Stable Investor’s note: Today’s guest post by Daniel Sparks covers an important topic of Anchoring Bias in investment decisions.

The study of how psychology affects our investment decisions is, rightly so, becoming more and more important. It has even been given a formal name: Behavioral Finance. Do we have to get an MBA or take a psychology class to understand the implications of behavioral finance on our investment decisions? Definitely not. We will have a huge advantage by simply recognizing and understanding the most threatening psychological bias to every investor: the anchoring bias.

Consider this common scenario:

John buys shares at $30. 2 months later the same shares are trading at $25. He holds on to the stock because he remembers that he originally paid $30 a share and he doesn’t want to lose money. He keeps holding and the stock drops to $20 a share. He freaks out and sells.

This is a perfect example of how deadly the anchoring bias can be. No matter how smart we are (or think we are!), the anchoring bias can be a serious threat if we don’t show it some reverence.

This scenario reminds me of a time when during one of my MBA classes the professor asked the students, “Does the price you paid for your house matter when you are selling your house?” Surprisingly, more than half of those who responded said, “Yes.” This is, once again, a perfect example of the anchoring bias in full affect. No matter how educated you are, it can still affect you.

When we are making a financial decision today, all that matters is one thing: value. The price you paid for a house, or the price you paid for a stock 1 year ago means nothing about value today.

So what exactly is the anchoring bias?

Anchoring bias: focusing too intensely on one piece of information or trait when making decisions.

So how can we avoid the anchoring bias in making investment decisions?

1.Show it reverence: studies show that simply recognizing the possibility of human bias and understanding our tendencies to be irrational will help us overcome biases.

2.Ignore what a stock has done in the past: focus on fundamentals and pretend like you are considering the business as a whole as if it is not publicly traded—this applies to selling and buying.

3.Be patient when making financial decisions: If the stock has moved up or down and you are tempted to sell or buy, make sure you are nottempted to make this decision simply because you are anchoring on what the price was before.

About the Author: Daniel Sparks has a passion for Value Investing and is a big believer in investing only in companies with a durable competitive advantage. He has served in US Army and is a part of Colorado State University. Read more about him at Value Folio.

Exactly 4 years ago, i.e. on 21^{st} January 2008, I bought some shares of Ranbaxy. The day is remembered as one of the darkest days for Indian equities as bell-weather Sensex lost 1408 points in a single trading session. This was the first-ever 4-digit loss for the Sensex at close.

And this big cut was just the start. It was followed by another bloody cut of 857 points on the very next day. (Read more about biggest Sensex falls here).

Now let’s go back a little deeper in past.

In July 2007, I invested some money in A. Ambani’s Reliance Natural Resources Limited (RNRL) at Rs 42. This decision to invest was neither based on any fundamental nor any technical analysis. The only reason which I can now remember is that there was a growing interest in ADAG stocks (herd mentality). Though I always want to believe that I am a sensible investor, the truth is that I have made my share of mistakes in stock markets and have traded in not-so-good companies quite often.

At times I have been lucky to have made some money. And at times not so lucky.

But in this case, I would say that I was quite lucky. Even in 2007-2008, RNRL was widely regarded as a speculative stock and not worthy of holding for long term. It was a stock which was abhorred by long-term investors. Luckily for me, markets continued being irrationally exuberant and started making new highs on a daily basis.

Out of my sheer fear of losing profits, I sold all my shares of RNRL at around Rs 200 each in first few days of January 2008. This investment gave a staggering 383 percent in 6 months and made me feel like a Stock Market Super Hero. 🙂

But my luck continued helping me and I used that money to purchase shares Ranbaxy at Rs 340. And as if markets had decided to prove all my decisions correct, the Japanese pharma major Daiichi Sankyo bought Ranbaxy and there was an open offer by the acquirer for shares of Ranbaxy. The open offer came at Rs 737, but I decided not to wait for the same and in August 2008, sold my shares in open market for Rs 552.

These two stock transactions gave a 7x return on my initial investment in just under a year! A compounded annual growth rate of close to 700 percent!! The above is the sequence of events which I personally experienced. And with loads of help from my luck, I made almost 700% in a market which was grinding down every day and was well on its way to crash 50% for the year.

