if you are in doubt, avoid it, and that’s what I did. There are always opportunities in the market which beat the previous growth records of some of the finest companies. Just yesterday, after months of research I decided to invest in a company which I sincerely believe could give me multiple returns over the next few years. My research lasted over a month during which time the stock moved in a 30-40% range. Yesterday when I bought it, the stock was almost 22% higher than where it was when I started looking at it. I am confident that this is just the beginning.

You don’t have to answer this to anyone but yourself – Are you already convinced that this company has great financials?

Was my story of riches in stocks (which you may never be able to verify), at least worthy enough so as to create curiosity to know more about this company, so perhaps you can research further?

Really?
Would you have been more curious, had a well sought after market expert on prime time television told you about that company? Or may be that friend of yours who made a fortune in stocks ? Over and over again, random companies with poor financials backed by the ‘blue eyed boy’ of TV news get purchased. Tragically, they often get researched before getting purchased. But again, with some nice talk to go with it, you may find a good enough reason to believe that the ‘blue eyed boy’ is the most successful stock investor of the present day.

Amongst the many psychological traits which have an impact on your subconscious mind, the two strongest ones are – (i) Overreaction and herding; and (ii) Overconfidence.

Overreaction and Herding: People tend to overreact to both good and bad news. For Example: if the quarterly results of a company are not good, a typical investor response is to sell his holdings even before understanding the reason(s) for the bad results. This has a disproportionately negative effect on stock prices. Similarly, a small incentive from the government to a particular industry or sector often results in fanatic buying of shares, of companies operating in that industry.

Investors also tend to imitate each other. Whether prices are moving up or down, they fear that others know more or have more information which makes them do what others are doing. This has traditionally been the most mindless, yet the most commonly performed act in the stock market (in my experience, this trait extends beyond stocks). These days everyone seems to be buying houses. Buying any land whether commercial, residential or some sort of a hybrid mix of the two, all seems to be in vogue. Often in localities where prices have consistently run up over the last 10 years or more. But again, I guess consistency fuels overreaction and herding.

Interestingly, using the skills of basic observation, I realized that those who are convinced that property prices will keep raising (may be because of an ever increasing population of the planet or for any other similar reason), are also the ones who firmly believe that so many investors and real estate advisers can’t (collectively) be wrong. I guess it’s about getting solace in the company of other distinguished thinkers. I don’t want to alarm anyone and I hope I do not sound stupid when I draw your attention to one of my all time favorite reads – the very first law of Human Stupidity put forward by Carlo M. Cipolla:

“Always and inevitably everyone underestimates the number of stupid individuals in circulation”.

For more on this research you could search for “Cipolla’s laws on human stupidity”.

Note: I express no views on investing in real estate as an asset class. I am not trained on the matter, nor involved in the subject. The commentary is meant only to explain the psychological trait of overreaction and herding.

Overconfidence: In general, people like to think that they know more than others which makes them overrate their own abilities. Overconfident investors not only make careless decisions for themselves but they also influence other market participants by their decisions. As the price of a stock recently purchased by an investor rises dramatically, it will form an opinion in his mind that his judgment is correct, making him believe in his expertise. As the price moves up further, the same investor starts believing in his abilities more than ever. This overconfidence often results in further mindless buying.

I read the best illustration on the subject in Nassim Taleb’s classic book, Fooled by Randomness.

A group of people participated in a contest of flipping coins and predicting the side on which the coin would land. Each contestant would play against the other in rounds of elimination until they reached a winner. After a few rounds when only some contestants remained (who of course had been successful in predicting the landing of the coin on all previous occasions), they were interviewed and asked how they managed to be successful each time. Many of them answered that they had mastered the technique of flipping coins. Of course, the probability of the coin landing on either side remained an exact 50%, in each case.

Many other psychological biases could influence your thinking and decision making, greed and fear being the other common ones. The list could be endless and it may not help to read a long list of biases to try and change your personality. It takes immense control and self discipline to hold on to your conviction, especially when people around you are making a lot more money based on theirs. If you have done your research right, stop looking around to see how much money is being made or lost, just hold on to your stocks and you will make a lot of money.

Remember, the nature of investing is such that those who rightly forecast before others are rewarded the most. One of the traits of a successful stock investor is that he strongly holds on to his conviction even when he finds himself in rare company.

Recommended Reading:
How to Start Investing in Stocks