Is your Heart Rate ∝ to Stock Prices?

When it comes to investing, we’re not as rational as we think we are. There is an entire field of study dedicated to this, called Behavioural Finance. It studies different psychological biases that we humans possess and how these biases affect us when it comes to changes in the markets.

Warren Buffett doesn’t keep a computer on his desk. He invests in stocks for the long run. He doesn’t let brief stock prices fluctuations impact his investing decisions. His advice to other investors is the same. “Don’t watch the markets closely!” He highlights that when investors are buying stocks, they are in agony when markets go down a little bit and consider selling them off when they bounce back up. This behaviour isn’t going to yield very good results. It’s just the mind second-guessing itself.

While it’s important to keep a check of all the developments at a company, it’s important not to let a company’s short term stock price change wrongly influence our decision-making. In many cases, short term price movements are purely random happenings and are nowhere related to the company’s operations.

As humans have evolved to feel losses significantly more than gains, an investor who experiences a stock price decline may be liable to make sub-optimal investment decisions.

Nassim Nicholas Taleb, in his insightful book Fooled by Randomness, talks about the difference between noise and meaning. He uses the example of a happily retired dentist who builds himself a nice trading desk in his attic, aiming to spend every business day of his retirement watching the markets while sipping decaffeinated coffee.  He tracks his portfolio of stocks via a spread-sheet with live price updates. “Being emotional, he feels a pang with every loss, displaying red on his screen. He feels some satisfaction when the performance is positive, but not a comparable amount to the pain when the performance is negative.” That is because the human mind works in a manner that we feel the negative effect of an average loss almost 2.5 times more than that of an average profit.

What one fails to realise is that over a short time increment, one observes the variability of the portfolio, not the returns.

The agony that a person goes through on his lows is greater than the ecstasy that he experiences on his highs. If you don’t like what’s happening to the stocks on your screen, it’s advisable to turn the screen off because short term movement in stock prices is not necessarily a guide to whether the investment is good or bad.

On bypassing the impact of seeing short term losses one gains the ability to get a long term perspective on their portfolio, a key edge in investing.

We have done a small analysis on the companies that we currently have in our portfolio. We checked to see how they have been performing in the past by checking the averages of our overall portfolio.

Averages of Portfolio 2016-2017 2017-2018 2018-2019*
ROCE 37.65% 47.84% 51.41%
Profit (Post Tax) 19.45% 25.08% 35.09%
Sales Growth 28.75% 30.67% 43.08%

*Note: – The Returns for 2018-2019 are Half-yearly Returns ending in September 2018.

In the above the table, we see that the performance of companies hasn’t changed and their fundamentals reflect the same. In fact, the companies have shown steady growth in terms of their ROCE and sales.

When we began our investment, we used straightforward investment filters. We saw through research that a simple idea outperforms the benchmark set by Nifty as well as other complicated systems.

We selected companies that showed a high moat and picked businesses with a high return on capital, low debt, and lower working capital requirement. We believe that the fundamentals of the companies we decided to invest in are strong, therefore we invested in them in the first place.

Our portfolio is oriented towards the following themes, taking into consideration the longevity and consistency of the ROCE performance:

  • More B2C (Business to Consumer) companies than B2B (Business to Business) companies.
  • More structure instead of cyclic plays.
  • Avoiding companies that borrow tons of money to grow.
  • With preferences given to companies with intangible strategic assets.

If the fundamentals of our businesses haven’t changed, then don’t let the stock prices mess with your brain.