Our brains are in sync with the speed at which the market is moving and totally out of sync with the speed at which a business is moving.

Of Falling Stock Markets and Shutting Brains

NOVEMBER 30, 2016 | VISHAL KHANDELWAL | 3 COMMENTS

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In one of the old interviews of Mohnish Pabrai of Pabrai Funds, he described the root cause of a common, but difficult to overcome, inefficiency in share prices –

Our brains are in sync with the speed at which the market is moving and totally out of sync with the speed at which a business is moving. You have to learn to dramatically slow your brain, which is very hard for most people. The reality is that you should make decisions based on how the business is changing, and that’s a very slow process.

You wouldn’t know that businesses change slowly from the share price activity in the stock market. Such volatility, of course, can be a boon for the disciplined investor waiting for what Warren Buffett refers to as a “fat pitch.” Most maintain a watch-list of what they consider to be superior companies that they would be happy to buy, but only at the right price. But the problem for most of us lies in deciding what that right price is because most of us find it difficult to understand what that underlying value of the business is, to which we must relate the price. And thus, most of us would rather make our decisions just looking at stock prices – especially when they are moving fast, up or down – than underlying intrinsic values.

Like what seems to be happening in the market these days. With the Sensex falling by a “huge” 2,500 points in less than three months – which, by the way, is “just” a 9% decline – I am seeing increasing noise of “buy stocks now”, “great opportunity to invest”, “you will rue your decision to not buy now”, etc. And a lot of this noise is, surprisingly, coming from retail investors who seem to have gotten smarter to be buying at every small crack in the markets.

Now, the problem here is that situations like these – when the markets fall sharply in quick time – is that it leads people to shut down their brains.

Scientists still don’t fully understand why we experience ‘brain freezes’ during stressful moments (like when the stock market falls rapidly in a short time). Of course, it’s long been known that the ancient and primitive part of the brain – called the hypothalamus – reacts to perceived danger by triggering a ‘fight or flight’ response. It sends a signal to release adrenalin, quickening the heart rate, speeding the breath and preparing us to confront the perceived monster or run away.

When it comes to the stock market, just the speed, and not the quantum, of fall is enough for us to act in funny ways. Like this gentleman – a professional money manager – whom I met at a friend’s place yesterday.

“So, are you buying now?” he asked me.

“Not much!” I said.

“Why?” he asked with an expression that I’m committing a sin not buying stocks in loads now. “The markets have cracked big time, and so have many good-quality stocks.”

“Big time? Where? When?” I asked.

“You must be kidding me!” he said. “I know of so many high-quality stocks that have fallen 15-20 percent in the last one month only.”

“Is 15-20 percent really a correction?” I asked. “Aren’t most of these high-quality businesses still trading at reasonably high valuations?”

“But they are still cheaper than a month back!” he countered.

“But they are still expensive than a year back!” I said. “Were you loading up on stocks then?”

“Well, oh…” he fumbled a bit, and thus changed the topic a bit. “But don’t you think this currency demonetization thing will take our economy into a new orbit, and so would the earnings of companies also rise, and thus the valuations look super-attractive after the latest fall?”

“Sorry, but I don’t know much about the real impact or extent of impact of demonetization. I hope it is net-positive for the economy, but how do I factor in a surge in corporate earnings because of this already?”

“But the domestic institutions like mutual funds are getting record inflows,” he said. “So even most other retail and big investors seem to be excited, isn’t it?”

“How do you say that?” I asked. “Getting new and big money into mutual funds is one thing, and mutual funds investing them in good value is another.”

“But what will funds do with such high and continuous inflows?” he said. “I read recently that fund houses are investing in large caps because they are finding the valuations attractive.”

“I won’t comment on what the mutual funds are doing – though I know most of them underperform even the benchmark – or whether large caps are really attractive, but all I know is that first, in investing it’s dangerous to focus on where the stock prices are going and not on where the businesses are going. And two, it’s dangerous to invest based on what other guys, especially the big guys, are saying and doing. Both are paths to hell as far as your money is concerned. And three, mutual funds don’t manage money, but fund managers within them, who are individuals with brains almost similarly funny as ours, do.”

“So how do you invest your own money?”

“Nothing special that I do. Just look at my watch-list and portfolio from time to time and see whether the underlying value of any business is attractive vis-à-vis the price, whatever the broader market may be doing. Though my brain also shuts down from time to time, and I also tend to make those silly mistakes.”

“And do you take cash calls? I mean, are you holding some cash now?”

“Cash? Let me not reveal that or Mr. Modi may listen and demonetize whatever little I have!”

“And what stocks are you looking at or buying now?”

“Well, let me not reveal that too, or the SEBI may listen.”

http://www.safalniveshak.com/falling-stock-markets-shutting-brains/