Investing in stock markets is only partly about knowing the right principles and techniques. Success is also determined by how much strength of character one possesses. It is first about taking time out to learn the right principles (instead of diving into the stock markets right away without any knowledge). And having learnt the principles, it is about whether one can adhere to them irrespective of which way the markets turn.
Most of economics rests on the premise that human beings are rational creatures who behave in a manner that will maximise their gains. A more recent field, behavioural finance, says that humans may not be as rational and devoid of flaws as we have assumed. Especially in the greed and fear-driven environment of the stock markets they display behavioural traits that prevent them from turning in market-beating returns.
Here are a few common behavioural flaws:
Representative bias: Sometimes when a particular sector is doing well, investors could blindly purchase a stock just because it belongs to that sought-after sector. For instance, around 1999-2000, when the information technology sector had caught investors’ fancy, everyone wanted to invest in it. Finding the likes of Infosys expensive, they invested in lesser-known IT stocks just because they belonged to the same sector and were expected to share in its growth prospects. They often bought these stocks at valuations that were not justified either by their past performance or prospects. Their subsequent poor performances showed that investors’ optimism about them was misplaced.
Recency effect: In decision making, investors often give excessive importance to what has happened in the recent past instead of going by what has happened over an economic cycle or two. They often extrapolate the recent past into the future: if a stock has appreciated recently, investors believe that it will continue to rise in future as well. In reality, valuations tend to be mean reverting. So a stock that has appreciated substantially in the recent past is more likely to languish at the same level for quite some time (undergo a time correction), or its price could even decline. The probability of a further climb (in the immediate future) does diminish if a stock has already climbed a lot in recent times.
Loss aversion: Psychologists say that if you administer pain and pleasure in equal measure to a subject, the sensation of pain will be felt three times as acutely as the sensation of pleasure. This has implications for investors’ behaviour in the stock market. Let us look at an example to explain loss aversion. Ajoy Kumar bought a real-estate stock in mid-2007 when this sector was booming. It is end 2010 now and yet the stock refuses to move up from the trough into which it fell in 2008. The company is mired in debt and many of its projects have missed their completion deadline for lack of funds. The management has not come up with any ideas for dealing with the company’s problems. One would think that Kumar would be better off selling the stock and deploying his capital in another that has better prospects. But Kumar is reluctant to book a loss and move on. He is waiting for the day when the stock will break even — something that may never happen. Booking a loss would mean inflicting a dose of pain on himself, and this he is reluctant to bear.
Herd instinct: Few of us possess the self confidence to be completely sure of our decisions. Most of us look for validation from those around us. We seek safety in numbers. For instance, conservative investors, who earlier shunned equities, may jump into the markets at a late stage of a bull run because they see their friends and neighbours making money in the markets. Since valuations are already high by then, this is the worst time to be entering the markets. Even when choosing stocks, they may not do any research themselves, but invest in the hot stocks of the day, or rely on tips. Such herd behaviour inevitably causes them grief.
By contrast, great investors such as Warren Buffet shun the herd. They do their own research, and having made a choice, stick to it, unmindful of what the rest of the market is doing. For instance, when markets turn expensive, Buffet is known to sit on huge amounts of cash, refusing to deploy the money until bargains become available once again.
Availability bias: Investors also tend to rely more on information that is available easily. For instance, most securities firms tend to focus their research on the better known stocks. Investors who depend on these firms for recommendations also then invest only in these stocks. But since these stocks are intensively tracked, instances of mis-pricing in them are few and far between. To find stocks that are trading at a discount, investors may have to venture farther afield into stocks that are not so intensively tracked. Since information about these stocks is not easily available, they will have to dig for it themselves. This they are usually reluctant to do.
Underpricing heuristic: Among a lot of Indian investors there is a belief that promoters underprice new issues and hence investing in initial public offers (IPOs) will lead to quick listing gains. This is a legacy of the times when the office of the Controller of Capital Issues (CCI) existed and promoters had to get the price of IPOs approved by this authority. In those days new issues may have been underpriced. But nowadays the majority of promoters try to sell shares at the highest possible price, which is why more IPOs come out during bull runs, when market participants are optimistic and willing to pay a higher price for these issues. When evaluating IPOs, if investors resort to the underpricing heuristic (instead of rationally evaluating their prospects and valuation), they will make an error in judgement.
To learn more about the field of behavioural finance, you could read books by Daniel Kahneman and Amos Tversky. Among Indian writers, Parag Parikh, chairman of Parag Parikh Financial Advisory Services (PPFAS), has written a good book called “Value Investing and Behavioural Finance” which has the added advantage of being contextually relevant (since it is based on the Indian stock markets).