Foreword :- 

Global markets,India being no exception, have  taken  a  significant  beating  following  the outbreak of Covid-19 pandemic. While an erosion in value of investments does worry an investor, it brings to the forefront two pertinent questions:

1. Can you control what is happening in the market?
2. Can you control how you react to what is happening in the market?

The  answer  to  the  first  question  is  “No”.  As  far  as the second question is concerned, the answer is “Yes”, but it is easier said than done.

Most  conventional  economic  theories that were path-breaking discoveries  of  the  20th  century made a fatal assumption that people are rational, thereby overlooking a key aspect governing human behavior.

Over  the  last  30  years,  a  lot  of  ground  has  been covered  on  this  subject  suggesting  that  it’s  time to   accept   that   humans are  emotional and are subject to cognitive   biases. These biases, from time to time, come in the way of effective decision making  concerning  each  and  every  aspect of our life, including personal finances.

In  this  edition  of  ‘Know  your  behavioral  biases’ , we have tried to elaborate the biases that individual  investors  commit,  thereby  endangering their  hard  earned  wealth.  As  with most complex problems,  the  solutions thereof  are  often  simple, and dealing  with  behavioral  biases  is  no exception.  Herein,  we  present  simple  yet  effective and easy methods to know, accept and overcome these biases.

Index :-

• How to respond to market cycles.
• Loss aversion bias.
• What is mental accounting?.
• Herd Mentality.
• Emotional attachment to inherited wealth: Endowment bias.
• Availability bias.
• Recency bias.
• Unable to bring discipline in investing.
• Is short term thinking a disease?
• Conclusion.

How to Respond to Market Cycles?

Greed and Fear in Market Cycles

Investor’s experience in the markets is one of the most important factors that determines his/her investment  decisions.  For  example,  someone  who  began  investing  during  the  negative  phase  of the markets (e.g. year 2001 – IT Bubble, 2009 – Global Financial crisis) will prefer to avoid equities compared to an individual who has had a good investment experience (year 2010)

Typical Reaction of an Investor – Joining the Dots

Below  chart  shows  how  greed  and  fear  overrides  investors  emotions  and  how  an average  retail investor  behaves during the ups and downs of the market cycle.

Currently, as the markets have fallen sharply from highs & in the process of again rising , it may not be a right thing to sell-out, instead adopt a long term approach to equity investing. It may even be prudent to go contrarian and make fresh allocations to equities in a staggered manner.

Our emotions often entice us to time the market, while, to make such decisions, we are no more equipped than a gambler before the roll of the next dice. More often than not, these actions driven by emotions are counterproductive. Simply adopting a buy and hold strategy for a long period of time can be more rewarding instead.

Understanding Market Cycles –

Markets are not linear and move in cycles.

Along  with the economy   and   business,   markets   also   go   through   periodic   expansions   and contractions.  Periods  of  expansions  are  characterized  by  business  optimism  and  increase  in business profitability. Conversely, periods of contraction are characterized by business pessimism and decline of business profitability. Markets anticipate these fluctuations and move ahead.

The long term average trends across cycles are typically upward sloping in a growing economy as economies, corporate profits, consumption levels, etc. grow at positive rates in the long run.

From  an  investors’  perspective,  the  turning  points  in  business  cycles  are  hugely  important. Investors who can position their portfolios in line with the cyclicality of the markets can make a fortune. This is different from timing the market, which can be fraught with risks. Understanding of cycles can help an investor position the overall portfolio with varying allocation to different asset classes. When it comes to individual investments, adopting a systematic Investment route would be ideal.

What to see around you?

Peak of a cycle

• Economy is strong; reports are positive
• Earnings beat expectation
• Media is full of good news
• Everyone around you is confident, optimistic and greedy
• People are ready to take risks
• Defaults are few Skepticism is low Euphoria everywhere
• Di cult to imagine things going wrong

This is the time for caution!

Bottom of a cycle

• Economy is slowing; reports are negative
• Earnings are flat or declining
• Media report only bad news
• Everyone around you is worried, depressed and fearful
• People are not ready to take risks
• Defaults soar Skepticism is high Panic everywhere
• Everyone assumes things will get worse

This is the time for aggression!

Is it time to be aggressive or defensive?

Loss Aversion Bias

Losses are felt much more than gains of similar value. People do not treat gains and losses in a linear way. It feels better to not lose Rs.100 than to gain Rs.100

I hate losing more than I love winning . Loss aversion is the tendency to avoid loss over maximizing gains.

Lets consider 2 scenarios:

Scenario 1:

While  you  are  walking,  you  find  a  Rs  500  note lying  on  the  ground.  You  pocket  it  and  feel happy about it.

