The Investing Journal

Notes on long term thoughtful investing

Page 7 of 7

Mental Model: Creatures of Habit

Think how repeatedly every time we go to same grocery store to buy our day to day merchandise. Or how frequently we take the same route to our office everyday though there being a couple of routes of reaching it. We go to the same garage every time our car needs some work to be done. We almost religiously eat the same brand of noodles, brush our teeth from same brand of toothpaste and shave from the same brand of shaving gel & razor month after month. It is startling to see this type of consistency in our day to day life in an era where in ‘disruption’ is the most used (and abused 🙂 ) term!

One of the reason behind all of this is that we humans are loss averse which means our mind wishes to avoid the need for frequent decision making and rather stick with the status quo if it satisfies our basic needs. Given the complexity which the decision making process involves, we satisfice ourselves.

Edgar Rice Burroughs in his book ‘The Beasts of Tarzan’ writes –

We are, all of us, creatures of habit, and when the seeming necessity for schooling ourselves in new ways ceases to exist, we fall naturally and easily into the manner and customs which long usage has implanted ineradicably within us.

So, unless our needs change, our decision remains more or less the same which overtime becomes our habits. As such, ‘creatures of habit’ is an important mental model. Think about the wealth it would have created – and is still creating – for those that have been on the receiving end of this right from our regular grocery store to multi-billion dollar global conglomerates.

Businesses Enjoying this

Let’s see how some of the successful businesses globally are utilising this tendency to their advantage.

Mc Donald’s

It is the world’s largest restaurant chain operating in about 119 countries selling burgers & fries which is certainly not difficult to make or imitated by others. Then what explains this type of success enjoyed by it over the years? Rory Sutherland, Vice-Chairman of international advertising firm Ogilvy & Mather in his interview says –

Why do we go to McDonald’s? Is it the best food in town? Probably not. The search cost of finding the best place to eat in town, given that we’ve only got one shot at having a meal in a strange town, would be pretty high. But also when you go into McDonald’s you know you’re not going to be ripped off, you’re almost certainly not going to be ill. By contrast I’ve become ill after eating at Michelin-Starred restaurants quite frequently. Once you understand the perfectly sensible evolutionary instinct to satisfice, then the preference for brands is not irrational at all: I will pay a premium as a form of insurance for the reduced likelihood that this product is appalling.

So as much as the quality & taste of the delicious food it serves, its huge network of restaurants spread across almost every important city on the planet and the mindshare it has built over decades enables it to compete and succeed by doing something as simple as making and selling good quality burgers.

Starbucks

It is worth prodding the reasons behind the success of a café serving expensive coffee – whose prices were multiple times that of competing brews when it started its operations. Dan Ariely beautifully explained this in his book ‘Predictably Irrational’ –

You are sleepy and in desperate need of a liquid energy boost as you embark on an errand one afternoon. You glance through the windows at Starbucks and walk in. The prices of the coffee are a shock—you’ve been blissfully drinking the brew at Dunkin’ Donuts for years. But since you have walked in and are now curious about what coffee at this price might taste like, you surprise yourself: you buy a small coffee, enjoy its taste and its effect on you, and walk out.

The following week you walk by Starbucks again. Should you go in? The ideal decision-making process should take into account the quality of the coffee (Starbucks versus Dunkin’ Donuts); the prices at the two places; and, of course, the cost (or value) of walking a few more blocks to get to Dunkin’ Donuts. This is a complex computation—so instead, you resort to the simple approach: “I went to Starbucks before, and I enjoyed myself and the coffee, so this must be a good decision for me.” So you walk in and get another small cup of coffee. In doing so, you just became the second person in line, standing behind yourself.

A few days later, you again walk by Starbucks and this time, you vividly remember your past decisions and act on them again—voilà! You become the third person in line, standing behind yourself. As the weeks pass, you enter again and again and every time, you feel more strongly that you are acting on the basis of your preferences. Buying coffee at Starbucks has become a habit with you.

Its rich ambience, huge network of café covering every nook and corner of the US and brand recall adequately supported by distinguished menu makes it a business which its competitors envy.

Gillette

It happens to be one of the world’s most valuable brands with its products – razors & blade – enjoying 70% market globally. Will you buy a product offered by its competing local brand which happens to be 10-15% cheaper? Never. You don’t wish to run the risk of hurting yourselves while shaving. Besides, you might think, the life of a branded product may end being longer than that of a local unbranded one thereby more or less compensating for the price difference.

Great product, almost omnipresent like availability of its products and strong brand recall is something which Gillette enjoys to its advantage.

There are several examples of businesses enjoying one or the other competitive advantage due to the tendency of its customers to maintain status quo and to satisfice rather than acting as rational beings 24×7.