But honestly, it was my sheer luck and nothing else. But this small story also has a few lessons for everyone to learn from market crashes. I have tried to list them out below:

Always be a big fan of fear in stock markets. When people become over pessimistic, it should be taken as an invitation to make huge profits. Even Warren Buffett says that “We are fearful when others aregreedyandgreedywhen others arefearful.”

Always be ready with a list of stocks to buy in market crashes, i.e. have a list of crash stocks. This list consists of stocks which one regularly tracks and is eager to buy in case prices fall sharply.

Courage in Crisis, but without Cash is useless. Always maintain adequate levels of cash to take advantage of such crashes. This can be done by using PE ratio as a tool. There seems to be a definite relationship between PE Ratios and Market Returns. When PEs are high, chances of correction are high and hence an investor should book profits and hold cash to take advantage of probable (but inevitable) corrections.

Always use corrections to buy fundamentally safe stocks which have the ability to survive major recessions/downturns/corrections. There is no point trying to find multibagger small stocks which have high mortality rates in downturns. And during corrections, the market gives us ample opportunities to pick large-cap stocks trading at massive discounts.

Always understand the difference between shares falling due to weakness in broader markets and those falling due to fundamental issues. A stock like DLF fell alongwith other shares in 2008. But it was not ‘just’ because of fall in broader markets.

Always keep an eye on 52 Week Low List. You may find some really interesting & investment-worthy-companies in the list during market crashes.

In our previous post, we saw that Indian markets are presently trading at PEG ratio of 0.97. We arrived at this figure by dividing current P/E of 16.7 by average growth rate (in last 18 years)of 17.1%.

We have chosen EPS growth rates to represent growth rates of a company. One can also use any other growth rates.

For each company, we have calculated 3 PEG Ratios –

Using latest EPS Growth Rates (2010-2011)

Using Average of all EPS growth rates in last 5 years

Using least positive EPS growth rates in last 5 years

Afterwards, we calculated another PEG for each company – Average PEG – which is an arithmetic average of previous three PEGs.

Normally, a PEG greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. But we must understand that PEG is just a ratio and it should always be looked in conjunction with other ratios and numbers.

For instance, a company like Bharti has an average PEG of 0.33, which is quite an attractive number when looked at on a standalone basis. But if we consider that Bharti operates in a highly competitive industry; has loads of debt due to 3G fee payments and African expansion; has decreasing average revenues per user (ARPU) and has a negative PEG(!) for current fiscal, the number 0.33 may not look so attractive.

But there are also few companies like BHEL (0.59), PowerGrid (0.83), Tata Steel (0.40) and Tata Motors (0.42) which have considerable moat (competitive advantage & operations in industries having high entry barriers) and can be said to be available at good valuations. But once again, one should understand that stock like Tata Motors are rate sensitive and cyclical. And under current global circumstances, may slip further.

A company like Sterlite Industries (pegged by few as future RIL) is available at a ridiculous PEG of 0.19 (or 0.25, 0.08, 0.26). But that does not mean that it is going to become a future multibagger. Similarly, Maruti is available at PEG of 0.10(!)

Then there behemoths like SBI which may be available at outrageous mathematically calculated PEG of 6.6, but are worth investing as there current PEG stands at 0.54. But one should also consider rise in NPAs of SBI and other factors before investing.

So a Stable Investor understands that one should never rely on just one mathematical tool to arrive at any investment decision. Any number should always be looked in conjunction with other ratios and numbers.

How do market experts predict future index levels? It is done by estimating EPS (Earnings Per Share) of the index and then multiplying it with what they consider a logical multiple (P/E Ratio). In past 18 years, Sensex’s EPS has grown from Rs 81 to Rs 1270 (E) as show below –

As per analyst estimates, Sensex is expected to do an EPS of 1055 in FY2011 & 1270 in FY2012. This information should be taken with a pinch of salt as these are predictions. And predictions can be based on speculation. Capital Mind has an interesting post on senselessness of EPS projections.

A little calculation shows that in last 18 years, EPS has grown at 17.1%. Analysts predict that EPS for next 2 years is expected to grow at more than 20%. But considering present challenges of high inflation, high interest rates & global macro events, it seems to be a little too optimistic.

So how do we decide whether markets are fairly valuing future growth or not?

