“With such positive good news from the company why is it
stock going down?”
“I have knowledge of reading balance sheet as I am a
qualified chartered accountant. I
went through the financials of the company. At the current
price the stock is too
expensive. I would not buy it nor recommend the same to
anybody. But I am surprised
that for the last two weeks the stock is up 15%.”
“My friend works with the company. He told me that the
company was doing
exceedingly well and have export orders worth crores in
hand. So I bought the stock. Its
six months I have been waiting but the stock is going down”
“The company has announced a 1 for1 bonus. Its good news and
I bought the stock.
However the stock went down instead of my belief that it
would go up on such good
news.”
“ I read this morning newspapers and was impressed by the
Finance Minister’s speech
and his intention to give sops to the economy. The markets
greeted the news positively
and went up. I bought stocks. The next day the markets were
down for no reason and I
am losing on my investment.”
“ I heard the expert comments on TV on the current budget
presented by the Finance
Minister. They were not very happy with the same. I sold my
stocks only to find that within a week the markets were up 10%. I don’t know
why I sold my stocks which I was
holding for the past four years.”
“ I cannot understand the markets. I would rather stay
away.”
Aren’t all these statements familiar? You have heard them
and may be you also have
made them. At some point of time I am sure you would have
encountered the above
situations. In an ever changing and an uncertain world we
are trying to find some
predictability where none exists. So what would one do? The
easiest answer is to avoid
such irrational markets. Well think before you feel that
way. Avoiding the stock markets
is not the answer. You would be missing out on one of the
most favourable mode of
investment. My sincere advise would be to catch the bull by
the horn. Confront the
problem rather than run away from it. Try to understand why
this happens to most of the
people instead of “wondering why is it happening to me”.
Heres my story.
During the recent IT bubble I also found myself bewildered
and confused. The
valuations of the Dot Com and IT stocks seemed inflated
beyond imagining. Pundits in
the market and the media were pontificating on the "new
economy" and were giving
convoluted justifications for what appeared to be sheer
insanity. Was the entire world
mad and I the only one sane or was I insane, and the world
perfectly rational?
There was this client, who had invested around Rs.70 lacs in
different IT stocks in 1998
on his friends recommendation. In 1999 his portfolio value
was around Rs.3 crores and when he asked me for my advice I advised him to sell
as I found that the PE multiples
were very high and the valuations seemed far too stretched.
He did not do so and six
months later when we met he informed me that the portfolio
value was around Rs.6
crores and asked me what he should do. I was a bit
embarrassed with the question, as I
knew that he was really not asking for advice but telling me
indirectly that I was not in
sync with the markets although that happened to be my
profession. I insisted that he
sell and he did not. Sometime later the portfolio value had
gone to Rs.8crores. This was
the frustration I had to go through. Being in the business
of stocks and not being able to
advise clients correctly. This was just a sample of my
experiences. There were times
where I would have sleepless nights fearing that the world
was going too fast for me to
understand. I doubted my abilities, my competencies and my
knowledge. The inability to
understand the madness and at the same time be proved wrong
every minute, every
hour added to the frustration. In fact I lost quite a few clients as they
thought that I was
too conservative and not in tune with the new economy that
was emerging.
To find an answer to this question I did some serious soul
searching. What was really
happening? The natural conclusion of my desperate quest led
to a fledgling, little known
field termed Behavioural Finance. Behavioral Finance, a
field where anthropology
meets economics and psychology intersects with finance.
Untaught in MBA curriculum
across the world, it remains the domain of a few Gurus and
special interest groups.
After an extensive study of the literature on Behavioral Finance
I first started observing
myself very intently and observed my own behavior when it
came to decisions regarding money matters. Off course this had more to do with
investing as it happened to be my
profession. I made some practical observations and studied
the behavior of my
institutional as well as retail clients when they made their
investment decisions. As an
intermediary I came across many cases and incidents of
investor irrational behavior and
this increased my faith to pursue a deeper understanding of
this field. The examples
given in this book are all real and I am a witness to all
the incidents in the course of my
dealings with my clients, friends, colleagues and
associates. I gained valuable insights
and this made me confident to pursue this field. It would
not only benefit me personally
but also help me to add value and differentiation to the
number of people who would
come in my life. With my passion for the subject increasing,
I decided that I needed
formal training and an active interaction with the scholars
who were pursuing this field. I
would take every opportunity to enrol myself to such
investment psychology or
behavioural finance training seminars to get new insights
and an opportunity to interact
with like minded researchers and professionals. Thus I
officially joined the small band of
cognoscenti on Behavioral Finance in the world.
