“The first principle is that you must not fool yourself — and you are the easiest person to fool.” ~ Richard Feynman

In the 1970s, two psychologists – Daniel Kahneman and Amos Tversky – proved, once and for all, that humans are not rational creatures. They discovered what we now know as “cognitive biases,” showing that humans systematically make choices that defy clear logic.

Now, having these biases and getting influenced by them is often not a bad thing. These have helped us survive for ages. Also, while we don’t always make decisions by carefully weighing up the facts, we often make better decisions as a result. This is applicable to most of what we do in life.

However, when it comes to investment decision making, our biases may get us into (big) trouble. What is more, the irony about these biases is that the more we read about them, the more we believe that we don’t suffer from them as much as others do.

In this second issue of Outside the Box newsletter, my friend Neeraj Marathe pokes a hole in this kind of thinking.

Neeraj is a Pune-based investor, trying to practice value-based investing. He is a SEBI-registered Research Analyst. He has been teaching Security Analysis, Portfolio Management and Behavioural Finance in a few B-schools for the past 12 years.

Let’s start right away with what Neeraj has to say about the nine key biases value investors have, and how they sometimes suffer on account of them.

Value investors are considered a class apart. They are thought to do things differently. They have their emotions under control. And they make fantastic returns over long periods of time.

We have ‘n’ number of examples to substantiate the same. Listen to Warren Buffett’s or Charlie Munger’s interviews vis-a-vis a broker’s or an analyst’s or a hedge fund manager’s, and you will agree.

Value investors are supposed to be well-aware of biases that commonly affect market participants and therefore they are supposed to be able to avoid them. But they are (mostly) humans, and thus suffer from most of all biases that get other investors into problems.

However, I got thinking as to, apart from the usual biases that affect all investors, what are the specific ones that affect the value guys.

My thoughts on this topic are based on observation of my own behaviour and thought-process and that of others whom I consider to be value-oriented investors and with whom I interact.

I agree that a specific value investor may not be prone to all the biases listed and also that there may be other biases out there affecting value investors. I would like to add that I am (and probably will be) very much a victim of some of the biases listed below.

So let me use this opportunity to try and take the mask off the value investing gang.  

1. Absolute Cheapness Bias
Followers of Ben Graham will especially understand what I am saying. Typically, value investors run screeners to find stocks that are quoting at absolute cheap valuations. Example – P/E ratio of less than 8 times etc.

Of course, it is just a starting point, but I have rarely seen investors of this breed being comfortable with P/E valuations of 30-40 times. Even value investors who take investing decisions exclusively based on a company’s business model and not just numbers like P/E ratio will flinch at the thought of a stock quoting at 40 times trailing earnings.

The flip side of this bias? There is a reason why some stocks are cheap. And they do tend to get cheaper. Adhering to absolute cheapness will cause one to miss some great, compounding businesses. In my opinion, cheapness has to be thought of in relative terms, not absolute.

2. Under-Researched Stock Bias
A large number of hard-core value investors I know enjoy the process (of finding an opportunity) more than the result (profit). Everybody loves profit, of course!   But because of this inclination towards the process, a lot of value-oriented people are obsessed with trying to discover something new, trying to catch something that the market has not understood.

Therein lies their ‘kick’. A Maruti or an HDFC is no fun! As a result, value investors enjoy digging into annual reports of unknown companies, trying to find value.

The flip side of this bias? Such investors will miss a ‘well-covered’ stock, like a large-cap, which sometimes becomes a ‘sitter’ due to Mr. Market going bonkers.

More often than not, risk-adjusted returns in select ‘well-discovered’ companies are much better than the unknown, untested companies.

3. Conservatism Bias
Value investors have a license to be conservative.   Lots of them can be also classified as pessimists. Of course, when a pessimist finds an attractive idea and loads up on it, the results could be fabulous. Obviously, this won’t happen very often, but that is okay. I feel 1-2 ideas in a year, in which you can load up is good enough.

The flip side of this bias? Lots of opportunity losses, because the ‘conservative’ value investor let it go; and selling the stock too early, because the ‘conservative’ value investor thought the stock has become ‘overvalued’ too early. Here, I think one has to be very mindful of crossing the line between conservatism and pessimism.

