Throw caution to the winds? NO! | Value Research Equity investors are always optimistic by nature, but sometimes…
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Throw caution to the winds? NO!

Equity investors are always optimistic by nature, but sometimes...

Throw caution to the winds? NO!

To put my readers in the right frame of mind for this article, I'll quote a quip from Warren Buffett's deputy Charlie Munger, whom someone has described as the richest comedian in the world, "Warren, if people weren't wrong so often, we wouldn't be so rich." The takeaway obviously being that when some people are wrong, others get rich at their expense.

I know you dislike negative stories - everyone does. However, understanding this dislike and overcoming it is important in becoming a successful investor. And what exactly do I mean by a negative story? Over the last two decades, writing in various publications as well as on Value Research Online, I have observed that negative articles are not popular. A negative article, or even just a piece of advice, explains to you what is bad and what not to do. A positive one tells you what is good and explains what you should do. A positive article is about how investors should make money. A negative one is about how investors should avoid losing money.

In my opinion and observations, the difference in attitude arises from the fact that equity investors are inherently optimists. We don't like to think about how not to lose money. You might think that equity investing makes people optimists, but that's not really true. The cause and effect are the other way around. Only people who are inherently optimists tend to become equity investors. To start investing in equities (or equity-based mutual funds, which is the same thing in this sense), you need to have a strong, inherent belief that tomorrow will be better than today. Everything else comes later. People invest in equity to make money, not to avoid losing it. However, the reality of equity investing is that it's just as important - or perhaps more important - to avoid losing money.

One of the problems of equity investing is that there are people who are actively trying to get you to do the wrong thing in order to get rich at your expense. At the heart of equity investing is the investors' ability to trust the information and the numbers that companies release about their business. Without this trust there is nothing. Historically, till at least the 90s, it was pretty hard to trust such numbers. In fact, stock prices had what could be called a trust premium or discount. For example, there was an MNC premium, which was mostly because you could trust the numbers. There was also a so-called south premium, although that dates further back than the 90s. Investors believed that South Indian promoters were less likely to fudge numbers. There were also premiums or discounts for other ethnic or regional communities but let's not discuss that. At the end of the day, the stock markets did not trust the data that was released. Physical verification was an integral part of stock research and it was common that a business that looked good on paper was a different story in reality.

Today, for large parts of the equity markets, the situation is quite different. For at least the 100 to 200 largest companies, you can by and large trust the financial numbers. A lot of regulatory reforms of different kind have made a difference, including those in auditing as well as the web of information created under GST. Moreover, for companies beyond a certain size, the attention of a large number of investors, as well as analysts, should mean that anomalies are relatively easy to detect. However, if you are doing your own research and investing in smaller companies, then you need to know how to look after yourself. In larger companies, people misjudge the business and the valuations.

Make no mistake, the accounting and tax systems reforms have cleaned up everything on a relative scale. Still, in smaller companies, there is a higher incidence of getting dodgy numbers and it's the investors themselves who have to have the forensic skills to guard against it. That, and a sharp self-control on their tendency to let their optimism ride roughshod over their innate caution!

Suggested read: Pessimists sound smart

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