Stocks to Riches: Insights on Investor Behavior - Parag Parikh

Stocks to Riches

Parag Parikh was an ace equity investor and founder of PPFAS Mutual Fund (India's leading mutual fund house). His fund has outperformed broader markets for an extended period of time making it one of the most successful fund house of country. The book Stocks to Riches is beginner's guide to stock market, how markets work and how people perceive it to work, behavioral finance, mental models and investor psychology. Mr. Parikh wrote this book in 2005 after the dot com bubble, and Asian economic crisis when the Indian equity market was about to enter a bull run. It is divided into 11 chapters, starting from the basics and gradually moving towards an investor’s behavioral insights.

Chapter 1

Like the Intelligent Investor, the book starts with defining what investing is and covers some basic terminology related to it like investment instruments, types, asset classes, etc. .It explains the difference between trading and investing which requires separate mindset, methodologies and perception.

Chapter 2

Here, a detailed analytical difference between investing and speculation is done. The kind of risk appetite, tenure to hold, capital available etc. are some of the factors combined with personal opinion can help an individual decide whether he wants to invest or speculate. The broad idea is to generate an alpha over broader markets. Sources of returns for investing are classified as Cash flows + Capital gains. Case study of Infosys gives a brief of valuation thesis using basic number crunching.

"Stock market investing is all about managing the rewards associated with the risks undertaken."

Chapter 3

Ways of investing-

1)Intellectually difficult way i.e. by reading businesses, valuing them and holding them with patience as practiced by renowned investors like Buffet, Munger, Lynch etc. They take a few bets every year but with deep convictions and have the patience to hold those bets. To quote Munger "Our predictions are better than other people is because we try to make fewer of them."

2)Physically difficult way i.e. by speculation and timing the market so as to generate returns to outperform markets

3)Emotionally difficult way i.e. by having an understanding how emotions guide decision making and how to inculcate emotional decision. To quote buffet "Be greedy when others are fearful and fearful when others are greedy."

Chapter 4

It introduces behavioral finance and how things work in real life. Behavior finance is intersection of anthropology and economics. It depicts how, in reality, things are much more distorted as humans does not behave in one common way. Every individual behave and perceive similar information in different manner and hence uniform results cannot be expected.

Chapter 5 and 6

Loss Aversion and Sunk Cost Fallacy these two behavior anomaly which are explained using conversations and case studies.  Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains.

"The idea that investors are not risk averse but loss averse is one of the main tenets of behavioral finance."

Sunk cost fallacy is to increase commitment to justify past actions as your ego is tied with that commitment. Both of these leads to "Decision Paralysis" and loss of opportunity.  Further he mentions about the endowment effect i.e.  too much emphasis on instant gratification and too little value on opportunity cost. The book guides us through Indian case studies that how these anomalies affect our decision making and suggests a few remedies to avoid them while decision making. A few include- Diversification of assets, taking in opportunity cost, reframing losses as gains. 

Chapter 7

Mental Accounting -It is the tendency to place different values to the same sum of money depending on how it has been acquired and the effect required to acquire it. Three episodes discussed in the book tend to show the perception of money that different people hold- from capital gains, lottery wins to spending in cash vs. using credit cards, large vs. small purchases, sacred money etc. Author suggests few ways to devise your own plan of action like always pay in cash, be alert what you really want vs. what you need, treat all income as earnings.

Chapter 8

It discusses the mental heuristics which overshadows facts and hinders clear decision making. Heuristic refers to the process by which we reach conclusion. The chapter quotes examples to explain each heuristic in detail like availability heuristic, representative heuristic, saliency heuristic, overconfidence, anchoring and adjustment, size bias, pattern recognition. This is must read chapter full of case studies with a lot of learning about human behavior.

"Investors anchor their future projections on past performances, seeing the future as a repeat of the past."

"The concept of pattern recognition would make us believe that growth rates will continue at 70-80 percent."

"Most often investors allow popular opinion and behavior to define values for them; sometimes for the good but often not."

"When individuals are anchored they under react to any new information that is made available to them."

Chapter 9

Mutual funds, fund managers and the future prospects regarding open and closed ended funds. Overall a short and sweet chapter which throws light upon fund manager's behavior and fund performance.

Chapter 10

This chapter explains the boom and bust cycles which underplay actually in the market and which is unseen by most of the investors. Real use of biases and heuristics, how stocks are pumped up and how markets perceive price. In the later part, Parag explains about -Systems thinking. It is highlighted as "looking at the whole picture, the different parts and the interconnection between them." Market works in loops and not in straight lines. Feedbacks, either reinforcing or balancing act in loops and all the previously studied heuristics creates endless cycles of boom and bust.

"In case of bull market we need to know the source of money and from where the money to fuel the source the boom is coming. In case of bear, we must know the source of information and the actor playing on insider information to depress the price."

Chapter 11 

The book closes with reiterating the importance of investing. The difference between rich and poor psychology using various cash flow quadrants-Investor, employee, self-employed and business.

Overall, it is a good read especially for someone new to finance or someone who wants to learn about behavioral finance.