To most students who learn something about finance, economics, markets and investing, it would seem that investing is all about numbers. Specifically, in the case of equity investing, it may mean projecting future earnings (EPS or Earnings Per Share) and determining multiples of that earnings (P/E ratio or Price Earnings Ratio) or maybe doing complex calculations to determine the Discounted Cash Flow (DCF) value per share of a company.
However, when a newly minted analyst with one of the famous qualifications comes to the market and observes the workings, he/she quickly realises that the reality of the market is far different than what academic theory suggests. As Yogi Berra pointed out long ago, “In theory, there is no difference between theory and practice. In practice there is!”
So what are the aspects that are relevant to the practice of investing? In this and subsequent articles, we shall be looking at the fascinating world of behavioural economics/finance and how that is relevant to investing. Do not be put off by the technical sounding subject. The subject deals with human behaviour rather than economics or finance per se.
Will this knowledge be enough to become great investors? Probably not. The first attempt we will make is to try and eliminate certain predictable and repetitive mistakes that we as investors make and also to get entertained in the process by looking at past follies of others investors (and maybe our own). It is only after we have reduced our own mistakes that the chance to profit from the mistakes of others may arise.
Of special interest in this field is the role played by heuristics (mental short cuts) and biases that are a part of our decision making process which may harm us.
What are heuristics? Say, you purchase one each of two articles A and B. The total bill for the same is Rs 110. You also know that A costs Rs 100 more than B. What are the prices of A and B?
If you were tempted to answer that A costs Rs 100 and B costs Rs 10, that would be perfectly normal as that is the first answer that pops into the head. However high school algebra tells us that the correct answer is that A costs Rs 105 and B costs Rs 5. This is an example of heuristics.
If a solution to a simple math problem is prone to error, what are the chances that humans will take rational decisions as regards their finances where the calculations are more complex? Say a new graduate at age 20 is joining the workforce and is expected to work for 40 years till retirement. The person has a choice of getting 8% p.a. on her annual retirement savings of Rs 1 lakh in a very smooth and low risk manner or to get 11% p.a. in a seemingly riskier manner. What should she choose?
Obviously choosing heuristics-driven solutions would not be ideal in such cases.
(In the first case, the corpus grows to Rs 2.59 crores on retirement while in the second it is Rs 5.82 crores.)
What are Behavioural biases? Behavioural biases are exactly what the name suggests. Human beings have biases on the basis of personal opinions, tastes, preferences and past experience. These may be in various forms and some of them may be linked to political views, religious views, gender stereotypes, race, ethnicity, language, region, occupation and so on. It is almost impossible to list out all the potential biases that a person may have.
Our study of behavioural biases as they affect our investing behaviour will attempt to keep us away from most of the harm that such biases do to our financial well-being.
Here and now
All this is fine for theory. How does this affect us today? We shall be taking a look at how the heuristics and biases are probably affecting us at the current moment.
Election season
Every election season, in India as well as globally, there is this parlour game that goes on about predicting election outcomes and consequently the impact on markets.
Quick, what would happen to financial markets over 5 years if a minority government came to power with the support of left parties? - In 2004, most people predicted a bear market. In fact the markets stopped trading and were frozen at a lower circuit. Actually, 2004 – 2007 was a period of one of the strongest bull runs that the Indian markets have seen.
What would happen if Mr. Donald Trump wins? Most people expected a Clinton victory and predicted a doomsday scenario in case of a Trump victory. Similar was the case with Brexit vote. As we all know, reality turned out to be different.
In short, no one knows the outcome of elections and even if one knew the election outcome, the impact on the markets may be unpredictable. Who would have thought that post BJP losses in 3 states and the resignation of the RBI governor, the equity markets would be resilient?
In conclusion, successful investing is about having a plan rather than a crystal ball, Happy Investing.
Disclaimer: The views and opinions expressed in this article are those of the authors