Archive for the ‘Behavioral finance’ Category.


I have been reading a few behavioral finance books on the various biases which impact us as investors (and in other walks of life too). I have picked up this topic of study for a very specific reason.

I have been analyzing my investment process and am realizing that the weakest link continues to be the various biases which commonly impact us. If I look back at the last 15 years of my investing life, I can safely say that I was fluent in the basics in the first couple of years and could identify good ideas by the fifth year.

The above statement would imply that I was an expert by year 5 and poised to be a good investor. Unfortunately the reality was far from that – you can read my journey till 2008 here. Knowing what to do is different from doing it.

Let me list a few biases and how I was impacted by them. I will also try to explore what one can do to avoid them

Social proof

This is a bias where in one is influenced by other investors and the general mood of the crowd. I wrote about a mistake I committed a long time ago – purchase of SSI and IT mutual funds during the dot com boom.

Although I was new to investing (around 3-4 years), I understood the importance of valuation and of not overpaying for stocks. Inspite of being cautious for the majority of my portfolio, I still went ahead and committed 25% of it to IT related stocks. As I look back, I recall that the main reason was that a few of my friends were investing heavily in this sector (and getting rich). In addition to this, a nice and pretty broker also recommended a few hot mutual funds (such as ICICI technology fund) which were sure to make me rich in a few years.

How could I miss?

I managed to lose 80% of my capital in a short period of six months. This was unmistakable evidence that I had made a spectacularly wrong decision. Ever since then, I have followed a few simple rules to avoid getting influenced by the crowd

Do not buy hot stocks. If the media is talking a lot about some hot sector or all my friends are getting into it, I will just avoid it. As a result I did not touch the real estate and infrastructure stocks during the 2007-2008 period and spared myself of a lot of agony

– Do not take stock tips from anyone, especially pretty girls 🙂

Anchoring bias

This is a bias wherein one gets fixated on a variable in the decision making process and uses that to make all subsequent decision. This is a difficult bias to recognize and overcome.

I had been following Crompton greaves limited for some time and decided to buy the stock in 2011 after the company reported poor results in the first quarter. The stock dropped quite a bit after that and I started purchasing the stock as it ‘appeared’ cheaper compared to the past results.

In the case of stocks, investor returns are dependent on future performance, but the data to evaluate that comes from past performance. It is an art, more than science, to evaluate the past results and arrive at an appropriate conclusion. In the case of Crompton, I got anchored to the price and the past fundamentals and did not weigh the state of the industry and management issues more heavily.

How should one avoid this bias? Once you have purchased the stock, it is very difficult to avoid the anchor of the purchase price and past performance. The best approach I know of is to be aware of this bias and constantly question your reason for holding a stock.

Commitment and consistency bias

This is a tendency to be consistent with one’s behavior in the past. It is a good way to behave in life – if you have been a decent and honest person once, you want to continue and be committed to that behavior.

However this behavior can cause a lot of trouble for an investor.  Once you have purchased a stock, there is a tendency to be committed to it and as a result one tends to underweight any negative information about the company.

Look at any stock boards – majority of the investors are talking about the positives of the company. If you are already invested in the company, does it make sense to find any additional information which just confirms your belief? How will that benefit your decision?

I have suffered from the same bias and I can’t think an easy way to avoid it. I have purchased value traps like Cheviot Company and held onto them even though the company continues to deliver mediocre performance and the stock price was stagnant.

The approach I take now is to rank all the companies in my portfolio in a descending order of attractiveness. This forces me evaluate more idea more objectively. Once I have my rank, I compare any new idea with the last idea in the list. If the new idea is better than the last one on the list, it gets replaced.

The title of this post comes from the concept of Darwinian selection – kill the weakest ideas to make way for the stronger one. This also reduces the impact of the commitment and consistent bias.

I plan to cover additional biases such as the authority bias, availability bias and more in the subsequent posts.


I have often ‘preached’ on this blog – when facts change, one should consider them rationally and change one’s mind if required. Well, as always, it is easier to preach than practice.

Let me tell you a recent story.

I spoke very briefly about a company in this post. The company was Ricoh (I) ltd. You can download my detailed analysis of the company here.

So after doing this detailed analysis in late 2010, I built a decent position at an average price of around 35-37 Rs/ share.  The company continued to perform poorly (as I expected) as it had done an acquisition and was also investing heavily into sales and marketing.

The topline grew by 40%, but the net profit dropped from around 15 Crs to a loss of 5 Crs in 2012. The price continued to stagnate in the range of 37-40 rs during this period.

I have been consolidating my portfolio and weeding out the weaker ideas for the last 2 years. As a result, I exited Ricoh in the feb-march time frame. I think it was a rational thing to do based on the information I had as of March 2012

The change

The company declared the Q4 2011 results in April 2012 and reported the following

Q4 sales growth, YOY – 60%

Net profit growth, YOY – 73% (12 Crs profit in Q4 versus 11 crs loss in Q3)

The price action can be seen below

As you can see, the market did not react immediately to the turnaround in the performance and there was a 1-2 month window for an intelligent investor to digest this information and purchase the stock.