 

Common Themes

Did you notice the common thread running across the above examples? For this principle to work, there must continuity which must be maintained i.e. habits should not be interrupted or broken else they may change. And what ensures that kind of continuity which works in their favour?

Well, first thing is availability i.e. product or service should be available whenever required. Starbucks would have been in a weaker shape had it not been in every corner of US and so would be Mc Donald’s. They need to be present where ever their customers need them. That is another reason why we find Mc Donald’s more frequently nearby interstate highways. We plan our journey stops depending upon where its stores are located so as to avoid eating potentially unhygienic food. Similarly, Gillette’s blades need to be present at a stone’s throw away distance where ever its customers reside.

Second, they need to continuously invest in advertising & marketing to maintain and expand the mindshare which they enjoy. It is an intangible asset which they are building but which gets no mention on their annual balance sheets – given that it cannot be precisely measured. There are a few things cannot be precisely measured but that does not deny their existence..this is an another topic altogether which can be saved for some other day.

Amount spent on it is charged against current profits but it would be reasonable to expect the benefits to flow for quite a long period.

Limitations

Every mental model has its limits. Recognising those limits are sometimes more important they knowing the advantages they may enjoy.

Let’s go back to our garage example. If the mechanic which frequently repairs your car happen to be replaced by a new recently trained one who made a small mistake while working on your car such that it is in a far worse condition now then you had left it in, you might think twice about bringing it back to the same place next time. In the words of Mr. Burroughs, there is a seeming necessity now to retrain yourselves.

When needs change, it is only reasonable to expect change in people’s behaviour which was otherwise set.

So, if tomorrow another competitor selling razors & blades happens to establish trust similar to what Gillette enjoys while selling them at a fraction of what Gillette charges, it would put their business at risk. They key is to assess how deeper has the challenger managed to build that trust and can Gillette also lower the amount which it charges by lowering its cost to its competitor’s levels? In essence, it becomes a race: whether Gillette would be faster to build those cost competencies – and disrupt its own business –  or whether the challenger would go on building a combination of cheaper economics and strong mindshare. By the way, as we speak, this race is actually being unfolding sparked by a small start-up called ‘Dollar Shave Club’ now acquired & resourced by Unilever.

This was just another attempt in order to assess and better understand how far does this simple concept of habit goes – and how powerful it is. It is never just one thing which ensures investing success in a world as complex as the one in which we live. It is rather a latticework of such models. Hope you enjoyed reading this and it added to your understanding of how world works just as much as it did to me while writing this. Cheers.

 

 

 

 

Predicting stock prices Vs Owning businesses for the longer term

There are multiple ways of creating wealth in stock markets. On one side there are intra day traders and traders doing BTST operations (buy today sell tomorrow) fully resourced by their brokers giving them trading tips – just like the talking hosts on tv – and at the other extreme there are investors which don’t mind buying and literally forgetting holding their stocks for years if not decades.

And given that many variations of these – depending upon where do they fall in between the above two extremes –  are being followed in the market generally by the masses one can say that people find some utility in these (or at least they so perceive:) )

 

Which approach should one follow?

Just like in other aspects of our lives, the chosen path should be the one which is walk able (or practical to follow) given that one needs to continue his stride for fairly long time in order to reach his end goal and also the one which promises the fulfilment of the goals which the traveller initially looked up upon before starting to march. In other words, it should something which doesn’t burnout its followers – or else they wouldn’t live to travel the course – and should also be rewarding in the end.

Let’s explore both of these extremes (trading and long term investing) further and try to make sense of each of these:

Trading

Trading is simulating. It requires information to act upon, involves frequent decision making, has high transaction cost, is tax inefficient, has excess diversification involved and is mentally stressful

(i) Information: Generally, a trader is constantly looking for information upon which he can immediately act and profit. As such, it wouldn’t be wrong to say that after a while he becomes addicted to information streams. And combine this addiction with today’s 24×7 connected world which means that somewhere there is an information overload. Research tells us that as information increases, decision making ability deteriorates. Beyond a point, soaking information only makes things worse. Today, information is commodity and ability to filter it through and separating knowledge from noise is the chief task which a decision maker faces. It wouldn’t be wrong to say that today, given the information overload in some form or other, odds are stacked against the trader as increasing information only impedes decision making.

(ii) Frequent decision making: Traders need to make decisions several times a day, every day and we know that when the frequency of making decisions goes up, so does the error of commission. Taking a hypothetical example assuming that if both a long term investor and a trader were to earn 15% in a year, the number of decisions taken by the trader to earn that return would be way higher versus that of an investor.

