This podcast episode and article answers the following questions:
- Who is Ravee Mehta and what is his book, The Emotional Intelligent Investor, about?
- What is Benjamin Graham’s Mr. Market?
- Are investors rational?
- Why risks come from not knowing what you are doing?
- Ask The Investors: How much of my portfolio should I invest in ETFs
Stock investing is not child’s play and the faster you understand how the game works, the better for you. Don’t ignore the role of psychology when it comes to stock investing because emotions often play a key role in investing and other financial matters. We often let our pride, ego and other prejudices overcome our logical reasoning and end-up making bad decisions. But, what if we were able to control these feelings and actually benefit from them? Well that’s where our guest, Ravee Mehta comes into the equation.
Who is Ravee Mehta and what is his book The Emotional Intelligent Investor about?
Ravee Mehta is the author of, The Emotional Intelligent Investor. His book talks about how people can use their emotions and intuition to become better stock investors. Ravee knows what he is talking about. With a background from the distinguish business school at Wharton, and several years of experience working for investors like George Soros and other capital management funds, he has already bought and sold more stocks than most people do in a lifetime.
Ravee finds that while a fundamental analysis should be a prerequisite for successful investors, you need to blend qualitative and quantitative analysis with technical analysis to have the best results. As an investor with experience you recognize certain patterns and sometimes you simply have an intuition about certain businesses or decisions. This might not seem logical to many people, but Ravee’s counter-argument is that there has to be a reason why investors like Warren Buffett perform better than super computers.
A computer can scan all the stocks in the world, but Warren Buffett only looks at a few companies (relatively speaking) and has better results. However, his intuition, alongside his highly analytical skills, tell him where he should search for potential investments.
All investors have biases, or said in another way, all investors can react irrational. To cope with this known deficiency, one must first become self-aware. For instance Ravee claims that he has a tendency to lock-in his gains to quickly. Since he recognizes this deficiency, he has set-up rules that can help mitigate this decision from taking place in the future. This was one of the main learning points that Ravee took-away when working at Karsch Capital. After making mistakes he was forced to constantly review and learn from them. We have found that great investors, like Ravee, Guy Spier, and Mohnish Pabrai have checklists where they write-down previous mistakes to ensure they don’t repeat them. Most importantly, they try to study the mistakes of other great investors so they don’t have to learn from personal experiences. The learning process grows exponentially when you learn from other people’s experiences instead of solely your own.
With that said, one of the most influential speeches on psychology and investing ever given was by Warren Buffett’s Vice President, Charlie Munger. In Ravee’s book, he talks about Munger’s speech at Harvard Law School back in 1995. You can read the speach, titled: The Psychology of Human Misjudgement, or listen to an audio here. Additionally, you’ll want to listen to our interview with Ravee to learn more about his opinions on emotions and how they impact an investor’s financial decisions.
Benjamin Graham’s Mr. Market
Aside from Ravee Mehta, few people probably understand the emotions better than Benjamin Graham. Benjamin Graham who was Warren Buffet’s professor in Columbia University is also the author of The Intelligent Investor, which was first published back in 1949.
The book sold millions of copies and Mr. Buffet attests to the fact that it is one of the best books ever written on investments. Graham emphasizes that one should focus on the value of a company instead of speculating wildly about the rise or fall of stocks. The best part of his theory is that it’s possible for a common man to invest in companies, without getting affected by the hysteria that takes over the market.
Graham highlights the importance of investment principles that worked regardless of the major fluctuations in the government as well as the society. His theories work great for patient, confident, people, since investors need to be able to tune out market hysteria, otherwise known as ‘noise’. In addition, it is vitally important for an investor to not panic or get depressed due to bad investment choices.
Benjamin Graham also made sure that his theories were easy to understand and introduced the idea of “Mr. Market” in his book. The Mr. Market story, an allegory, teaches students how decisions driven by confusion, panic, and euphoria lead to poor results. Graham asks readers to imagine that Mr. Market is a business partner. So consider Mr. Market as your partner, but what would you do if he approaches investment options based on his reactive and emotional mood, instead of adopting a logical and calm approach? What if he offers a chance for you to buy shares at a low price and later sell them at a higher price in only a day? With bad judgment clouding his mind, he thrives on extreme moods ranging from euphoria to depression. When things in his world are upbeat, he offers stocks at a high price to you, but sometimes, he becomes way too pessimistic and decides that the company’s future is going south, so he offers the shares at a very low price.
