Archive for the ‘Behavioral finance’ Category.

 

Guaranteed approach to losing money – Look at the last 3-5 year returns and extrapolate mindlessly. Invest when past returns are highest and sell after the market corrects

Starting amount: Rs 100000

1. Invest infrastructure mutual funds in 2008 (after the boom) based on hard selling by mutual funds
2. Sell in 2009 with a 40% loss on average
3. Recuperate from shock for 2 years
4. Invest in gold mutual fund in 2011/12 after seeing 5 years of boom
5. Lose 10% of principal in next 3-4 years
6. Now, invest in mid and small cap funds, after 3 years of boom.

The investor has already managed to lose 50% of principal by now. The above tale may be an exaggeration, but you can check mutual funds with the above kind of performance, with most being launched towards the tail end of the boom. Someone is surely buying these funds at the top of a cycle !

It may not be the same investor in each case, but I can assure there are definitely a few who manage to achieve this ‘feat’ over a lifetime as they never get over their greed and refuse to learn from their losses (it is always someone else’s fault)

If you think, I am mocking such people – that is not the case. I did the same thing when I started out, but the only difference is I swallowed my pride, accepted my mistake and have tried to learn from it.

An oversized ego is always dangerous to the wallet

 
 

I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (here and here).

Some good books/ resources on the topic are listed below

Poor charlie’s almanac

Thinking fast and slow

The psychology of influence

The art of thinking clearly

Seeing what others don’t : The remarkable ways we gain insight

Professor sanjay Bakshi’s website (here) and all his lectures (here). I would encourage everyone to read the lectures multiple times.

Lets explore a few more baises and how one can avoid them

Sunk cost fallacy – This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted,  then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.

I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.

Story bias

Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.

It is however dangerous to get seduced by a story stock or company. Unfortunately you can find investors buying into stories all the time and overpaying for it. The stories change, but the basic theme is always the same. A new or exciting development comes to the attention of a few investors (IT stocks, real estate stocks or consumption stocks). These smart investors have the insight of investing early at attractive valuations. This ‘story’ is soon picked up by the media and now others follow blindly into the story at astronomical valuations. The ‘story’ feeds on itself and everyone looks good as long as the price is rising. At some point investors start realizing that the valuations are too optimistic and the selling begins. The ‘story’ is discredited and investors wonder how they got sucked into it

How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.

Base rate neglect

If you ask someone an unpleasant question – are you more likely to die in an airplane crash or heart attack, what is the more likely answer? I can bet in the majority of the cases, it would be the airplane crash (heart attacks are a more common cause). An airplane crash is more vivid and comes on the front page of a newspaper, whereas heart attack deaths are almost never publicized.

Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.

How does one take advantage of base rates? One needs to focus on areas where the odds favor you. It is far easier to do well with companies and industries where the underlying business has a high rate of return. In such cases, unless one pays too much, the investor is likely to do well over time.

In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.

Over optimism and overconfidence

One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?

If you find yourself, attributing all the success to your intelligence and failure to bad luck and other factors, you may be crossing the line. As an investor, if your performance is not above average (after several years) and you still think that there is nothing wrong with your approach and think that it will all work itself out, then you need to dial down your confidence and optimism.

What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.

In my case, the actual results have given me the confidence to be more aggressive, though I still finding myself doubting all the time.

No silver bullets

We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.

The first step in overcoming these biases is to recognize them and acknowledge that we are often influenced by them. The next step is often to build routines to reduce their impact or negate them completely. Some shortcuts I try to use

–          Do not look at the stock price when analyzing a company to avoid getting ‘anchored’ by the stock price

–          Never buy a stock which is hitting upper or lower circuits. There is a lot of emotion around the stock/company and it is better to let the dust settle down, before one can analyze the situation calmly and make a balanced decision

–          Try to look for at least three reasons which could cause the idea to fail

–          Do a probabilistic analysis of the stock, to evaluate the downside. How low can the price drop?

–          Avoid IPO, options and current fads

–          Never listen to tips – especially from TV. If it is recommended on TV, everyone and his uncle knows about the company and the price already reflects the prospects.

–          Analyze the stock from a 2-3 year perspective where I have a strength over the other short term players in the market.

–          Don’t tell about your losses to your wife. She will think that you are smarter than you really are 🙂

 
 

I personally think that being rational is extremely important in becoming an above average investor. So how does one become more rational?

There is a book called – predictably irrational by dan ariely which talks of the irrational behavior in most of us. The more interesting part of the book however is the ‘predictable’ part. It means that most of us are consistently irrational. The good thing about this predictability is that if one can identify these patterns, then there is a possibility of reducing the irrationality (I don’t think it can be completely eliminated)

The first step in reducing the irrationality is to name and classify the various behaviors which impact us negatively as investors. I started exploring the various biases which affect us in the previous post and will continue with a few more in this post.

Authority bias

You may seen this bias in others (most people think they are themselves immune), when they  purchased a stock based on a recommendation by some TV presenter or commentator. In other cases, the recommendation may be from a broker or some sales person in a bank.

I have personally avoided this bias in the above form by having a simple thumb rule – TV presenters are actors and should be watched for entertainment alone. As far as brokers and sales people are concerned, I refuse to listen to them.

The above comments may imply that I am immune to this bias – but I am not. I follow a few other bloggers and top investors. In the past, if one of them was invested in a stock, I would develop a much more positive view of the stock and even went ahead and invested in the same.

The biggest source of my bias has been from the top thinkers in the field of investing (Warren buffett, Ben graham etc). It is not that their teachings are not worthy of following, but I have followed them blindly without understanding the context.

Case in point – Warren buffett talks of the buy and hold philosophy. A lot of people miss out that they he does not imply buy and forget and certainly not buy and hold bad companies. The pre-requisite condition is that one should buy a good company at an attractive price and then hold it for a long time. I have bought duds and then held it for some time, thus compounding my mistake.

How does one avoid this bias – As in all other biases, it is not easy. I have found one approach which works for me a bit – Never accept blindly what others say (including your idols). I  try to analyse the context of a statement or idea and try to think of a scenario where that idea is not true.

First conclusion bias

This is a very common bias and we know it by another name – First impressions. We tend to form opinions of other people in the first few seconds of meeting them and then any interaction tends to re-inforce the impression. This bias has a lot of implication in job interviews, but that is a separate topic.

In the case of investing, this is closely related to the commitment and consistency bias. As an investor, I have found that when I am looking at a company and its financials, I tend to form a fuzzy view of the company in the first few minutes – such as looks worth of investigation (may even buy) or maybe this company is junk. Once I reach this view (often subsconsicously), my subsequent analysis and thought process is influenced by this first conclusion. In addition, if I make a token purchase the commitment and consistency bias kicks in. Once this happens, my decision is kind of locked (even if i think it is not)

How does one avoid it ? For starters, I look at a company and form a view (even if subconscious) and then just drop further analysis. I make a note of the company and then move on to something else – allowing for a cooling period. I will usually come back to it after a few days and then read up on it further – making notes as I go along.

The final decision to buy comes usually after a few weeks and even then the position is a small one. I am not sure if I have been able to reduce the bais, but it prevents me from buying a stock when I am in heat. The downside is that the stock price may run up before I can buy a full position, though in balance I would rather loose the upside occasionally than make a foolish decision.

The next post will the final one on this topic and I will explore a few more biases and discuss how it is important to build routines in your investment process to reduce their impact.