Day 15 - Mind it!!!

For the past 8 days I have gone on and on about biases and today I am going to tell you that while it difficult to overcome these biases, it is not impossible to reduce the effect that they have.

A famous behavioral finance professor carried out this experiment in her class. She asked all the students to write down the last two digits of their cell phone number on a piece of paper. And then she asked them to estimate the number of countries that are there in Africa. Then she collected all the papers and showed that those whose cell phone numbers were higher offered higher estimates. Then she did it again after telling the students that they had been warned. And the same result emerged again.

So what this tells us that just being aware of a bias is not enough to overcome it. We see it all the time in real world too. Cigarette warnings, fat content warnings on junk food, need to exercise et al. We know all of this but find it hard to follow them. Because we are humans. This is harmful to our physical health.

And the behavioural biases are harmful to our financial health but we still continue to be plagued by them.

The one way I have learnt to atleast move one step ahead of just knowing that I have a bias, is to figure out a way to pause between a thought/stimulus and action. Its called being mindful. Mindfulness is said to be a buddhist concept and has been made popular in the west by Jon Kabat-Zinn.

And the way to pause is to check yourself before acting on your thought and the best way to do it ....you guessed it...have a checklist of things to keep in mind before acting.

Mindfulness and use of checklists may perhaps be the single most concept that I can perhaps try and convey to all the readers. Being mindful and using checklists has not made me error free. I still make errors. But I make fewer errors and usually I dont make the same ones again.

Tomorrow more on checklists. Today lets pause and be mindful.

Regards
Anish
QED Capital

Day 14 - Putting the biases together

Today I am going to try and show you how these four biases which I have written about early impact each stage of decision making in investing. 

• Confirmation Bias :The tendency to ignore information contradictory to prior beliefs or look for information confirming prior beliefs.
• Herding : Also known as the “bandwagon effect,” herding is the tendency for individuals to mimic the actions of a larger group.
• Anchoring Bias :The tendency to rely too heavily on the first piece of information received.
• Disposition Effect: Investors tend to sell winners too early and hold on to losers too long.

The starting point for a retail investors starts off with a belief about which he/she has already made up his/her mind. And then they look for information to confirm that belief. They think they can understand or analyse the impact of demonetisation on the indian economy, Or the benefits of GST implementation or how inflation will impact the RBI's decision in the next credit policy and so on. 

At times the belief also stems from herding i.e. a colleague, friend or neighbour has "apparently" made a lot of money from that idea and you just cant be left behind.  

And they have the friendly business channels also to their rescue. If you close your eyes and try and listen for about 5 mins to what the anchors are saying something about the day's market movement, it will not amount to anything. That's 5 mins of your life you will never get back. (I have tried it). 

Investors also believe they will correctly able to assess the impact of all this on the earnings of a company, on the sector and then are able to also express this into a position i.e. buy or sell or hold. Most of the time its a buy. And once they get some information that supports their prior belief, they get heavily anchored to that. And even if by chance they get information to the contrary they will find it hard to disregard the earlier information. 

Now it is virtually impossible to get someone to consistently do all of the above. Not even Rakesh Jhunjhunwala or Warren Buffett will get all the time. Infact Steve Cohen has famously said that his best traders are right on a trade only 50%  of the time. So now where does that leave the average retail person. 

But with a high degree of confidence and ego invested, if the stock starts going south then disposition effect (tendency to hold on to losers) kicks in. One will tend to hold on to it even if the orignal investment belief is proven wrong and information is available to that effect. 

And if by chance, the stock goes up, then itchiness to sell the stock and book profit kicks in. Greed and ego wants to lock in the gains. 

However there is one place where one can get away with all this. Read the next two paras from an article by Barry Ritholz.

"In politics, you can get away with this. Voters live in bubbles of their own making -- the selective perception and confirmation bias through which they view the world. The penalty for fabricating your own reality, false though it might be, seems to be minimal or nonexistent in politics. Voters live with the consequences of the ballots they cast, though the effects may not be felt for years. Making up alternative facts about childhood vaccines, the unemployment rate, climate change or where your predecessor was born certainly hasn’t hurt Trump -- it may even have helped him win the election.