I wish to begin sharing my knowledge with you. We may come
across some theories of
Behavioral Economics, which I may need to explain for your
understanding. But please
be assured that this is not a book on theories, there are a
host of such books available
and I don’t intend to repeat the same. Moreover I am neither an economist nor an
academician. I am an investor, a stockbroker, a financial
planner and a professional. The knowledge gained by me is due to the extensive
reading of the works of various
scholars, economists and academicians who have toiled and
done extensive research
on the subject. I would be failing in my duty if I do not
acknowledge the original work on
behavioural finance done by the great thinkers and scholars
like Amos Tversky and
Daniel Kahneman, Richard Thaler, Hersh Shefrin, Richard
Geist, Robert Shiller,
Benjamin Graham, Warren Buffet, Gustave le Bon, Charles D.
Ellis, Max Bazzerman,
Gary Belsky and Thomas Gilovich to name a few. I am only the
facilitator to bring a part
of knowledge of these great thinkers. I am still learning.
This book helps me to share
with you, my experiences dealing with various types of
investors, fund managers,
corporate, the media, students etc. An optimist as I am, I
am fortunate that I am writing
this book at the start of one of the biggest bull markets in
Indian history. The learning
and my inference from my experiences, I am sure will help
you to be a better Investor.
Even if you become aware and learn to identify some of the
common psychological and
cognitive errors that beset even the wisest investment
professional, it may be enough.
You will take a giant step forward
If Investments do well, why do Investors fare poorly?
We did some number crunching as to how different types of
Investments have done
over the past 20 years.
Historical returns over a 20 year
period
15.8% 11.2% 4%
Equity PPF Cash
Returns: 1984 - 2004
Needless to say equities have done exceedingly well. But
whenever we ask investors
as to their performance in the stock markets, the majority
would say that equity
investments are risky and they have lost money in the stock
markets. They always
curse the volatility and blame it for their losses. Even
well educated investors with an
above average IQ do not do well in the stock markets. Is it not a Paradox “Equity
Investments have done well but Investors have done Poorly”.
Actually everyone
who invested in to equities should have done well with the
equities returning 15.80% in
the last 20 years.
But the reality is that human beings not only make decisions
with their mind but also
with their hearts. An integral part of this humanness is the
emotion within us. Our
emotions define us and make life worth living. Indeed, we
make most of our life
decisions on purely emotional considerations. Our logic and
rationale only retrospectively justify these decisions; they do not determine
them. Our emotions are
subject to change rapidly and this affects our behavior and
decision-making.
Emotions change Paradigms:
This is a true story of my friend who had started a coaching
class with one of his
colleagues. They started off to a very good start and within
a couple of months they
were full to capacity. After six months a few students came
to my friend with a complaint
against his colleague for his rude behavior with students.
The allegation was that he
was very short tempered and arrogant. They wanted him to be
removed or else they all
would discontinue the classes. My friend was worried. His
colleague was his 50%
partner and in no way he could be removed. Moreover he was a
very brilliant
professional and an able tutor. He did not know what to do.
After a couple of weeks the
colleague fell ill and remained absent for some time. The
students were very happy and
they thought that they had been successful in removing him.
They all rejoiced at their
achievement.
My friend one fine day got the news from his colleague’s
wife that the colleague had
brain tumour and he needed to be operated upon. This news
shocked my friend, as now
his partner would be out of action for quite some time. He
informed the students of this
calamity. The students were totally shocked and this
emotional shock changed their
paradigm. Hatred and resentment gave way to empathy and
love. They all gathered and
fell very sorry for him. They went to the hospital with
flowers and tears to greet him.
They repented for their stand and prayed for his early
recovery so that he could come
back to teach. The purpose of this story is to understand
that we human beings are emotional people
and all our behavior and decisions are guided by our
emotions. The colleague was the
same. Emotions made the students changed their attitude of
hatred to that of empathy.
Frequently emotions prompt us to make decisions that may not
be in our rational
financial interest. Indeed, decisions that enrich us
emotionally may impoverish us
financially. Behavioral Finance is the study of how emotions
and cognitive errors
can cause disasters in our financial affairs.
Warren Buffet
“Success in investing doesn’t correlate
with IQ once you are above the level of 25.