(iii) Transaction costs: As the frequency of buying & selling stocks is high, transactions cost are also high. It ends up taking a toll on the returns one earns during the year. When it comes to compounding money over long periods of time – which is what our discussion is all about – such differences end up being significant in absolute terms. 100,000 compounded at 18% for 20 years is 35,60,000  and that at 16.5% for 20 years is 26,50,000. Every percentage point counts when it comes to investing.

(iv) Taxes: With frequent buying selling comes the need to pay taxes regularly. And generally short term tax rates are much higher than long term tax rates and in India currently, returns from long term investments in equities (>1 yr) are exempt . Also, we know that even if tax rates were to similar the fact that tax deferrals add value to an investor’s portfolio should not be forgotten.

(v) Excess Diversification: As a capital market participant some diversification is valuable but beyond a point (say >20 or 30 stocks) it starts adding negative value to the portfolio. Difference in weights between the hits & misses narrows. Remember, what matters over time is how much money you make when you are right and how much you lose if your wrong. When it comes to traders, things are even worse since generally they prefer to trade simultaneously in many ideas due to which they are unable to build worthwhile position (say >5-7%) in any investments.

(vi) Addiction to stock quotes: If you want to make a trader’s day worse, just cut him off from checking stock prices during market hours 🙂 . He would crave for have just one look.

(vii) Mental Fatigue:  Given the need to take frequent decisions, gulping in information in huge doses everyday, constant hunt for news flow, etc takes toll on physical and mental health of a trader. It is not unheard of young guys below the age of 40 dying in this industry due to heart attack. For compounding to work its magic, you need to be here not for a couple of years but decades all together.

It is clear that odds are stacked against a day trader when it comes to compounding money & wealth creation over a longer period of time. As the saying goes, activity is the enemy of an investor.

 

Long Term Investors / Business Owners

As against traders, long term investors enjoy several advantages. They can concentrate their holdings, take advantage of – as Benjamin Graham said – other person’s follies given their longer term horizon, save on transactions costs & taxes, retain their ability to separate knowledge from noise by avoiding information over dose and do all this while living a fulfilling life!

(i) Concentrated Portfolios: In markets, one is paid for his conviction. By investing in businesses which one understands and not over paying for the same, one can turn odds in his favour. When one starts to see a business from the eyes of the business owners while taking a longer term outlook, ability to take concentrated bets increases (say <15 or 20 stocks in a portfolio). This bodes well for a truly long term, value oriented investor

(ii) Taking advantage of market follies: As Graham once said ‘Market is like a voting machine is short term and weighing machine in longer term’. Market is known to be inefficient over long term (3 to 5 yrs) and this is precisely where the advantage of a long term investor lies

(iii) Save on costs & taxes: Since buying selling decisions undertaken by an investor is less versus a trader, he saves on transaction costs. Also, tax benefits derived by it over long periods could add up to be significant. Consider this, if an investor is holding just 10-12 stocks in his portfolio and has a holding period, on average, of 3 years. It means that he needs to find just 3 or 4 stocks every year to buy & replace the existing ones!

(iv) Avoid information overload: Unlike a trader, an investor who thinks & acts like a business owner is under no obligation to read every new bit of information which comes across relating to the companies he owns. He enjoys this luxury due to his understanding of the business, longer term outlook and owner like attitude.  In the end, odds are better placed for him to enable him to make better decisions since he never bombards himself with excess information dosage.

To sum-up, when it comes to compounding duration matters. One needs to find an approach which is something that can be almost religiously followed not just for years but for decades. While trading is tiring and in itself a ‘negative feedback loop’, long term investing is exact opposite of this. This is not to say investing is easy. Far from that. But it is simple and one just need not complicate it.

Cheers and happy diwali. Have a safe one 🙂

Is it really worth it?

This is my first post on the website. There were some thoughts going on in my mind as to whether I should go ahead with this idea of starting a blog or not.

After all, blogging requires a commitment of time & effort. And as Mr Munger says, if something is not worth doing at all, it is surely not worth doing well.

So question was – is it really worth the effort?

Investing frequently involves weighing value you get versus the cost you need to pay. While the cost involved was clear here (couple of hours every week), what was the value which I was looking to derive?

To start with, writing something makes us stop and think deeper. Habits like writing a diary or a blog regularly not only improves one’s thought process, it also helps in improving upon one’s communication skills.

Diary becomes a ‘log’ which can be looked back over time and thoughts could be revisited. In essence, this means that thoughts can remain ‘intact’ just as they were while writing.  Also, these could be improved upon learning from newer experiences, overtime.

In case of a blog, there is also a timely ‘feedback’ from the reader which sometimes gives the topic a different perspective which we would have otherwise missed.

To sum up, when it comes to investing, the importance of clear thinking cannot be understated. Writing about it will only make one better at it overtime while helping several others to get better at their own game – a cause which makes the effort worth taking!


 

Niraj Bardia

 

 

 

 

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