BORING IS GOOD

In a world addicted to instant gratification, the greatest investment advantage lies in patience. High quality, boring stocks are persistently undervalued and offer superior returns over time. This challenges conventional wisdom and proves: boring is good.

The big money is not in the buying or selling, but in the waiting - Charlie Munger, Vice Chairman and Architect of Berkshire Hathaway (1924–2023)

The more risk you take, the higher the return.

We would intuitively agree with this statement, and it would confirm the efficient market hypothesis.

Financial markets are efficient in the sense that an investor cannot consistently achieve returns above the average market returns on a risk-adjusted basis. Put simply; to achieve higher returns in the market, one must accept more risk.

Evidence is mounting, however, that what may be true in theory, according to our gut instincts and from academia, is not necessarily the case in practice – where people driven by emotions are anything but rational. This is where the big missing mosaic piece comes into play that I find so absent in today’s fast-paced world.

A long-term horizon and perspective. Or the strongest investment habit you can have:

Patience.

Instant Gratification vs. Delayed Gratification

It bothers me. A lot.

The urge for instant gratification, for the next dopamine kick, amplified by the rise of social media and its algorithms. They are trained just to keep your eyes glued to the screen, capture you for a mere eight seconds and then let you move on to the next kick.

We know that this has a negative impact on our brains and has implications for our daily lives. Not to mention the consequences for younger people who are most absorbed with social media, including myself, who fall victim to the algorithm.

We are only being trained for instant gratification, for short-termism.

Since we have now fallen below the attention span of a goldfish of nine seconds, investing is also becoming increasingly difficult. This short-termism has also been reflected in the rise and massive success of 0DTE (zero days to expiration) options or the average holding period of stocks on the Bombay Stock Exchange – and yes, I know that trading algorithms have an impact on this, but it still reflects our behavior well.

Leaving aside the criticism of society, there is a growing body of evidence for the significant benefits of delayed gratification in investing.

It is the greatest advantage we can claim as investors.

And it is reflected in time horizon arbitrage.

Contradicting the core of finance

First, let’s talk about the entry point to the introduction – risk.

Research shows that between 1990 and 2011, across 21 developed markets, the least volatile decile of stocks generated an annualized total return of 8.7%, while the most volatile decile lost 8.8% per year. For Indian equities, the least volatile decile returned an average of 15% per annum over the same period, while the most volatile decile lost 9% per annum.

We can agree that 20 years is a short time horizon to analyze and that there have been severe bear markets (flight to quality phenomenon) during this period. Nevertheless, the results are noteworthy, and according to the researchers, the fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is both persistent and comprehensive, respectively. It extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.

Other studies by Goldman Sachs, (Paying for Quality : Is the market Too Cynical), and BCA (The Quality Factor In Equity Markets), consider the Quality factor. According to these studies, owning good quality companies reduces risk and increases returns.

Quality has ALWAYS outperformed most other factors.

In a nutshell: Lower risk stocks or companies that are of higher quality perform better.

But why?

Possibility Effect vs. Certainty Effect

People never cease to amaze me. One of the greatest explorers of human psychology and behavior is Nobel Prize winner Daniel Kahneman, who passed away this year and whose book Thinking, Fast and Slow is highly recommended.

Some points on behavioral finance from him and his book as well as the BCA paper on why higher risk stocks are an unnecessary risk compared to quality stocks:

1. Lottery-like stocks

• Why do market participants over appreciate?low-quality or junk stocks and underappreciate?high-quality stocks? One reason could be a preference for lottery-like stocks. Gamblers seem to be willing to pay an excessive price for lottery tickets?– beyond what the odds would justify –?as they pay a small amount (limited downside) for the possibility of a big win (unlimited upside). We tend to underestimate high probability events and overestimate low probability events.
• Market participants show the same trait when chasing the next big thing or home run stocks.

2. Simply Over-paying

• You can lose 100% on a stock but gain many times the amount invested. Why choose a low-risk stock that potentially?carries the same risk to capital but has much less upside potential? Investors may feel that high quality companies – which tend to be stable, profitable and more expensive – cannot achieve the same kind of extreme gains and may even be prone to mean-reversion as their success is obvious and well known.
• Market participants tend to overpay for perceived future potential.

3. Increase of relative chances of survival

• Imagine your startup is struggling, and a new technology could enhance your chances of success by 10%. If your chances were 50/50, a 10% boost would certainly be valuable. But if your chances were nearly zero, you would likely pay much more to increase them to 10%. Similarly, if you had a 90% chance of success, you would value increasing it to 100% more than going from 50% to 60%.
• Market participants tend to pay more for extremes, i.e. for a high-risk stock with great future potential (at 10%) or a bond (at 100%) compared to a high-quality stock of the same company (at 90%), as the bond has a certain and safe coupon and redemption value, while a stock is still a stock with uncertainty about the share price and dividends. Either an extreme possibility for success or extreme certainty.

Let’s dig a bit deeper into the last and most important concept illustrated in Daniel Kahneman’s book and in the chart below.

It is about the possibility and the certainty of an outcome. The conclusion is simple (from the book): the decision weights that people assign to outcomes are not identical to the probabilities of these outcomes. Improbable outcomes are overweighted; this is the possibility effect. Outcomes that are almost certain are underweighted relative to actual certainty; this is the certainty effect.

This is a chart of Kahneman's showing the relationship between objective probability and subjective importance. The dotted line is the objective probability of success, and the solid line is the psychological "decision weighting" for each probability of success level. From 0 to 30%, you overvalue and overpay for chances of hitting it big, akin to lottery tickets/high-risk stocks. Between 30% and 100%, you underpay, with a sharp increase in value from 90% to 100%.

This psychology implies that near-certainty is undervalued. This is where you will find low beta/high-quality stocks, offering stable returns with some uncertainty. Investors are either looking for home run investments (lottery tickets) or investments that are 100% certain (like bonds) and therefore undervalue this area – which is our opportunity.

This is one of the reasons why the quality anomaly exists and why quality stocks outperform others over the long term. They are structurally undervalued because they are boring and yet uncertain.

Now let’s move on to the missing mosaic piece and time horizon arbitrage.

To give you the catch right at the beginning: nobody wants to get rich slowly.

Search for boring quality companies

The last part of my introduction was: patience.

You have to be invested for a long time in high quality compounders, winners that keep winning and you need to adhere to the concept of time horizon advantage. It is beyond what most investors can stomach. It lies not in the short-sighted quarterly performance that many market participants focus on and are incentivized for, but in the years, if not decades of compounding.

The conclusion from all this is simple, yet mind-boggling. Instead of seeking outperformance by buying risky stocks, investors should search for boring quality companies, i.e. those where you cannot make a quick buck and where you need patience to outperform the market.

This is the difficulty for our goldfish brains and dopamine-addicted minds in search of the next thrill: We simply must sit tight and let our capital compound with boring businesses.

After all, the big money is not in the buying or selling, but in the waiting.

And I have shown you clearly: boring is good.

Article especially compiled for young investors who are TIME BILLIONAIRES. #Jaiavalani