Too Much Trust…

Risk aversion is what keeps the market honest & sane

– Howard Marks.

Is there something like ‘too much trust’? Can there be a situation where we so blindly accept our fate in the future that we forget that there ever was something like uncertainty?

I think, valuations of businesses, from time to time reflect this oscillating level of trust among investors where wave after wave of investors remain undecided about how much to trust the future prosperity of a business. Usually trust among market participants is good because it encourages liquidity & the promise of value being exchanged at fair price. When the outcomes are unknown & knowledge can only help us so much, trust can help exchange of securities.

But what happens when we take the trust in the market / the companies to the extreme?
Is too much trust a bad thing?

Too much trust enables…
– ease of taking risk
– forgetting cyclicality
– availability of cheap leverage / equity for managers who have not learnt to run their operations frugally
– imaginary safety net of the market which goads us into taking a that leap of faith at no-matter-what valuations.

But this excess of trust has another negative consequence. It closes the gap between the reasonably valued business & the fairly valued business. That leads to a scarcity of good investment opportunities. That means there’s no safety net available for some investors who decide to participate in the market regardless of this scarcity of good ideas.

A while back I read this very nice & thought provoking book called Scarcity by Senthil Mullainathan. It mentions the unique effects of scarcity on our decision making –

Scarcity alters how we look at things; it makes us choose differently. This creates benefits: we are more effective in the moment. But it also comes at a cost: our single-mindedness leads us to neglect things we actually value.

The new crop of investors who make a quick buck while some stock they picked surged over a week’s time, will never get a chance to really understand what it is that they should truly value. Not learning to appreciate the importance of real things like cash flows, scale of operations & how difficult it is to manage a larger business as compared to a much smaller one, will lead to constantly looking over our shoulders for that hitman (i.e. a slow quarter).

Well, each day is indeed a learning opportunity, where those who sit on the sidelines sulking about the scarcity of ideas, learn more about themselves & find that it’s really really tough to sit on our hands when the whole world is clapping. It’s a complete loss of hope in the ability to pick good ideas which in the world of Flight Club, is freedom.

About Raunak Onkar

Raunak Onkar heads the Research department at PPFAS Mutual Fund. He started his career at PPFAS as part of his internship during MBA.

He holds an MMS (Finance) degree from the University of Mumbai.

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