But wait, there’s more… The best part of this entire scenario is that you get to call the shots. You either accept or reject Mr. Market’s offer. And oh, don’t think twice if you want to reject him because he doesn’t have feelings. Really, he won’t mind. So, make your decisions after your strong convictions and research shows you the financial state of a company.
Although top investment experts like Graham and Buffet advocate various principles for investments, many of us are guilty of making irrational decisions based on our emotional state. It’s easy to panic when you see stocks plummeting, but you should be able to look at the big picture. The word ‘intelligent’ in the book doesn’t refer to people who are math whizzes or scientists, but it simply means that people who are able to control their emotions with a long-term goal in their mind are more likely to succeed. You can’t expect to become a billionaire in a day, can you? So, stay calm and replace your fluctuating emotions with cold, hard logic.
It is also important to note that businesses remain the same, regardless of Mr. Market’s good or bad moods. Remember that you’re an investor, but not a speculator. Mr. Market is not out there to guide you but it’s actually the opposite. It’s almost always impossible to speculate the outcome of various events, let alone stock investments, so stock trading can be dangerous for you if you are a mere speculator. But if you’re a true investor, you would be more concerned about the quality and value of the company you’re investing in. To put it bluntly, you’re doomed if you purchase stocks driven by your emotional fever.
On the other hand, an intelligent investor is someone who rarely tries to change the direction of the market. He isn’t someone who succumbs to the erratic behavior of Mr. Market, because the stock market acts like a voting machine in short term, but behaves like a weighing machine in the long term. This means that the stock price will show its true value gradually, and the person holding the most shares in the end is the one who has truly accumulated real value. This also proves that stock trading isn’t for people looking to make a quick profit.
Graham also raises an important point. He advises that it’s always best to have a ‘Margin of Safety’ when an investor invests in a company. This means that it’s recommended to buy stocks when the price is way below the intrinsic value of the company. Most importantly, this could lead to profits, especially when the market revalues its stocks to the fair value. On the other hand, this also provides a cushion for you if things go haywire and the business fails. It is important to indulge in investments with this mathematical approach.
Apart from that, the psychology of the market plays a huge role for several people. For instance, if you see cars changing lanes ahead of you, you tend to do the same thing because you’re expecting a accident, right? Similarly, our psychology often depends on what others are buying or selling in the market. If everyone’s buying, we tend to buy more and if everyone’s selling, we do the same.
Warren Buffet drives the point home with his famous quote – “Be fearful when others are greedy, and be greedy when others are fearful.” This simply means that you need to perceive the fear in the market to make accurate decisions. As investors are filled with fear, greed, and envy, they tend to fail in the stock market. Consequently, they buy when they are supposed to sell and vice versa. It sounds impossible, but in order to become a successful investor, you need to be able to ignore the greed and fear of the people in the market around you. This truly comes from increasing your knowledge of investing. This can be done by studying accounting, general investing principals, and also making reasonable assessments about yourself, like Ravee Mehta recommends.
Are Investors Rational?
Graham states that there are two types of investors, namely the passive and the active investors. While the passive investor treads cautiously and invests with the long-term future in mind, an active investor tends to seek investments that offer quick profits in the market. You could either be an active or a passive investor, depending on what your goals are, but no matter what you are, you must be a rational investor. With this mindset, you will be able to distinguish between companies that are going to fail and the ones that are going to succeed. As a rational investor, you will also be able to remove yourself from the paranoia that surrounds the market.
The point is to remain calm here. Consider an athlete for example. Let’s assume that one player is driven by adrenaline, pressure and the limelight that surrounds him. He is all set to play, but obviously, he is more influenced by emotions. The other player is calm, controlled and is all set to play too, but he adopts rational approach and is more consistent. Given a choice between the two, whom are you willing to bet on?
Sure, sports and stock investments are worlds apart, but it’s the rational thinking that comes out as the winner, no matter where you use it. Most importantly, rational investors easily avoid risks and buy stocks, based on their own analysis, but psychological factors come into play again there. A common man, even if he isn’t into stocks and investments, will usually choose a surer path instead of an uncertain one when given a choice. That’s pretty reasonable because he doesn’t want to take unnecessary risks. For example, if we are given a choice between choosing $100 with certainty, or choose $500 with a 50% chance of receiving it, most will choose $100 since we aren’t sure about the $500. However, Kahneman and Tversky’s test proved that some people will choose the $500 even when they know that they are going to lose the $100. This type of ‘Everything or Nothing’ behavior isn’t necessarily irrational, but this risk-seeking attitude could be dangerous in the long run.
