“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” - Howard Marks.
We have been sharing our views on the market, our investing style and strategy, proprietary forensic CLEAR framework, etc. While all these processes/strategies are very important to succeed in the market, it is equally important to have an understanding about the concepts of “behavioral finance”. Most of the Type C Risk accidents (risk due to sub optimal decisions) occur due to psychological issues.
Dan Ariely in his book Predictably Irrational, has beautifully explained - while standard economics assumes that we are rational, making logical & sensible decisions, the fact is we are far less rational, and our irrational behaviors are systemic and predictable.
We often come across such irrational instances in our own behavior and while interacting with investors - the idea of discussing this is to constantly be aware and keep fighting them.
Often, we come across investors who keep oscillating between the “feeling of being left out” & “waiting for correction”; however, when the correction comes, they still wait for further correction and end up with a feeling of being left out yet again. Or end up investing at the top when markets rally.
Most smart investors fall prey to such behavioral biases. We would like to discuss some of the biases which makes us behave the way we do.
We surveyed a set of underinvested equity investors in Jan 2022 and April 2022 when the Nifty was around 18,000 levels on their willingness to invest in the markets; about 80% of them said they will aggressively invest in equities, if the markets correct by ~10-15%. Guess what!! markets corrected by ~15% to 16,000 in March 2022 and June 2022. Despite reaching their desired levels, only 20% of them invested and that too only half of the amount that they wanted to.
This is due to Recency bias. Human mind gives more importance to recent events over historic ones. Most of the decisions are made as if the recent events will keep repeating.
When the markets corrected to 16,000, there surely were reasons for the same. Human mind starts analysing these reasons and ends up completely forgetting the previous reasons based on which they were ready to invest at the levels of 10-15% below 18,000 levels. One should always remain objective and not forget the original hypothesis; and keeping the new information in mind; re-asses rather than just avoiding the risk completely. If there is no major fundamental change, then one should avoid the noise and stay put to the objective. But that is tough - one gets caught into the noise and is fearful of going wrong/making irrational decision.
Irrationality in behavior leads us to forget the objectivity and only focus on recent past.
“Efficient market hypothesis” does not exist in the real world and often while making an investment decision, emotions get a higher weightage than logic.
Similarly, the Anchoring bias also plays a big role in our decision making. Most of us anchor our investment decision around a price/an event and that becomes real while everything else becomes unsustainable/difficult to act. For instance, if one has evaluated a stock at Rs. 100 and before the investor could decide to buy, the stock has rallied to Rs. 140, it becomes very difficult for the investor to buy even if there is a reason for the change in price. The Investor has anchored himself to this price. There are many ways this bias works even in the stocks he already owns. Every correction appears artificial, and one keeps averaging down.
Anchoring could either be “absolute or relative” and could be pertaining to:
Price (pls refer the chart of a chemical company below)
Valuation (PE of 7x for chemicals in 2014 why 20+ now!)
Sector (stick to specific sectors, ignoring risk reward in others)
Corporate Governance (impairs ability to assess turnarounds)