Friday, 5 August 2016

Why Investors Miss Multi-Baggers

The other day I told a colleague about a little-known company that I hold in my portfolio. His reaction was: “It’s a dodgy company.” I enquired what he knew about the company. He knew nothing. But because he hadn’t heard of the company, that rang alarm bells for him. 

On another occasion, somebody asked me what company he could invest in. I suggested a name that he was not familiar with. He gave me a confused look and asked for another suggestion. I suggested to him a well-known large-cap stock, and he was happy because he “knew” this company.

For both experienced investors and amateurs, the familiarity with a company’s “name” is an important investment criterion, though they won’t confess it. They would prefer a company whose name they have heard of to a company that they don’t know. 

One can’t blame the investor community for this behavior. The reason for the inclination towards what’s familiar is psychological in nature. Familiarity breeds trust. And lack of it engenders caution. Naturally, investors turn cautious of what they haven’t heard of. But due to this psychological instinct, many great companies are skipped. These companies later turn out to be multi-baggers.

How do you overcome this problem? First, “curse” yourself. You don’t know enough, so you must not trust your own knowledge. Just because you haven’t heard of a company doesn’t make it a dodgy one. All it indicates is you have limited exposure and you don’t know. It’s plain ignorance—yours. Second, don’t stop at a company’s name. Study it and then make a judgment. While studying it, don’t begin with a negative impression of it. If you do, you will simply pick evidence that confirms your suspicion of it. That’s another psychological bias, called the confirmation bias.

In investing, psychology plays a more important than finance. Ignoring it and staying buried in finance books won’t get you anywhere. To spot multi-baggers, understand psychology more than IRR or CAGR or whatever. Is the analyst community listening?

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