To establish the point further, let’s take a look at Prospect theory. Prospect theory, also known as “Loss-aversion theory” states that people often value losses and gains differently and will base their decisions on perceived gains when compared to perceived losses. This suggests that many people express emotions towards losses in a different way. Needless to say, people get more stressed with their losses but aren’t all that euphoric with their equal gains. Investment advisors will also attest to this fact. For example, an investment advisor might not receive royal treatment when his/her advise makes a client gain $100,000. However, you can bet that the client will make the advisor’s life miserable if he loses $100,000. Therefore, when losses occur, they always appear gigantic and the value of money immediately changes.
Some investors also hold on to stocks that are losing money and the reason for this can be explained by Prospect theory. They live dangerously and approach the market with the intent to avoid losses, instead of making more gains. While they do this, they also hope desperately for the market to change even when they have taken huge risks. This attitude can be compared with that of a gambler’s behavior and though this might not seem irrational to some people, it is important to understand that the risks could be devastating. So, instead of adopting this approach, it’s always better to think rationally and focus on the value, quality, and gains returned from a company.
We don’t have to look at hypothetical examples and theories to see that the stock market is often irrational. For instance when the actress Anne Hathaway is present in the media, it’s proven that Warren Buffett’s company Berkshire Hathaway is traded more frequent on the stock exchange because of defects in the algorithms of super computers that are set to conduct high-speed momentum trading.
Risks come from not knowing what you are doing
As you may know now, discipline, rational thinking, and a deep analysis will make you a better investor. If you steer away from speculation, you are bound to succeed. Also, distancing yourself from the market noise will aid in better results. In the end, treat Mr. Market like he’s your servant, but never your guide. Ignore him if you’re not interested in the stock market’s current prices, because the choice is entirely yours.
While many people play with stocks, others find it rather arduous. Why? To a large extent, the investing community is responsible for the paranoia they have created in the minds of common people. In the end, the fear is completely tied to the lack of knowledge.
Of course, this is extremely unfortunate because investing in stocks is actually a great avenue for a common man to accumulate a decent amount of wealth. However, we do understand that this assumption isn’t without merit because many people tend to remember the fates of several investors who committed suicide since they lost money. Added to that is the fact that investments appear like a gambler’s arena, where everything works on pure gambling. But, the stock market is not responsible for these perceptions and myths. It is up to every individual to delve into complete research of a company’s value and other financial details.
The reality is that a share is just a part of a company, and as a shareholder the profit from that company will ultimately return to you. That said every business comes with a risk factor, and your success depends on your ability to determine the company’s intrinsic value and it’s associated risks.
A serious investor understands that time plays a huge role in investments. A company that could be suffering today could make millions of dollars tomorrow. It can also stand the test of time and prove everyone wrong. Mr. Buffet stresses that businesses of high quality always multiply your wealth and will continue to grow as time progresses. On the other hand, companies of mediocre quality won’t be able to withstand the pressure and will disintegrate over time. Warren Buffet invests his money with the assumption that the market could close the very next day, without opening for the next five years! To Warren Buffet, there can be no friend equivalent to time, because patience is an extremely vital asset for an investor who wants to be successful.
So, in conclusion, if you pay attention to the value of a company, think rationally, and adopt a policy of strict self-discipline, you’re separating yourself from the pack. It’s not easy, of course, but it isn’t rocket science either.
Ask the Investors: How much of my portfolio should I invest in ETFs?
Perhaps the first question you should ask yourself goes back to the key points of Ravee Mehta’s book, The Emotional Intelligent Investor. How well do you know yourself. If you know that you are too emotional as an investor, then you might consider placing a significant portion of your portfolio into ETFs. The reason is, you’ll be less likely to second guess your decisions if the market performs poorly. This is due to the comfort of knowing you own a conglomerate of different companies. You’ll also have the comfort of knowing that it wasn’t necessarily a poor decision of owning an individual company that you might have failed to research appropriately. On the other hand if you feel that you are very good at accounting and can assess the risk of an individual stock pick, then you might want to venture more into the individual stock picking territory. This question really depends on each person and it heavily relies on your honest assessment of your own capabilities.
Books and resources mentioned in this episode
Stan Weistein’s Book, Stan Weinstein’s Secrets for Profit in Bull and Bear Markets– Read reviews of this book.
Charlie Munger on BBC – Listen to the first question