Investors, however, aren't quite so lucky when their belief systems diverge from reality. Mr. Market seems to take delight in taking money away from those whose capital is deployed based on a set of faulty convictions. This is why I harp on cognitive issues, the importance of understanding your own psychology and, most recently, not mixing politics with investing."

You can read the entire article here.

There are many other biases but these four are key. And today I will end here and from tomorrow we will move on to other aspects of investing like the nature of markets and how it is complex adaptive system which is never in equilibrium and then how trends are formed. 

Thank you too all of you for reading and supporting. You all know who you are. I really appreciate the support and encouragement. 

Regards

Anish

Day 13 - Understanding Greed and Fear: Anchoring Bias

Anchoring Bias :The tendency to rely too heavily on the first piece of information received

Most vegetable vendors in Indian markets use this bias to great effect while bargaining with buyers. The first quote that they give is high but not so high so as to drive the buyer away. And then the negotiations anchor around the first quote. Sometimes the buyer will wear him down and sometimes they get the better of the buyer.

Even auction houses use this bias by setting a reference price or a reserve price. Given below is an example of a bid for a wine bottle. Both the bidders are first asked their social security number and then asked to bid for the bottle. Both give widely different bids, which are close to their social security number.

In the context of investing, this effect plays out when investors get anchored to their buy price. All their future decision making then is referenced around this buy price. And then this bias feeds into the Disposition effect that I wrote about here. 

Remember Disposition Effect is the effect to hold on to losers and sell winners early.  

And once price goes below the buy price, most investors will not sell it until is comes back to break even i.e. the buy price. Another way it plays out is when a stock falls from a recent high and buyers rush, anchoring their reference point to the recent high and think they are buying at a discount. 

Tomorrow we will tie up the key biases that I have written about.

You can read more about Anchoring Bias here 

Regards

Anish

QED Capital  

Important Disclaimer: Please do not treat anything on my blog as investment advice. I do not provide any recommendations of any stocks or securities. Any stock mentioned may be merely by way of an example.

  

Day 12 - Understanding Greed and Fear: Herding and Magazine Covers

I came across these magazine covers today and they totally fit in with the point I want to make about herding. 

Also with the Dow Jones Index finally hitting 20,000, Barron's has decided to put it on the cover and make a prediction yet again. But dont sell your stocks just yet. 

Number one coming up is the crude oil chart. When Crude oil was at approx $105/bbl in July 2011, Barron's put out a cover saying get ready for $150. And Oil just decided to top out there and then in Feb 2016 when oil was at $35 , Barron's again put out a cover saying get ready for oil at $20. The oil chart with monthly chart is given below. They got the top and the bottom almost accurately - Just in the opposite order.

Now in February 2016 when the markets dived, Barron's put out this cover with Sanders and Trump on the cover saying that markets are concerned about the rise of these two extreme candidates. See the weekly chart of the Dow Jone for 2016 and 2017 below.

The covers above clearly show that how media tries to marry the narrative with price. Markets are a complex adaptive system and do not follow a linear set path. Even if one is able to predict the outcome of a certain economic or political or social event, it is next to impossible to call the next month , quarter or year move. Because no one knows for sure what the market has already priced in and what it is expecting. It is clear only in hindsight.

And when a mainstream business magazine puts out some prediction on its cover, you can be rest assured that it is already a crowded trade i.e. the sheep have been rounded up and FOMO is driving the ones who are left out.  

And now for the scary cover before I go sleep.

All the best. Please support the Nudge Foundation. They are doing a wonderful job. You can donate here. No amount is too small or big. Your participation will give the foundation and me a lot of joy and encouragement.

Regards

Anish

QED Capital  

thenudge.ketto.org/anishpteli 

Important Disclaimer: Please do not treat anything on my blog as investment advice. I do not provide any recommendations of any stocks or securities. Any stock mentioned may be merely by way of an example.

HT:@charliebilello

Day 11 : Understanding Greed and Fear: Herding Bias

Herding Bias: Also known as the “bandwagon effect,” herding is the tendency for individuals to mimic the actions of a larger group.