There is no hard and fast rule of which growth rate one should take. One can either take an estimate of future earnings growth or an average of the past earnings growth.

At present Sensex is trading at a multiple of 16.7 (Get latest P/E from here; For Nifty50, you can check this analysis too) and we take average EPS growth rate of 17.1% in our calculations. This gives us a PEG of 0.97 (=16.7/17.1).

So how do we interpret this number?

Normally, a PEG of greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. So a PEG of 0.97 indicates that at present, Sensex is fairly valued.

Lower the PEG, the lesser one has to pay for each unit of future earnings growth. So, to put it simply, one should be interested in low PEG values.

Consider a situation where you have a stock with low P/E. Is it that the market does not like the stock? Or is it that the market has overlooked a fundamentally strong stock of good value? To figure this out, we look at the PEG ratio. Now, if the PEG ratio is big, we know that this is probably because the “earnings growth” is low & this is kind of stock that the market thinks is of not much value. Now consider another situation where the PEG ratio is small. It may be because the projected earnings must be high. We know that this is a fundamentally strong stock that market has overlooked.

But PEG is not a fool proof way valuing future growth and there are a few issues –

In strictest of sense, it is more of a rule of thumb rather than a formula. Reason being that the two sides of the formula have different units: you’re comparing a fraction with a percent.

It works well with normal values of growth rates only. For certain values, the results can be absurd. For example, it implies that a company with zero growth should sell for a P/E of 0.

An interesting but technical take on PEG Ratios can be found here. Drawbacks of PEG ratio can be found here.

Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate. Also, being just a ratio it should be looked in conjunction with other ratios and numbers.

What have been stock markets annual return given in last 1 year?

What have been Sensex returns since inception?

What have been Sensex returns in last 20 years?

What have been Sensex returns in last 10 years?

What has been Sensex CAGR or the average Sensex returns till now?

These are some questions that gain popularity as the year comes to an end.

During this time, we all have this uncontrollable urge to ‘know’ how markets have done in last one year. And how it compares to annual returns of the last few years.

But still, we do get attracted to things like Sensex yearly return figures. Isn’t it?

So as we have completed another year, I have decided to analyse Sensex historical returns of widely tracked market index Sensex – a widely tracked index of the Indian stock markets, which is made up of shares of 30 largest Indian companies.

Sensex closed 2018 with gains of about 5.9%.

After a lot of upheavals and volatility, 2018 did not turn out to be a very great year for the markets. But this comes on the back of a good 2017 – where making money wasn’t difficult.

But how does this compare with the longer Sensex return history and the averages?

Nifty has a CAGR of 13.1% in the last 20 years (since 1998) and 14.1% in the last 10 years (since 2008).

But that is the nature of markets. The average figures will not be achieved every year. Also for SIP investors, it is important to understand that these returns will be different from your rolling SIP returns (but we will discuss that some other day).

So below is the Sensex historical chart showing annual Sensex returns since 1991 (i.e. 2+ decades):

To see this from another perspective, have a look at the table below.

It gives you the current value of Rs 1 lac invested in Sensex every year since 1995-96:

As already mentioned, looking at average figures has its own pitfalls. An average of 12% annual returns might sound great on paper. But it requires you to witness -30%, +20%, 5%, -15%, 13%, etc. for few years. You won’t get that 12% fixed returns, no matter how much you want it. 🙂

So obviously, the 2+ decades-long journey has been a volatile one. In the last 28 years, we have had:

20 years with positive returns

8 years with negative returns

You might draw out the conclusion that more often than not, markets will give positive returns.

That is true. But how much of that return will be captured in your portfolio is another matter.

So if you had invested somewhere in 2002-2003, the annual index returns after that have been 3.5%, 72.9%, 13.1%, 42.3%, 46.7%, 47.1%.

And this is not normal. This was unprecedented and chances are high that such a sequence of high positive returns, might not get repeated again for many years if not decades. So do not have such expectations of multi-year high returns from stock markets.

Infact, we should be ready to face ugly years like 2008-2009 – when index itself fell by more than 50% and individual stocks crashed by 80-90%. I have said countless times that one should invest more in market crashes or when everyone else is giving your reasons to not invest. But that is easier said than done. When a crisis like the one in 2008-2009 comes, it is not easy to combine your cash with courage.

