Bandwagon Effect could be defined as the tendency for people do something because others are doing it. Often times, it could be related to following the herd mentality.
When it comes to stock picking, retail investors often fall prey to block deals / bulk deals made by marquee investors and blindly clone them without looking into the fundamentals of a stock.
Here is a real-world example from a company called KRBL:
After Mohinsh Pabrai bought this stock, the stock price went up around 7%. After a week, the stock price came down to the level that Mohnish had bought.
This kind of news makes an investor appeal to their emotions without relying on fundamentals. History has shown that “The markets are aware when these marquee investors enter, but we do not know when they exit.”
The next time when the crowd is doing something, ask this one question "What could go wrong with the crowd’s decision? What does the crowd know that I do not know? What value does the buyer see in a stock that others are failing to see?
Last but not least, if you take care of your downside risk, your upside will take care of itself. After reading this, I believe you make decisions based on facts and reasoning, and not on celebrities.
The Indian stock market is very inefficient. Look at the recent pump and dump SMS stocks (Ex: Ejecta Marketing, Alphs Motor Finance). Just an SMS giving a few positive words, an unbelievable target price and people start buying it in loads. If a stranger can change the mentality of an individual investor like this, imagine what a well-known investor can do.
Thanks for your response Dinesh. Experienced investors have a checklist while making a key investment decision. There are instances in which the crowd was right as well as wrong. How do we separate the wheat from the chaff? remains a key question.
For reasons given by you, it remains true that no stock becomes a good purchase until you have personally made sure that it passes your own investment code-of-conduct with flying colors. This is mine, for example. I don’t really abide by it as much as I’d like to, seeing as how it keeps evolving over time (I’m still a very novice investor).
All stock investments are an advanced form of poker where luck and skill form an equal part. Due diligence only makes sure that you improve the odds of being lucky drastically.
I disagree. Cloning the picks of your favourite investor can be profitable, if done systematically. Most investors only focus on stock picking and entry techniques. An equal effort must be made in developing sound exit criteria, which limits your downside, and position sizing.
Most investors underperform because they allocate too little to their best winners and too much to losers. That is where psychology comes into picture; it’s difficult to buy a stock when it is above your initial price and too easy to average down. Infact, bad position sizing has been my biggest mistake too, and I am only in the process of fixing it.
How can retail investors do this process systematically? Take the above example for KRBL, it that case, how can a retail investor size his or her position and set downside.
Is it not true that it is hard to predict the winners and losers early?
These discussions will help viewers to reduce this bias from their decision making.
First, write down the exit criteria before making the Investment. It involves answering where the market should not go, if you are right. A good exit criteria should help you cut your losers short and stick to your winners long enough. You can test your criteria against past data, but most importantly, you must understand your concept and why you believe it is a good exit criteria.
Now let’s take this case. I intend to take position in KRBL because Pabrai has picked this stock recently, and he is good at picking multibaggers. Clearly, I should keep the position until Pabrai’s exit, if my goal is to take advantage of his future multibaggers. But exit can be tracked only on quarterly or annual basis (if he/she is a large enough investor). However I have access to market price movement. Hopefully, I also know about his past entry and exit. In particular, I need to estimate how low the stock price can fall to be fairly certain that he has exited. This point is our stop loss, and the gap between the current price and stop loss is our Risk per unit (assuming we will be able to sell at stop loss point)
Now comes position sizing. How much should we buy? I have not developed a good model for that yet. A good starting point would be to take 1% of your total networth as your risk per position. The position size, then, is Total capital at risk / Risk per unit, which we calculated above using the exit criteria.
Now this determines your initial position. It ensures you won’t lose much, if your initial stop loss hits. Now as the price moves up, so does your stop loss. You can do this by applying your exit criteria to the highest price reached after your investment. Every new high should move your stop loss higher. Once it exceeds your initial buying price, it implies that your initial risk has been covered, and this may be a good point to add new position, to pyramid. (Note: pyramiding also doubles the capital risked. I am still trying to think of good pyramiding scheme, one which keeps the capital risked bounded relative to net worth.)
Note: These are not original ideas, but what I picked up from reading Jack Schwager’s ‘Market wizards’ and Van Tharp’s book recently.