Shepherds, Teachers and Pied Pipers in the stockmarket use this bias to great effect. I used to observe my kid's teachers. They ensure that and the first 3-4 kids were walking properly in line and then rest of the class would line up. Shepherds identify the leader in the herd and use them to keep the rest of flock in control. There are many in the stock market who use this a lot. Financial news channels who get "ëxperts" to predict the next 50-100 point "big move". I only have one question for the viewers: If the experts knew, why are they still coming on TV and telling you all this. After all the stock market is a zero sum game. But humans are gullible and want to be led like sheep. 

Adult humans are bit more complex but as a group they behave similarly. There is a modern word for the bandwagon effect - FOMO - Fear of Missing Out. The younger generation uses this word a lot. But it has been around for centuries. Everyone wants to be cool, have the latest "in things" etc.

And hence diamonds are sold not because they convey your love for your beloved effectively, but because everyone does it. Everyone wants the new iphone, the new "new" thing.

As I explained in the blog on how bubbles are formed. When a sound rational premise is taken too far, price action takes over. We dont pause to think if the original premise still holds true. If it has been true for so long it must be still true. I repeat a paragraph from that blog because it is a recent and very prevalent example.

In his testimony to the Financial Crisis Investigation Committee, Buffett is said that the housing market demand was driven by a sound reason to buy a home because over a period or time it costs more to buy a home and if you are going to buy a home to reside in it then it better to buy early than later. However, as time passed genuine demand for housing began to taper off, but the supply of financing continued to be strong. And this caused housing prices to go up and at some time buyers were buying homes not because they wanted to stay in those homes but because prices were increasing at a rapid pace and cheap financing was available. And a sound investment premise became a bubble. The crossover point is known to none. And that's what makes it a market.

A trader wakes up in Tokyo and looks at what US has done overnight. Indian trader wakes up to see what Singapore, Hkg and Tokyo are doing. Europe ambles in about 5 hrs later and checks what Asia is doing. And US wakes up again to see what Europe is doing and where Asia has closed. And then the merry go round starts again. 

Investors and traders are lemmings. No one wants to be left behind even if one is jumping off the cliff. 

But thats how it rolls.

About 100-150 people are reading this blog everyday. Thank you very much for it. And only 5 have contributed so far. So please use your online payment method and make a contribution.

http://thenudge.ketto.org/anishpteli

More tomorrow.

Regards
Anish

Day 10: Understanding Greed and Fear: Confirmation Bias

It is going to be a short blog today.

Confirmation Bias is one of the most lethal biases and also very hard to detect. It has a overlap with Conviction. Its a slippery slope.

And hence one of the best ways to avoid it is to 

• Seek out data contrary to your belief
• Try to disprove your own theory
• Talk to someone who is not invested in the outcome of your idea

However being aware of this is not the only way to overcome confirmation bias. Before making a buy decision it is best to put down on paper or make a note of why you are buying the stock. It need not be a very detailed note but even if you make a half pager covering the salient points it should be enough. A very importannt component of your note should be the scenario in which your investment thesis is proven wrong and what action would you take in that scenario. I will try and provide a format in the coming days. 

Going back to the Day 6 blog, profits take care of themselves, losses seldom do.

And hence when a stock goes in to a loss , that is when we start looking for data points to justify our decision to keep holding on to our position. It hurts our ego to book a loss and there is also FOMO (Fear of Missing Out) incase the stock starts going up after we sell it. And some stocks will. 

Here are two intersesting articles to read on confirmation bias.

• How Investors Suffer From Confirmation Bias
• Why We Think We’re Better Investors Than We Are

Wishing you all a very happy Republic Day.

Regards

Anish

 

Day 9 - Understanding Greed and Fear: Confirmation Bias

Belief: If Trump wins, markets will tank, gold will go up. If Hillary wins, markets will rally.

Confirmation Bias: All kind of data was mined and displayed. This is the 2nd/3rd longest bull run in history. It wont last. A Trump victory will result in flight of capital from equity and into safe haven assets.

Reality: Today the Dow Jones has hit 20,000. It was 18200 odd on November 8th 2016 when Trump won.

Now we dont know how the year will pan out but it sure has started well.

