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Predictably Irrational – Psychology of Investing

Updated: Sep 21, 2022

“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:

  1. Price (pls refer the chart of a chemical company below)

  2. Valuation (PE of 7x for chemicals in 2014 why 20+ now!)

  3. Sector (stick to specific sectors, ignoring risk reward in others)

  4. Corporate Governance (impairs ability to assess turnarounds)

When the evaluation of any materialistic thing is involved – people tend to undervalue the possessions they own. However, that is not the case when a comparison of “intellectual ability” is involved. It is very difficult for anybody to accept one’s own error and mistake. That is precisely the reason, why investors keep on feeling that the market is undervaluing the stocks that they own. This is known as “Endowment effect”. You tend to have a positive bias that the stock you own is a “story in making”.

Some of the effects of Endowment bias that we practically see in our daily lives are –

  • More often than not – investors tend to look for “positive news” for the stocks they own.

  • Analysts keep on highlighting the order wins for the companies which are there in the portfolio – however the reality could be that the whole industry is on an upswing.

  • You tend to believe that the valuation gap would narrow down by the low P/E stock that you own – ruling out the chances that the high P/E stock can also some down.

A study done by a pair of Canadian psychologists (Knox & Inkster, 1968) uncovered something fascinating about people at the racetrack: “Just after placing a bet, they are much more confident of their horse’s chances of winning than they are immediately before laying down that bet.”

Warren Buffett says – “What the human being is best at doing, is interpreting all new information so that their prior conclusions remain intact.”

It is very difficult for human nature to write off any decision that he/she has taken in the past. It is virtually impossible to put a “0” value to the decision taken in the past. This is despite the fact that “past cannot be altered”. This is precisely the reason as to why people sit till the end despite the movie being a boring one. In investing, it is very important to understand that every incremental money generates return from the point of time it is deployed. In true essence, the new deployment does not help in “averaging the purchase price”.

(Pls understand that strategy of deploying money in tranches is different than averaging the purchase price.)

Some of the effects of sunk cost fallacy that we practically see in our investing journey are –

  • Given a choice to allocate more money to the stocks that you already own – there is a very high chance that you will prefer to purchase the stock which is below the acquisition price.

  • Very often we see that, even after a long period of time, allocation of “winners” in the portfolio does not materially go up. This is because investors end up “averaging their losers”.

There are many other biases we have; it is very important to acknowledge that while making an investment decision, emotions get a higher weightage than logic. It is only post its acknowledgment, that one will try to find solutions towards these biases.

How to avoid such biases

Investing is an art and not a pure science. Human behavior plays a key role in the field of equity investing. It is extremely difficult to eradicate these biases – they can only be minimized. Below are things we believe investors should keep in mind to minimize these biases:

a) Be objective / acknowledge a material development

It is extremely important to be objective. Often noise surrounding us impairs our objective. Even though one believes India is the best story over 5-10 years – any short-term noise coming from global issues can either scare an investor or enable him to invest more – that will clearly depend on his “objective assessment & understanding of India”. This will also determine his eventual return outcome. Most investors get scared when markets correct and feel nice when they rally. Assuming facts remaining same, the risk reward of investing on correction is higher than on a rally.

There is no alternate to one’s own conviction.

b) Forget your purchase cost

This may sound very difficult, but the reality is that purchase cost is sunk cost. The stock returns from a particular point in time and has correlation with the business developments that are happening from that point in time. They have absolutely zero correlation with the investor’s purchase price. The decision to remain invested or sell out or add more should have nothing to do with your original price but should depend on the developments. For those who play poker, money played in round is not yours and whether to bet additional money is also not only dependent on your hand but rather on your assessment of what other players have and how they are betting.

c) Money is fungible

Very often we see inherited wealth lying in non-productive assets. The reality is money is fungible. This simply means that Rs. 100 in lottery winnings, Rs.100 in salary and a Rs. 100 tax refund should have the same value as they have the same purchasing power. In investing, objective is to generate returns on overall portfolio, not on a particular stock.

d) The basic still remains – “Price is what you pay; value is what you get”

Core principles always remain the same and they always deliver if you stick. It is very important to understand the difference between a good company and a good investment. Risk v/s Reward evaluation is important at every juncture. While arriving at an investment decision, one should be aware of “What is the price factoring in?” and “What is the probability of that happening or not happening?”

e) Actively seek out contrary opinions, but make your own judgement

Most of us seek confirmatory information. To avoid this, investors should try to rebut the hypotheses rather than confirming it. One should seek out contrary viewpoints and assign someone to take opposing position. One should become good to hear the bearish analyst’s views and reasoning, if you own a stock.

One can always get additional peace of information to evaluate. One can listen to everyone, but finally must make his/her own judgement. One can’t make money on borrowed conviction.

To summarize, the religion named “Investing” requires an:

  • Open, curious, and adaptable mind to spot emerging trends and convert them into actionable ideas

  • Understanding on emerging business models/trends which helps building “conviction”.

Markets give ample of opportunities as mentioned below for to the one who carries an open and an adaptable mind:

We would like to highlight the fact that, there are 228 stocks (Market Cap > Rs.1,000 crores) which have given >20% CAGR & within that 151 stocks have given > 25% CAGR returns in the last 20 years.

We continue to believe and argue, despite lot of noise around, India is in one of the best phases of wealth creation cycle and investor should remain Long India over next 10 years. Every correction is best opportunity to deploy rather than worrying.

“Success in investing doesn’t correlate with IQ once you are above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in to trouble in investing.” - Warren Buffet

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