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Are You Right Because the Stock Moved Up?

"The prices on the market are the ultimate form of social proof, reflecting what other people think."

- Charlie Munger ( Trades , Portfolio )

Do you ever ask yourself this question - how do I judge the success of failure of my investment decision making? In other words, how I know whether my investment thesis is right or wrong? If you do, what is your rational answer and is your practice consistent with the theoretically correct answer ?

From my observation, most market participants judge the quality of an investment decision by one single factor - the price movement (especially) of the underlying security. If someone pitched a long idea and the price of the stock moved up say 30% during the next few weeks for whatever reason, he or she will be rewarded with credibility and respect. Conversely, when Bill Ackman (Trades, Portfolio) pitched the case against MBIA and the price kept going up and up and up for years, he looked like an idiot during these years.

I think this predictable irrationality caused by a combination of reinforcement and social proof is one of the most under-appreciated concepts in the investing world. We talk about how to sharpen our analytical skills and how to value a business very often but we don't talk enough about how to avoid the folly of being misled by the powerful irrational movement caused by social proof. This predictable irrationality is almost ubiquitous. I've known investors from all over the world and we exchange ideas on a regular basis. For a while I was befuddled by the following behavioral pattern: I would receive congratulatory emails from my friends because the stock I wrote about moved up but very few of them wrote me congratulatory emails when the thesis of my investment was gradually holding water yet the stock price remained tamed.

Such is the human side of investing. We are subconsciously subject to a super powerful lollapalooza effect - the availability bias, the consistency and commitment bias and the social proof bias. Very often the price of a stock is readily available whereas other data may take a while to find. Then we are inclined to pound in what we shout out. Ultimately we feel secure and comfortable when the whole investment community agrees with us and insecure and horrified when the herd is against us.

There are many great examples of how we can minimize the impact, or even overcome the aforementioned lollapalooza effect. My favorite examples are given by David Einhorn (Trades, Portfolio) and Bill Ackman (Trades, Portfolio). Readers can read the book "Fooling Some of the People All of the Time" and "Confidence Game: How Hedge Fund Manager Bill Ackman (Trades, Portfolio) Called Wall Street's Bluff." Whatever bias you may hold against Mr.Einhorn or Mr. Ackman, don't let them stand in the way of appreciating the remarkable battle they had against the herd and human nature in their short bets against Allied Capital and MBIA.

Another great example that is still developing is Warren Buffett (Trades, Portfolio)'s investment in IBM. I've laid out my simple case for IBM in one of my previous articles. As IBM's stock price has been stagnant during the past few years, Buffett and Munger are facing a growing amount of criticism and doubts. Obviously Buffett and Munger have their way to handle the tremendous power of social proof and commitment and consistency tendencies. Their approach is simple- pay attention to the fundamentals of the business and ignores the price movement. I encourage the readers to adopt this simple approach. Let me illustrate this point with the help of Value Line's IBM report:

As we can tell, on a per share basis, both revenue and net income have been increasing consistently since Buffett took a stake. The profit margin is expanding. IBM continues to shrink its share count, giving Berkshire a higher ownership%. Its return on equity is still enviable. In short, the fundamentals of the business look very healthy despite the much discussed challenges faced by IBM.

I suspect this is why Buffett and Munger are not swayed by the nay-sayers and critics, who most probably focus on the easily available and social proofable stock prices. The wiser men focus on rationality and sound investment thesis supported by quantifiable evidences.

Ok, I have done my part of preaching. Fully aware of the limpidness of my thinking and experiences, I look forward to thoughtful comments from fellow intelligent readers.About GuruFocus: tracks the stocks picks and portfolio holdings of the world's best investors. This value investing site offers stock screeners and valuation tools. And publishes daily articles tracking the latest moves of the world's best investors. GuruFocus also provides promising stock ideas in 3 monthly newsletters sent to Premium Members .

This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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