44 Beyond Market 10th Oct ’11 A MIND OF ITS OWNThe knowledge of behavioural nance can help market participants <strong>to</strong> recognize and avoid bias and errors in their decisions It’s simplified...
Do you know who the biggest enemy of a trader or an inves<strong>to</strong>r is? No, it is not inflation or high interest rates, or global fac<strong>to</strong>rs and not even market opera<strong>to</strong>rs. The biggest enemy of a trader or an inves<strong>to</strong>r is his or her own mind. It is a known fact that the markets thrive on two major human emotions – fear and greed. However, human emotions like hope, despair, regret, pride and optimism, among others <strong>to</strong>o play a major role in affecting the psyche of an inves<strong>to</strong>r. Till few decades back, emphasis was laid on studying the s<strong>to</strong>ck markets from a funda<strong>me</strong>ntal or a technical point of view instead of emotional fac<strong>to</strong>rs. It was only recently that a relatively new concept of looking in<strong>to</strong> these human emotions and studying the effects of human psychology on the overall outco<strong>me</strong> of profit or loss in the markets in an inves<strong>to</strong>r’s life was put forth. This concept is known as behavioural finance. BEHAVIOURAL FINANCE The study of behavioural and cognitive psychology that affects the financial decision-making process is known as behavioural finance. There are nu<strong>me</strong>rous concepts under behavioural finance and it would be almost impossible <strong>to</strong> cover all of them in one or two articles. So what we have done is handpicked so<strong>me</strong> of the key concepts that an inves<strong>to</strong>r co<strong>me</strong>s across in everyday trading, <strong>to</strong> help him understand the causes and effects of each and how we can control them <strong>to</strong> e<strong>me</strong>rge winners in the markets. PROSPECT THEORY Imagine a scenario wherein you give a child four chocolates and tell him that he has <strong>to</strong> give two chocolates <strong>to</strong> his younger sister. Now imagine a second scenario wherein you give the child two chocolates and tell him he can keep both of them for himself. Which scenario, in your view, would be considered more favourably by the child? Rational thinking says that there should be no difference in his emotions as the end result is that the child is left with a net of two chocolates. But it is not so. Research shows that the child reacts more favourably <strong>to</strong> the second scenario. In the sa<strong>me</strong> manner, a straight `1,000 profit is viewed differently from a `2,000 profit followed by a `1,000 loss in the s<strong>to</strong>ck market. In the second scenario, even though the net profit is still `1,000, it is not viewed positively as the effect of the loss is much more than the profit on the trader’s mind. This effect is popularly known as Loss Aversion. The theory states that humans perceive gains and losses differently. The pain of loss is much more than the pleasure of a gain. In fact, it is said that the pain of a loss is almost three ti<strong>me</strong>s more than the pleasure of a gain of the sa<strong>me</strong> value. This is why we see that we are quick <strong>to</strong> lock-in our profits, however small. But we let our losses run for long. This is because we cannot bear the pain of a loss. This is also the reason why in a panicky situation, inves<strong>to</strong>rs shift their funds <strong>to</strong> bank fixed deposits where they are assured of 8% <strong>to</strong> 10% guaranteed returns and avoid investing in the s<strong>to</strong>ck markets where even though the returns can be as high as 30% <strong>to</strong> 50%, the risk of capital erosion is equally high, which can cause pain. Re<strong>me</strong>dy The best piece of advice is <strong>to</strong> look at the net figure of profit minus loss and not focus on each entity in its singularity. Also, re<strong>me</strong>mber that the s<strong>to</strong>ck market is a risky place and that loss is an integral part of trading. And if you do not take risks, you will not reap rich rewards. Finally, set a ti<strong>me</strong> fra<strong>me</strong> for your invest<strong>me</strong>nts and do not exit before that ti<strong>me</strong>. GAMBLER’S FALLACY How many ti<strong>me</strong>s have we restrained ourselves from buying a s<strong>to</strong>ck or have sold off our holdings just because it has moved up in 5 <strong>to</strong> 6 consecutive trading sessions in a row thinking that it cannot go up any further and that the next trading day would be a down day for the s<strong>to</strong>ck? We guess many a ti<strong>me</strong>s. But <strong>to</strong> your surprise, it goes up the next trading day and even the next one, as well. In a gambler’s fallacy, a trader thinks that after an event or a series of events has occurred, the likelihood of it occurring again is very less, even though it is an arbitrary event. A gambler’s fallacy is the worst enemy of a trader. After a series of losses, an inves<strong>to</strong>r feels that his streak of bad luck is coming <strong>to</strong> an end and a U-turn is just round the corner and he keeps on investing and betting more and eventually ends up losing everything. This normally happens with traders who tend <strong>to</strong> look for s<strong>to</strong>cks that are trading at or near their 52-week lows, because they feel that the s<strong>to</strong>ck cannot go down any further and the only way is up. But how many ti<strong>me</strong>s have we seen the s<strong>to</strong>ck moving downwards and forming new 52-week lows with each passing day? Re<strong>me</strong>dy Inves<strong>to</strong>rs should bear in mind that the s<strong>to</strong>ck market is a ga<strong>me</strong> of probability and that past events do not change the probability that certain events will occur in the future and there is always a 50:50 chance of it recurring. Rather than just blindly predicting that the trend will reverse, inves<strong>to</strong>rs should do Beyond Market 10th Oct ’11 It’s simplified... 45
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