So that proves my level of intelligence 🙂

The explanation

It is easy to call the decision, stupid and move on. The true reason for my failure to capitalize on the change in performance (which I was expecting) is due to a behavioral bias.

The bias is called the commitment and consistency bias. In simple words, once one makes a decision, the tendency is to ‘commit’ to the decision and be consistent with it. This results in ignoring positive information as in the above case or holding on to a losing position (inspite of consistent negative news) and hoping that the price will rise in the future.

Not a one off case

The above incident was not a one off in my case. I have made the same mistake twice earlier – in the case of VST industries and Mayur uniquoters. I sold the stocks and then saw the fundamental performance improve, after the sale. Instead to getting back into the stocks (as I already knew about the companies), I just ignored them and lost out on pretty decent gains.

I have become alert to this bias now and am paying more attention to sudden turning points in the performance of the stocks I hold or have held in the past.

It is better to look foolish (in my own eyes), than miss out on a good idea

Added note – The above example does not mean Ricoh India is a good buy and should be purchased at the current price. It is quite possible that the performance may regress and so would the stock price. The example is only for illustrative purposes.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.


One of the least discussed topics on investing is emotions. I have rarely found any discussion on this topic. Behavioral finance does take up this topic and there is a lot of academic analysis on the various pitfalls and mistakes of investors. However there is still a lack of discussion on emotions and how one should handle them while investing.

Are emotions important?
If you are Mr. Spock, then emotions do not matter. For the rest of us, emotions play a very important role in our lives and definitely in investing.

As an investor, one is faced with feelings of joy, confidence, euphoria or despair, frustration, fear and similar other emotions. I can’t speak for others, but I have had all these emotions and more.

Should feelings be ignored?
One school of thought is that one should be a completely rational investor and should take emotions completely out of investing. I find this as the stupidest advice.

Do you think that is possible? Can you invest without ‘feeling anything?

The only time one does not ‘feel’ anything is when one does not care about it. If you are dealing with your hard earned money, how will not feel anything?

Understand and manage feeling
I have found that it is far more important to acknowledge your feelings and then try to think rationally about them. In some instances, you may be able to realize that your feelings are leading you down the wrong path and you will be able to correct yourself. In other instances, your gut or feelings are telling you something and you are better off listening to them

My own experiences
During the start of my investing life, I rarely thought about how I felt and just went with the flow. For example, if I started analyzing a stock and ‘felt’ confident, then my tendency would be to rush through the analysis and just build a position.

Once I had created a position, a confirmation and consistency bias would set in and I would avoid negative information on the stock if it went against my view. If you think you and others are immune to it, think of the time you and your friends have tried to ‘defend’ your stock (as if your stock needs defending!) and have discounted someone who is giving you contrary information. This tendency sometimes gets vicious on public stock forums (which is one reason I avoid criticizing other’s stock picks)

The converse of the above situation occurred when the stock market was down and everyone was bearish. I found myself overly pessimistic like others and would constantly keep questioning myself. As a result I did not build as big a position as I should have – case in point: I bought concor in 2002-2003 at a PE of 5. I should have built a big position, but never did. Same with blue star and several others

My current approach
I did not get hit by lighting or have achieved any enlightenment like Gautama Buddha. I tend to feel the same emotions as earlier. The difference is that I try to acknowledge them when they happen and to understand what they are conveying.

During 2008, I too had feelings of uncertainty and some amount of doubt. However based on past experience and based on the valuations I could see, I decided to ignore them and went ahead with my positions.

Conversely, I have been feeling fairly smug and happy with my positions and optimistic (atleast till last month) in general. This matched with the feeling,  others have about the market. I think this itself is a red flag for me. The time when I start feeling confident and on top of the world is the time to start getting worried. In response to this, I have started reducing my fully valued positions and have not really been buying much (though have been tempted several times).

I don’t go against my feelings always. On analyzing my past positions, I have realized that my position size is driven a lot by my feelings. I maintain a few major and some minor positions (see my portfolio here). I have found that the stocks in my minor holding are cheap and at a higher discount to fair value than major positions.

However for some reason which I cannot articulate, my ‘feel’ for the minor positions is not as good as the major ones. For example, I always felt that a grindwell Norton is a better position than a VST. As a result my position size has been larger in the former than the latter. On analyzing my past results I have found the major positions have done far better than the smaller positions (though I did not realize that at the time of making these investments).

I don’t claim to infallible. Far from it ! I have done enough silly things and confident that I will continue to do so (options may be one 🙂 ). However I think listening to your gut is important, even if you do not always follow it.

As an aside – I think if you feel a little bit apprehensive and scared when trying something new, it’s a good thing. It means that you are pushing the boundary of your learning. I feel the same with arbitrage and options and think that it is the right thing to do.