4. Do Nothing Bias
I feel this is one bias behind which value investors hide when they are actually scared to act. It becomes nothing but a mental justification.

For instance, a value investor might be actually scared that the market will fall because of the debt crisis in Europe, unemployment in the US, interest rates in India, real estate in the Middle-East, fudged data in China, and due to there being too many craters on the moon. He might thus not buy a stock he thinks is really cheap, so that he can buy it lower when the market falls.

What he is actually doing is trying to time the market, but the mental justification to this is that “sometimes inaction is the best action.” This is a very very dangerous bias and often leads to confusion, incorrect decisions, and overall misery.

5. Bad Management Bias
Without taking any names (for my protection), there are certain families or promoter groups in India that are considered to be ‘bad managements’ due to their past activities. If such facts are present, ignoring such companies makes sense.

Now I have to mention something, which happens a lot of times. When someone asks me to ignore a company because its management is bad, I usually ask for a reason for the same. Often, the answer is that vague, like ‘someone told me so’ or ‘it’s generally said that they are bad’. Rarely, people give sensible reasons why they think a particular management is bad. They just ‘think’ it’s bad, and that’s all.

Now, while there are certain business groups whose companies I won’t touch, having this in-toto mind block may sometimes lead to some really good opportunities being lost. The management might change, and a new generation might take over which is radically different. Keeping an open, alert, mind helps!

6. ‘Ignore the Macro’ Bias
A lot of value investors I know take investment decisions based purely on valuations and not based on the macro scenario. This has its pitfalls too. For example, interest rates affect our discounting rates, and industry scenario will change our growth assumptions.

I personally am not very great at analyzing macro stuff, but totally ignoring macro happenings may lead to incorrect decisions. I think that a fine line is to be maintained here as per one’s inclination as well as the ability to understand and analyze the macroeconomic data.

7. Circle of Competence Bias
We have heard Buffett and Munger often talk about the concept of circle of competence. It simply essentially means we must identify what we are good at and what we know, and also what we are not good at and what we don’t know. Then, we must stick to the former, i.e., what we are good at and what we know.

But some lazy value investors escape taking efforts by putting certain things under their “outside circle of competence” framework.

For example, I have a similar excuse when someone asks me about a pharma company. I simply tell them that I do not understand pharma. Now, what stops me to get off my behind, and learn about the pharma industry? Nothing! But I still haven’t done it.

So, this is a good justification for my laziness, right? Having a circle of competence is great, but not getting comfortable with it and trying to expand it is equally necessary.

8. ‘We Must Do Things Differently’ Bias
I have experienced some value investors having this compulsion of doing things differently. They have this compulsiveness to be different all the time. I agree that being different is a good trait of a value investor, but being different, thinking differently and acting differently just for the heck of it doesn’t make sense.

The flip side of this bias? You will frustrate people you talk with and they might probably hit you on the head with something. On a serious note, such investors will make a simple straight-forward decision complicated and make a mess of things. It is not always necessary that things must be done differently. Re-inventing the wheel is often not necessary.

9. ‘I Must Be A Value Investor’ Bias
Value investing has become quite a rage these days and it seems fashionable to be a value investor. While value investing as a concept is quite loosely defined, it’s surely the most abused. So many people I see first decide to be ‘value investors’ and then get into investing.

One must appreciate that there are different ways of earning money from the markets. While investing (and its forms) is one, trading, speculation etc. are also there. Don’t force yourself to be a ‘value investor’.

Without understanding what appeals to you, what you can identify with, if you decide to do something, results will not be optimum. Understand yourself, then decide. Not the other way round!

Value Investor, Be Aware
Well, there you have it. These were some biases I think value investors face. I do not claim that all of these biases are undesirable and should be avoided. Some of them are very much desirable, depending on the kind of investor you are. But what is important is to recognize these biases, identify whether a bias exists in yourself, and watch and monitor it carefully.

Awareness of these is critical. See to it that it doesn’t cloud your decision-making process.

Cheers and happy (value) investing!

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