But that is what separates poor investors from good ones and, good ones from great ones.

Now we have seen Sensex historical returns for the last 25+ years. But that gives us only 28 data points to look at. And that is not sufficient to draw out any meaningful conclusions.

Ofcourse it is interesting to look at annual return figures. These give us a benchmark to compare our own portfolio’s performance.

But it is very important to understand what these annual figures won’t tell you. We can pick and choose data to prove almost anything – as it has been rightly said – “Torture numbers, and they’ll confess to anything.”

You might find people telling you that markets can give you 15-20% returns. And they might even show you data to prove it. But just picking one particular Sensex 5-year return period or even a 10-year period will never give you the complete picture. You need to see how markets have behaved in ‘all’ such 5-year and 10-year periods.

So when talking about Sensex yearly returns, lets not just evaluate year-end figures. Instead, let’s analyse rolling 1-year returns. That will give us a better picture.

I have used monthly Sensex historical data since January 1990. So that is where we start.

Now to calculate one-year rolling returns, we pick every possible 1-year period between January 1990 and December 2018 (on a monthly basis).

So we have the following:

Jan-1990 to Jan-1991 – 1^{st} one-year period

Feb-1990 to Feb-1991 – 2^{nd} one-year period

…

…

Dec-2017 to Dec-2018 – Last one-year period

In all, there were about 336 rolling one-year periods.

And this is what Sensex did in these one-year periods:

And here is the graph of these returns (since 1997):

If you study the graph carefully, you will find interesting things.

Some 1-year periods have seen returns of more than 75%. But there are also periods of major cuts (like the early 2000s and 2008-2009).

Now one obvious thing to note here is that when rolling returns are low for some time, then chances are high that rolling returns will increase in near future (as can be seen in sharp up moves after low returns in the above graph).

I leave it up to you to draw out your own conclusions.

Another important point to note here is that these graphs and tables are based on Sensex levels. It does not reflect the impact of dividend reinvestments. The index that captures ‘dividend reinvestments’ is called the Total Returns Index (TRI). So basically, Total Returns Index or TRI is Sensex including Dividends.

Now 2018 didn’t turn out to be a very good year for most market participants (after 2017 being a really good one).

But for long-term investors, a year of low returns would bring in a lot of opportunities if we are observant enough. And I am not just talking about index levels here. Even individual stocks offer various opportunities by oscillating between their 52-week highs and lows.

As for 2019, there is no point in predicting what will happen.

So let’s not rush and instead, wait for another 365 days to see how next year’s Sensex annual returns turn out to be. I am sure we will have interesting data to add to the Sensex return history soon.

A poston The Motley Fool inspired us to write about dividend investing in Indian stocks.

They say that if a person plans to have a long term portfolio of 10 stocks, atleast 3 should be good dividendpaying stocks.

Companies generally pay dividends when they have stable, predictable cash flows and don’t have troubles covering their dividend obligations. So when you invest in good dividend paying companies, it can be safely assumed that the chosen company is there for the long run.

A talk on stock dividends generally leads to further discussion on its Current Yield (Ratio of Dividend Paid & Current Market Price in percentage terms). Read more about Current Yields here. We will again take up yields later in the post.

It is important for a long term investor that when he selects a stock for its dividends, he looks beyond just its current yield. What a stock pays as current dividend is not as important as its future dividends. It is also important that dividends are sustainable & keep coming year after year.

One interesting concept given in The Motley Foolis about Effective Yield – Dividend Yield measured by referring to the original purchase price. Even if a stock carries a modest yield when you buy it, rapid dividend growth can boost your effective yield very quickly, making it much more attractive.

To indicate the relevance of Effective Yield, we take up Clariant Chemicals (I) Ltd. (BSE Code: 506390), a mid cap known for generous and increasing dividend payouts.

In April 2007, Clariant paid a dividend of 180% (at face value of 10). At a then market price of Rs 300, it translated into a yield of 6%. Come FY 2011 & it paid a total dividend of 100% (Interim) + 200% (Final). This translates into a Current yield (CMP – 650) of 4.6%. But if we calculate the effective Yield (@2007 Purchase Price), we have an effective yield of almost 10%. This effectively means that by means of increasing dividends alone, the stock would be able to pay back the investment in less than 10 years!