Instead of trying to predict winner and losers, we can develop rules to help us maximize profit and minimize loss. At the same time, we should always remain open to the possibility of our rules not working. That is, we should have some criteria to decide when our rule is not working, so that we can refine our system.
There is another aspect called survivorship bias. These media glorify only the successful picks of celebrity investors. They do not mention failed picks by the same celebrity. For example do you know what has happened to Mohnish Pabrai’s pick J&K Bank? He had brought huge chunks of it. Thereafter, it went nowhere or rather moved down. Media has stopped mentioning this stock long back.
Exactly. Even the world’s best investors have made wrong Investments, at times. They just don’t get mentioned.
If even they can fail, why does the average investor keeps searching for holy grail of stock picking or entry? Why does he believe he can do better? This begs the question - do you want to be right always or do you want to make profit?
Once you accept your likelihood of being wrong, more often than you imagine, you will begin to appreciate the other aspects of investing. Afterall, the very best investors have been profitable consistently, despite occasional ‘mistakes’!
In my opinion, it’d be imprudent and a disservice to our portfolio to clone the investment decisions of the so called experts. Most of us suffer from an authority bias. Investors who are placed on a pedestal also err often. To imitate others’ strategy on borrowed conviction can lead to many a sleepless night.
A lot of investment decisions are made by retail investors because of the fear of missing out. And, such ill considered decisions lead to erosion of capital.
Sometimes it’s enough to do nothing and reduce portfolio churning for returns to be decent.
Barring a few lucky ones, no one can predict the performance of a stock. Tempering expectations will save a lot of trouble to people. Most analysts are wrong most of the times. And, their projections are excessively optimistic. Always make the necessary downward revision in estimates.
Keeping these points in mind, now KRBL trades at 583 / share. It is below the purchase price of Mohnish Pabrai. Does this offer margin of safety? What are the arguments for and against it?
In my humble opinion, KRBL was a very attractively priced stock a couple of years ago. Today, at a valuation of around 14000 crores I find it expensive. The growth in rice consumption will clock a CAGR of less than 1 percent for the next 2 decades. I expect Basmati, being a special category of rice, to grow faster as people’s disposable income increases. However, the share of the pie of other players will also increase. There’s no reason to believe why the competitors won’t be able to grow faster. Underestimating the other large producers of Basmati would be reckless. People usually are loyal to brands. India Gate is a fantastic brand. But, the only constant is change. It’s entirely possible that a couple of years down the line another brand may catch the fancy of consumers. At current valuations, we expect the sequence of events to be ideal.
At a multiple exceeding 25 I think it’s priced to perfection.
I can’t muster the courage to invest at these valuations.
A preliminary search revealed that the AUM of the Mohnish ji’s funds is around 400-450 million USD which is around 2700-2800 crores. The investment in KRBL is worth 394 crores. So, it’s around 15 percent of the portfolio. It seems like a high conviction pick. However, please exercise caution before investing. He, like all of us human beings, isn’t infallible. He had lost quite a significant fund in his investments in commodity companies a couple of years back.
Always perform your own research before investing.
Just my thoughts.Apologies if I’ve erred.
I do not know whether this pick of Pabrai will be a winner or looser. Only time will tell. What I was trying to point out that media/forums write too much about his successful picks such as rain industries etc., and there is not even a single line report about this (so far) not so successful pick. One must not get misled by this biased reporting by the media. That is what I was trying to point out.
@saravananb1994
How do you define failure? Failure is the lack of return generation or the loss of capital?
If you’re referring to loss of capital Mohnish ji’s high conviction pick Horsehead Zinc lost a lost of money. It was assigned 15 percent of his portfolio. Hedge fund veteran Julian Robertson lost a lot of money when he was shorting tech stocks in the tech boom. Bill Ackman, the widely revered hedge fund manager went horribly wrong with Valeant Pharmaceuticals.
Frankly, there’s only so much research an investor can perform for a stock investment.
There are always factors beyond our control.
We, often, prove to be inadequate to assess the fair value of securities and end up resorting to heuristics to assign a value.
If the management is charismatic, aggressive, ambitious we are inclined to believe that the company will do well. A lot of times there’s also the halo effect at play. I see that in quite a few companies off late.
And, most importantly we fail to recognize the significant possibility of things going wrong. Competitor neglect is common among companies. So, my suggestion is that investors should exercise restraint before cloning anyone’s strategy.