Markets and equity markets in general are all about the narrative. Humans are very uncomfortable with uncertainty and randomness Everything has to have some explicible cause. Hence there will be multiple stories with healthy doses of hindsight how they saw a rally or crash coming.

At this stage I must introduce this excellent book by Michael Mauboussin called The Success Equation. Michael does a great job of explaining how luck and skill impact various professions.

Below is the luck and skill continuum. Investing and trading fall somwhere closer to luck than to skill. Not to say that there is no skill there but chance plays a big role. 

So how do we avoid falling prey to confirmation bias? 

• Seek out data contrary to your belief
• Try to disprove your own theory
• Talk to someone who is not invested in the outcome of your idea

There is a very thin line between conviction in your idea and having a confirmation bias. But then that is what makes investing challenging.

I hope you enjoyed reading the blog. If there is any feedback or comment please feel free to write to me or in the comments section below.

And also contribute to my campaign http://thenudge.ketto.org/anishpteli

Regards
Anish
QED Capital

Day 8 Understanding Greed and Fear: Confirmation Bias

After Disposition Effect, today I am going to talk about another very prevalent bias in our behavior: Confirmation Bias. Confirmation bias is when someone forms an opinion and then will accept only information that agrees with it discounting or ignoring everything else.

To understand this, we have to take a step back and understand how belief's work and affect us. Over a period, a limited set of experiences take root in our brains and give rise to our Core Beliefs. Most of the time these beliefs govern our behaviour in the real world and protect us from danger and harm. As a result, we also carry over or extrapolate these to challenges in the modern world where the dangers are more mental or to the mind. At times we also get blinded by these beliefs which lead to mistakes that can have serious repercussions.

Let us see some very famous examples of beliefs leading to confirmation bias and the consequent outcome.

Belief: President Bush believed that Iraq had Weapons of Mass Destruction. Confirmation Bias led him to see and believe only data which supported his belief. And we know how it ended. When the US army invaded Iraq, they found no weapons of mass destruction.

Belief: Donald Trump was a joke and that Hillary Clinton was going to win the primaries and then the US presidential election? Nate Silver,someone who hasnt been wrong for a while now, for example, said Clinton had a 99% chance of winning the Michigan democratic primary. Confirmation Bias led someone as data driven as Nate Silver to ignore what his data and models were telling him and he let his beliefs take over under the excuse that Donald Trump was an out lier as a candidate. Result: Hillary Clinton lost Michigan Primaries to Sanders and also lost Michigan and also the election to Trump. Sui Generis was Silver's excuse
.

Belief: Closer home let us look at a recent event. The belief was Demonetization will result in black money hoarders not depositing money in the banking system. Hence almost 20-30% of the currency in circulation will not come back. This was stated by the Attorney General in the Supreme Court. Now we dont know what were the assumptions or data backing the decision of the RBI and the Government but its more likely now that they presented data which supported this claim rather than looking at the data objectively and then coming to a conclusion. Instead today it is estimated that 95% of the money has come back into the system. Now the jury is still out on the longer term benefits of this exercise but the quick win of a windfall gain for the goverment has not materialised.
                                              

If such smart, resouceful and powerful entities and institutions can fall prey to confirmation bias then you can imagine what the average retail investor faces.

Tomorrow we will see precisely that.

Regards

Anish

http://thenudge.ketto.org/anishpteli 

Day 7 - Summary: Behavior Gap, Greed and Fear and Disposition Effect.

On Day 7 today I am going to go over all that I have covered in the last six days. Not just for your benefit but also for mine. 

I have to keep reinforcing these principles day after day, week after week and month after month. And sometimes I slip but as long as I avoid large errors of commission and make some errors of omission, I am going to be fine. 

My goal is to survive and position my self to take advantage of the big move "when" it comes. There is no question of "If". As a famous trader said, "There are bold traders and there are old traders. But there are no bold old traders".

Day 1: I wrote about the Behavior Gap. Most investors when they turn over their investments to a money manager or a mutual fund manager are not happy with market returns. But what they should be keeping in mind is whether their manager is doing a better job than what they would be doing with their own money. If he is, then half the battle is won. 