Once you have ordinary intelligence, what
you need is the temperament to control the
urges that get other people in to trouble in
investing”Classical Economic Theory V/s Behavioral Economic
Theory:
Classical Economic Theory talks about efficiency of the
markets and people making
rational decisions to maximise their profits. It assumes
that the markets are efficient and
no one can benefit or take advantage from its movements. It
also assumes that humans
are rational beings and will do all acts to maximize their
gains.
However Behavioral Economists believe that the markets are
inefficient and human
beings are not rational beings.
If you and me were walking on a busy street of Colaba and
you see a Rs.5 coin on the
road. When you tell me the same I will shrug you off. How
can it be possible? So many
people would have walked this road and the markets being efficient someone would
have definitely picked it up. However in real life we do
come across such findings. This
signifies the fact that the markets are not efficient, as
they seem to be.
Moreover if we assume that people make rational decisions to
maximize profits then
how would one explain people giving to charities or throwing
a party to celebrate a
birthday or an anniversary? Definitely these are not acts for maximizing profits by
rational people. Charitable organizations, the Rotary Club, the Lions Club would not
exist. Following is another example of irrational behavior
when we give tips to waiters.
TIPS: To Insure Prompt Service. I will give you an example
of how irrational one can be:
Why does one give tips to waiters at restaurants? The
acronym TIPS stands for: To
Insure Prompt Service. If it ensures good service one should
be tipping before the
service starts. Yet, we all give tips at the end of the
meal. One even gives tips when the service is sub standard. Moreover one gives
tips at places where one will never visit
again. This tipping business is more a habit or a custom. We
do it mechanically,
unaware that we are behaving irrationally. Yet, in economic theory
we are rational
beings always intent on maximizing our economic status. This
is a common mental
mistake we make consistently without realizing its pure
economic implications.
So we are human beings and we do not necessarily make
decisions out of our mind.
Being emotional beings we also make decisions out of our
heart and that is the reason
that even smart and intelligent people make big money
mistakes. The study and
understanding of Behavioral Finance is important especially
when we are dealing with
money. That means it includes not only our investment
decisions but also all our
spending decisions.
Behavioral finance researchers seek to bridge the gap
between classical economics
and psychology to explain how and why people and markets do
what they do.
Behavioral finance raises a couple of important issues for
investors. The first is whether
or not it is possible to systematically exploit irrational
market behavior when it occurs.
The second issue is how to avoid making suboptimal decisions
as an investor. The goal
is to close the gap between how we actually make decisions
and how we should make
decisions. In the stock markets, Behavioral Finance explains
why we:
hold on to stocks that are
crashing
sell stocks that are rising
ridiculously overvalue and undervalue
stocks
jump in late and buy stocks that have
peaked in a rally just before the price
declines
take desperate risks and gamble wildly
when our stocks descend
avoid taking the reasonable risk of
buying promising stocks unless there is an
absolutely ‘assured’ profit
never find the right price to buy and
sell stock
Prefer fixed income over stocks
Buy when you have to sell and sell when
you should be buying
Buy because others are buying and sell
because others are selling
Psychology can play a very important strategic role in the
financial markets and its role
is increasingly recognized. Students and proponents of
behavioural finance create
investment strategies that capitalize on irrational investor
behavior. They seek to identify
market conditions in which Investors are likely to overreact
or under react to new
information. These mistakes cause under priced or over
priced securities. The goal of
Behavioral Finance strategies is to invest or disinvest in
and from these securities before most investors recognize their errors and to
benefit from the subsequent jump or
fall in prices once they do.
The Three Sources of Alpha for Superior Performance
Today all intelligent investors depend on information based
strategies. They generate
performance by obtaining better information about companies
and processing it better
than their peers. But gaining advantage through these
methods is becoming
increasingly difficult. This is due to an increasingly
efficient market where electronically
published information is easy to access and available to
everyone equally. Here,
Behavioral Finance investment strategies give you an edge
over most traditional
approaches to investing.
Three Sources Of Alpha
Exploit
Information
Better
Model
Exploit
Behavior
Traditional
Managers Quantitative Managers
(Procedures to
Process Information)
Behavioral Managers
(Mispriced securities
because of behavioral
factors)The recent stock market volatility and the losses
suffered by so many investors’ calls for
a drastic change in the way we look at the stock markets.
From this great crisis arises a
greater opportunity to embrace the new concepts of
Behavioral Finance as a strategy