So what does dividend investing offer to a Stable Investor?

Dividend Investing can help Stable Investor generate an ever-increasing stream of cash. This cash can then be deployed to buy more such assets and so on…

An important point is that one should not be fooled by high dividend yields. The reason for high yield may be a sharp fall in market prices or a one-time special dividend payout. It is very important to focus on sustainability of business when one is investing for dividends. There is no use investing in business for dividends, when the company is not in a position to exist after some time.

The Motley Fool has another insightful post on successful dividend investing that can be found here.

If you have read some of the older posts, you would have a fair idea about what Stable Investor is all about. And you will also understand that timing of stock markets is not what this website is interested in. And that is because for all practical purposes, it does not work!

A famous columnist once said,

“The market timer’s Hall of Fame is an empty room.”

“I can’t recall ever once having seen the name a market timer on Forbes’ Annual List of Richest People.”

This clearly shows how successful (or unsuccessful) market timers have been. In an ideal world, an investor would have all relevant information and would know when to invest and when to get out of markets.

To explain these concepts, lets take a scenario, in which there are 3 investors – A, B and C. All three are ready to invest Rs 5000 every month from January 2000 onwards. But timings of their investments are different. Investor A invests at lowest index level during the month (i.e. A has all the information); Investor B invests at highest index level during the month (i.e. B mistimes the market every month!); Investor C is indifferent to news flow and invests at month-end closing prices. Each one them has invested a total of Rs 7,20,000 in 144 months.

So where do A (Perfect Timer), B (Perfect Mistimer) & C (Indifferent Investor) stand at the end of 12 years?

This analysis shows that the difference between a Perfect Timer (A person who has all the insider information) and an Indifferent Investor (Does not care about intra-month fluctuations and has automated his investment process to invest at month ends) is of just 6%. Just 6%. That is, if you are ready to invest in a disciplined manner for long term, having information and timing does not matter much. Even an indifferent person can make money by investing dispassionately.

So what does this analysis point to?

It should be understood that there is no point in trying to time the market. Though it has been tried by millions of people and people have made money and have become millionaires, the fact remains that it is neither easy nor feasible for a average investors like us.

Timing is possible. But only for those who are part of the inner circle – people who have insider information.

There is a difference between information and wisdom. An investor should be vary of all information being bombarded at him and one needs to be wise enough to filter out the noise.

As a regular retail investor, it makes sense to keep on investing in a disciplined manner. The reason being that there is not much to lose (6% – Refer to above example) if an investor decides to ditch time-the-markets approach.

They say that it is best to invest when valuations are low.

Sensex is currently (December 2011) trading at a P/E of 16.5. So is this the right time to invest? Is this what experts call a low valuation? We at Stable Investor have decided to answer these questions.

Analysis of Sensex’s last 12 years data (from 1^{st}Jan 1999 onwards) reveals a few interesting points –

Over any rolling period of 5 years in last 12 years, Sensex has not given negative returns! So if you are ready to stay invested (in this case, in an Indian Index Fund) for a period of 5 years, you won’t lose money.

Returns earned during last 12 years, when segregated on basis of P/E ratios are –

Returns (Over 3 & 5 years) & P/E Ratios

This clearly indicates that at current P/E of 16.5, we have a chance of earning more than 15% per annum for next 3-5 years!

(Caution – This statement is made on basis of historical data. Past performance is no guarantee of future performance.)

So after analyzing this interesting relationship between P/E Ratio and Returns, what does a Stable Investor do?

Stable Investor is now in a better position to respond to people’s view that it is better to invest in markets of lower multiples (P/E). Our analysis clearly shows that if investor invests in markets of lower multiples, probability of earning high returns is very high.

P/E Ratios are still relevant for judging overall valuations of markets, if not individual stocks.

It is advisable to invest when markets are trading in early teens (i.e. 13<P/E<16). It has also been seen that Indian markets tend to stay between P/E Multiples of 12 and 24 (Read Indian Markets PE 12 to 24 for details)

P/E Ratio is a beautiful indicator of market’s overall valuation. But before making any buy or sell decisions, an investor should also look at a lot of other information/data.