Day 2: I wrote about how most media and any one who tries to forecast markets almost always gets it wrong. Most major market turns have been made when a major business/non business magazine has made a major prediction about the direction of markets on their cover page. 

Day 3: I wrote about how bubbles are formed. In times of extreme euphoria when a good premise is taken too far and when investment action is driven solely by prices and leads to too much easy money flowing into markets. It is then that a bubble is formed. No one can predict when or how a bubble will burst. As Keynes famously said, "Markets can remain irrational far longer than you can remain solvent". Two basic primal emotions drive markets: Greed and Fear.

Day 4: I wrote about a particular phenomenon called the Disposition Effect: Holding on to losers for too long and selling winners early. Everyone makes this error and the important thing is to be aware of this behavioral bias. 

Day 5: I wrote about Warren Buffet's most famous self admitted error: Buying Berkshire Hathaway when it was a slowly dying textile business. Buffett converted it into an investing vehicle to take advantage of losses and in time added an insurance business to it. 

Day 6: I put my self out there and shared with you an exercise that I carried out when I checked up my own portfolio a few years ago and the impact that Disposition Effect was having on my returns. 

ET reported that Disposition Effect and overconfidence resulted in Indian retail investors losing Rs. 8,376 crs between January 2005 and June 2006 as per a study conducted by Prof Sankar De and his team at Indian School of Business. The total number of investors who traded at least once between January 2005 and June 2006 stood at 25 lakh. If one mirrors a secular trend over the years, the total losses for Indian individual investors would be around Rs 20,700 crore or Rs 82,800 per active investor per year.

And please contribute to my fund raising campaign for the Nudge Foundation.

Regards

Anish

QED Capital  

Day 6 - Understanding Greed and Fear

I want to start off by thanking all of you for reading my blog and for contributing to my campaign to raise funds for The Nudge Foundation. I have reached 20% of my target in six days and I am sure that I will reach my target soon. 

Today I am going to talk about how I discovered what my disposition effect was costing me. Just to remind you: Disposition effect is holding on your losing positions and selling winners early.

In 2011-12 when I was evaluating my portfolio I did an exercise. I examined the list of stocks and I found a pattern. I had belief that a long term investor doesnt sell easily and consequently held on to positions for way too long. 

Below is a list of stocks which were losers. I have assumed an equal position size. And the loss I booked when I sold and the loss I would have suffered if I had sold them when they went down 10%. And in the third column, CMP, is the market price when I carried out the exercise in 2013 ( am not sure of the exact month).

I sold the stocks at 39% loss but if I had held on to them I would be sitting on a 62% loss. 

Given below is a list of winners. These stocks did not dip by more than 10% from my time of purchase. This table shows that profits take care of themselves. The average gain on winner portfolio was 75.6%.

And then I put the the winner and loser portfolio together see how much the portfolio makes on average in three scenarios. The first scenario is the actual scenario, the second scenario is the one in which I cut losers if they fall 10% and in the third scenario if I continued to hold on to them.

In the scenario where I sold stocks where I did, I ended up with a respectable 18.3%. But if I had continued to hold on to the stocks for another 6-12 months my returns from the portfolio would have fallen to 6.8% : a return below FD returns. But the big stunner was the portfolio return of 32.8%  if I had sold my loser stocks when they fell by 10%. 

And now whenever I try to hold on to losers for too long this table comes to my mind. The 10% Stop Loss is not sacrosanct. Some small/mid caps may fall even further before moving up and so a differential Stop Loss number has to be used of large, mid and small caps. This blog was more to illustrate how important it is to recognize that if a stock you have bought has gone then you have got one of two things wrong : either you picked the wrong stock or you got the entry time wrong. Either ways you were wrong. Good and strong stocks usually take off immediately. 

I would encourage and urge all of you to do this exercise for your own portfolio. It may turn out be an eye opening moment and change your investment portfolio returns.

All the best. Please support the Nudge Foundation. They are doing a wonderful job. You can donate here. No amount is too small or big. Your participation will give the foundation and me a lot of joy and encouragement.

Regards

Anish

QED Capital  

Important Disclaimer: Please do not treat anything on my blog as investment advice. I do not provide any recommendations of any stocks or securities. Any stock mentioned may be merely by way of an example.

