Tuesday, May 15, 2018

Stocks that spell danger for Buy and Hold Investors

Beta measures the volatility of a stock relative to the market. Many traders love High Beta stocks, but what about the Long-Term investors? In this piece, I highlight why High Beta stocks are painful for Buy and Hold Investors. The reason is not because High Beta means more Risk. It is more to do with our mind!

“Understanding how our brains work – our limitations, endless mental short cuts and deeply ingrained biases – is one of the keys to successful investing”   Seth Klarman
Buy & Hold Investors may have to endure significant losses
Warren Buffet, the epitome of Buy and Hold Investing,  famously said “Unless you can watch your stock holding decline by 50% without becoming panic stricken, you should not be in the stock market.”
But Losses are Not Easy to Handle
Surely there is a reason why Warren Buffet is who he is. For us lesser mortals this is one of the most difficult advice to adhere to. There is a good reason why this or even a 20% loss on our position so difficult to swallow.
Daniel Kahneman won a Nobel Prize to explain the reason
Daniel Kahneman and Amos Tversky explained that most of us have a huge aversion to Loss. According to them, we are almost twice as Unhappy to Lose, say, Rs. 10,000, than to Gain the same amount.
Sounds irrational, but that’s how human mind is wired, unless you are like Warren Buffet ! This concept is famously known as the Prospect Theory and it was the topic of the paper written in 1979 by these two Israeli Psychologists.
In fact Daniel Kahneman won a Noble Prize in Economics(!) in 2002 for this (since his colleague had passed away he did not receive the prize as the Nobel Prize is not given posthumously).
What has High Beta and Buy & Hold Investing got to do with this?
High Beta Stocks are those which have been much more volatile relative to the market. For example, a Beta of 1.5 for a stock means that the stock is 50% more volatile than the market. If the market falls (or rises) 15% the stock will typically fall (or rise) by 22.5%.
Now if we suffer from the Loss Aversion that the Prospect theory talks about, a loss of 22.5% can feel very painful.
In a falling market, a High Beta Stock causes much more pain than a stock with Beta of 0.8 as that stock in the same situation would have fallen only 12%.
Selling at the Price that we bought at is the most common outcome
Because of Loss Aversion we find it very difficult to sell a stock when it is down. But the Painful memory means that more often than not as soon as it reaches the price we bought at, we heave a sigh of relief and sell. In the process we miss out all the subsequent gains. So we may have identified the stock perfectly, but our mind games make us miss the Upside!
In my piece, HDFC Bank: 5 Reasons the stock fits any portfolio, I had highlighted that “the Beta of the stock at 0.79 is ideal for a long-term investors as lower volatility makes Buy & Hold strategy easier to implement.” The ride is much smoother in these low beta stocks.
So the next time you Buy a High Beta Stock for Long term Investing, please be aware of this pitfall.
Always test your own patience using Beta before the markets tests it!

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