The term ‘investment’ can mean different things to different people. For instance, it could refer to time, money, effort, etc. Though it can take different forms, ‘investing’ basically involves an initial outlay with the aim of recouping more than what we have put in. Of course, not all investors succeed in achieving their objectives. Just as in any other profession, only the cream rises to the top, so too, in the investment profession. However, unlike more traditional professions, ‘investing’ is rather nebulous as it neither requires a ‘formal’ education nor does it have to correlate very strongly with high IQ levels. Also, while many investors may blame external factors for their failures, rarely do they blame themselves and their irrationalities for it. A little bit of introspection may throw light on the real reason behind their failure. In one sentence, it is merely that, “We are human after all... and therefore, irrational.” Rational vs irrational behaviour.
Yes, investments theory assumes that human being (including investors) are rational creatures, each undertaking actions to maximise their own individual benefit, which, in turn, benefits society. However, our real world experience suggest otherwise. It is irrationality which is the prime reason behind the exhilarating surges and gut wrenching downturns in the stock market. Often, these movements have more to do with the moodds of market participants rather than the performance of companies.
Greed and fear are the key drivers of markets. Most investors get swept away by these two strong forces and end up losing the battle of investing. If indeed we are rational, we should act in a diametrically opposite manner to that of the crowd. Sadly, this is not the case.
Biases can be risky
A branch of finance termed ‘Behavioral Finance’ aims to alert us to these biases which stem from our inner feeling and failings. This school of thought believes that finance, and investing in particular, is an amalgam of art and science. It believes that human attributes play an important part in the outcomes of actions. That is why successful investors comprise those who have mastered their emotions, in additional to mastering the numbers. This stream of thought gained worldwide recognition when two of its proponents Daniel Kahneman and Amos Tversky, won the Economics Nobel Prize in 2002.
According to this school, human biases are broadly divided into two types namely, cognitive and emotional.
Cognitive biases deal with errors of judgment. A prime example of this is the representative bias (which leads us to purchase a stock merely because some other stock in the same sector is performing well.)
Emotional biases are rooted in impulsive or intuitive actions, such as the overconfidence bias (which leads us to believe that our performance is solely due to our skill.) Example of this include the endowment effect (wherein owners of a stock always feel that their stock is undervalued and often desire higher prices for their holdings), and loss-aversion bias (where investors are mentally unwilling to see a loss on paper as an actual loss. Hence they may keep holding on to a bad investments in the hope that it will eventually recover). These (often) subtle biases can serve as roadblock on the road to wealth creation through investing.
Short term vs long term strategy
Often, the level of investment activity in the stock market is inversely correlated with investing success. Astute investors will wait patiently for the right opportunity to arise, conserving their capital in the meantime. Surprisingly, most market players consider this to be an extremely difficult task. For them, ‘investing’ is the art of making money by taking advantage of every microscopic wiggle in stock price. Actually between the two options, it is the latter which is more difficult to do. However, there is no dearth of players trying to win this seemingly difficult battle.
Devils in our way
Other than our own inner devils, there are others that stand in the way of us being good investors. Prime among them are:
- Brokerage houses: They aim to make money by making others transact as much as possible. They are not so much concerned with price movements, as to find reasons for stimulating action among their clients. Often this will result in ‘Buy’ and ‘Sell’ recommendations popping up at the most inopportune time (from the clients’ perspective), causing manic purchases, and panic sales at precisely the wrong times.
- The financial media: Though it is not strictly a ‘market’ participant, it certainly influences the decisions of investors. It does this in several ways such as broadcasting ‘expert’ opinions, survey of stockbrokers, and sponsoring seminars on the stock market, among others. Whatever they do, there is always (with a few notable exceptions) greater stress laid on short-term market movement as compared to the long term.
Efficiently allocating one’s capital is a difficult task. However the task is further complicated by inconsistencies within us, as well as certain external stimuli; all this is bent on stymieing our actions. Just as a seed takes time to grow into a full grown tree, capital too takes time to yield outsized returns, and we will have to bear with volatility on the way. If we can not accept this, or deal with it, it may be preferable to outsource the investment activity to a professional fund managers. Investing your capital without possessing the proper attitude and aptitude can be as dangerous as indulging in self-medication, when a good doctor is the need of the hour.
The views of the author are personal