Day 5 - Understanding Greed and Fear

Yesterday I wrote about Disposition Effect: Holding on to losers and selling winners too soon. I give below a true example of how Buffett made this mistake but ultimately turned the investment around.

It would come as surprise to many that one of the most valuable companies in the world Berkshire Hathaway owned by the most successful investors of all time Warren Buffett, was actually a lemon as an investment when it was originally made. 

Warren Buffett began buying shares in Berkshire Hathaway on December 12, 1962 at $7.50 a share. His initial intention was to flip his shares for a relatively quick profit but changed his mind after having some problems with Berkshire’s president, Seabury Stanton, and ultimately bought enough Berkshire stock to control the company. Buffett’s investment in Berkshire Hathaway would go down as arguably the worst investment of his career.

Why?

• Berkshire Hathaway was undervalued for the wrong reasons; nine years of losses and had closed more than a dozen textile plants over the previous decade.
• The textile business in the US at that time was not a good business and was going downhill; to a significant part as a result of foreign competition, which was squeezing profit margins to the point of no return.
• Berkshire’s financial position was unlikely to improve.

He would later explain: “So I bought my cigar butt, and I tried to smoke it. You walk down the street, and you see a cigar butt, and it’s soggy and disgusting and repels you, but it’s free, and there may be one puff left in it. Berkshire didn’t have any more puffs. So all you had was a soggy cigar butt in your mouth. That was Berkshire Hathaway in 1965. I had a lot of money tied up in the cigar butt. I would have been better off if I’d never heard of Berkshire Hathaway.”

Buffett being Buffett turned Berkshire into a vehicle for making future investments and ultimately made it to a big winner. But there is only one Buffett and then there are the rest 99.9%.

So for the rest of us it is best to get out of losers early.

Tomorrow I will talk about my own follies. 

All the best. Please support the Nudge Foundation. They are doing a wonderful job. You can donate here. No amount is too small or big. Your participation will give the foundation and me a lot of joy and encouragement.

Regards

Anish

QED Capital  

Important Disclaimer: Please do not treat anything on my blog as investment advice. I do not provide any recommendations of any stocks or securities. Any stock mentioned may be merely by way of an example.

Related Links

1. WarrenBuffett Admits To 5 Big Mistakes
2. Brilliant Blunders

Day 4 - Understanding Greed and Fear

It turns out that there are specific names for the behavioural patterns that I have described in my earlier blog which you can read here.  Over the next four days I am going to break down greed and fear into four specific behavior patterns which are also called behavioral biases.

The very first one is something we have all experienced and are guilty of. Everyone from Warren Buffett to a first time investor makes this. Holding on losers for too long and selling our winners early. Whereas we should be doing the opposite. 

Why do we do that? We do it because we hate to accept our mistakes and a loss isnt a loss until you sell the stock. And we will do everything we can to put that away. And we keep hoping and hoping that a stock that we have bought and has gone into a loss, will atleast come back to break even. Sometimes it does and we hold on to that memory and forget that most of the times it does not. But humans have survived on hope and optimism but that does not work well in the stock market. 

And why do we sell our winners early. Because we want to feel good and stoke our ego. We want to feel warm and fuzzy in our heart by seeing a winner in our portfolio and we want to lock that moment in. Fear of giving back profits sets in as soon as a stock goes into profit and every down tick is painful.

A stock owner goes through myriad emotions as price moves. The picture below illustrates this.

And it turns out that there is specfic name for this behavior pattern and its called the Disposition Effect. Researchers have traced the cause of the disposition effect to so-called "prospect theory", which was first identified and named by Daniel Kahneman and Amos Tversky in 1979. Kahneman and Tversky stated that, "losses have more emotional impact than an equivalent amount of gains," and that people consequently base their decisions not on perceived losses but on perceived gains.

What this simply means that losing Rs. 100 gives us more pain than the joy of gaining Rs. 100. It turns out that it takes twice the amount of gains i.e. Rs. 200 in the above example to offset the loss of losing Rs. 100.  

And this happens to the best of investors. So know that when you fall prey to this behavior, you are not alone. But it so happens that you can train yourself to over come this or check youself when you become aware that you might be making this mistake.

Remember, it is not wrong to make a mistake, it is however wrong to continue holding that mistake and not taking action. 

A simple rule to follow for your monthly/quarterly portfolio review would be: Keep winners, discard losers. 

In my later posts I will be more specific about how to identify a stock has become a loser. 

And with that let us welcome the 45th President of the USA. Donald J. Trump. 

All the best. Please support the Nudge Foundation. They are doing a wonderful job. You can donate here. No amount is too small or big. Your participation will give the foundation and me a lot of joy and encouragement.

Regards

Anish

QED Capital  

Important Disclaimer: Please do not treat anything on my blog as investment advice. I do not provide any recommendations of any stocks or securities. Any stock mentioned may be merely by way of an example.

Day 3 - Greed and Fear - Making of a Bubble

Day 3 - Greed and Fear

The two most basic instincts of humans from the days of Adam and Eve. Adam was greedy and got tempted by the apple. And then fearful because he knew he would have to pay for his greed. 

These are our primal emotions. So then how do we get over them ? Each of us is emotionally wired differently. But as a crowd or mob our reactions are pretty much the same. I have a quote in my office by Charles McKay that says "Men think in herds, they go mad in herds. While they recover their senses, one by one."

And this is true from the 17th Century Tulip mania right down to the 2008 housing finance crisis. 

Now you may ask why does this cycle repeat itself when it is so evident. It repeats itself because with each cohort of older investors exiting the market, either because they have run out of financial or emotional capital or have passed away, a new set of younger investors enter the market. And these investors do not learn from the mistakes of the older generation because human beings like making their own mistakes. 

Now the name of the crisis or bubble may be different but the basic structure of a complete market cycle remains the same. Look at sketch below by Behavior Gap's Carl Richards. You can put the name of tulip mania, or gold rush, 1929 Great Depression, 1987 October Crash, the dot com bubble or the housing bubble or take your pick. It all fits into this one sketch.

And who better to illustrate this point with an example than Warren Buffett. In his testimony to the Financial Crisis Inquiry Commission he was asked. I have extracted this from an article in Fortune which you can read here

Brad Bondi [financial crisis inquiry commission]: What do you think it was, if you were to point to one of the single driving causes behind this bubble? What would you say?

Warren Buffett: My former boss, Ben Graham, made an observation, 50 or so years ago to me and he said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”

After a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over. The price action takes over because people have forgotten the limitations of the original premise.

Now, we saw the same thing in housing. So this sound premise that it’s a good idea to buy a house this year because it’s probably going to cost more next year and you’re going to want a home, and the fact that you can finance it gets distorted over time if housing prices are going up 10 percent a year and inflation is a couple percent a year. Soon the price action -– or at some point the price action takes over. And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten.

And the price action becomes so important to people that it takes over the—it takes over their minds, and because housing was the largest single asset, around $22 trillion. Such a huge asset. So understandable to the public—they might not understand stocks, they might not understand tulip bulbs, but they understood houses and they wanted to buy one anyway and the financing, and you could leverage up to the sky, it created a bubble like we’ve never seen.

The Internet was the same thing. The Internet was going to change our lives. But it didn’t mean that every company was worth $50 billion that could dream up a prospectus.

To summarise what is written above, incase you found it too long, Buffett is saying that the housing market demand was driven by a sound reason to buy a home because over a period or time it costs more to buy a home and if you are going to buy a home to reside in it then it better to buy early than later. However, as time passed genuine demand for housing began to taper off, but the supply of financing continued to be strong. And this caused housing prices to go up and at some time buyers were buying homes not because they wanted to stay in those homes but because prices were increasing at a rapid pace and cheap financing was available. And a sound investment premise became a bubble. The crossover point is known to none. And that's what makes it a market. 

No one is going to ring a bell at the bottom or the top of a market cycle because no one knows precisely where the market is going to make a top or bottom. But if you observe in a somewhat detached manner, you will know that what is going on does not make sense. But because we all suffer from FOMO (Fear of Missing Out), we jump in.

Tomorrow we will see what we can do to manage these two emotions.