Scenario 2:

While you are walking, you find a Rs 2000 note  lying  on  the  ground.  You  pocket  it and  subsequently  someone picks your pocket  and  you  loose  Rs  1500  (say  from other pocket)

Which scenario will make you happier? Payoff from both the above scenarios are same but the emotional outcomes are different. A loss of Rs 1500 gave you more pain than gain of Rs 2000.

Similar experience is observed in investing; consider the below scenarios:

Scenario 1 :- Investment with cost price of Rs 1000 is sold at Rs 2000

Scenario 2 :- Same  investment  has  touched  a  high  of  say  Rs  3000  and  is  now  trading  at  say  Rs  2000,  the pain  from  notional  loss  of  Rs  1000  will  be  much  more  compared  to  the  overall  gain  on  the investment.

An investor with net worth of Rs 1 cr looks at loss and gain of Rs 1 lac as

This  is  evident  from  the  fact  that  investors  prefer  Fixed  Deposits  over  instruments  with  variable returns but with an ability to beat inflation more effectively.

Pain or Joy, We Remember only Extreme Cases

We all prefer pain to be brief and joy to last longer. Lets consider the below example where you are under medication and have to undergo either of the two options below:

Scenario 1 :- An injection every day for the next 20 days

Scenario 2 :- An injection, which is 20% more painful, everyday for the next 12 days

Individuals  tend  to  remember  the  intensity  of  the  pain  whereas  duration  of  Pain  /  Joy  is  often ignored. Since under option 2, pain is 20% higher, most individuals will prefer option 1.

Similarly,  in  investments,  time  correction  does  not  affect  emotions  as  much  as  price  correction. Investors  often  remember  negative  events  like  “Black  Mondays”,  “Tragic  Tuesdays”,  etc.  Investors often ignore the fact that a big fall in markets on a single day followed by a slow recovery is similar to markets staying flat/ remaining range bound mode over a year.

EMI schemes, Personal Loans, Women’s Kitty Party all follow similar concept.

How to Deal with Loss Aversion Bias?

• Free yourself of emotions as much as possible
• Do not invest directly in volatile asset classes like equity
• Choose a professional fund manager
• Also take the help of an Investment Advisor
• Adopt  a portfolio  approach  and  do  not  focus  too  much on  each  individual  investment.  Leave  the  job  of  product/scheme selection to the Investment Advisor
• Investing is better left to experts.
• Mutual Funds (MFs) are cost effective and convenient.

What is Mental Accounting?

It shows how individuals separate their budget into different accounts for specific purposes.

Mental Accounting : Money Jar Fallacy

Mental accounting, a behavioral economics concept introduced in 1999 by Nobel Prize-winning economist Richard Thaler, refers to different values people place on money, based on subjective criteria, that often has detrimental results.

The  concept  of  mental  accounting  is  beautifully  explained  by  Thaler  and  Cass  Sunstein  in  their book Nudge: Improving Decisions About Health, Wealth and Happiness through the example of Hollywood actors Gene Hackman and Dustin Hoffman .

Mental Accounting and Investments :-

People also tend to experience mental accounting bias in investing. When it comes to investing, mental accounting can also cause people to make illogical decisions.

Investors  invest  their  wealth  based  on  the  source  of  income.  Higher  weight-age  is  given  to hard  earned  money  like  salary  as  investors  usually  prefer  to  take  lower  risk  while  investing their salary income. An investor who is young should ideally have a higher portion of his/her wealth in equities. However, since there is a emotional attachment to hard earned money; he may not be willing to invest a larger portion of his salary income in equities. (as equities are perceived as risky asset class). The same investor when faced with windfall gains tend to take higher risk with that amount.

Value of money remains the same for an investment made on the advice of a distributor or through own research. However, when evaluating a loss making investment, investors tend to hold on to the same forever if the initial decision to buy was that of the investor himself / herself (as booking a loss hurts his ego). The emotion of regret is in play here. On the other hand, if the initial decision to buy the investment was as per  the recommendation of another person,  say,  the  advisor,  the  investor  would  be  willing  to  sell  the  asset  at  some  point  and move on. This decision to sell is taken at the cost of diversification.

To avoid the mental accounting bias, individuals should treat money as perfectly fungible when they allocate among different accounts, be it a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments). But it is easier said than done.

Other Examples of mental accounting :-

Overspending on credit card rather than cash

More  impulsive  buying  on  a  shopping  trip  could  be  attributed  to  the  use  of  credit  cards  as compared to giving away cash. However, ‘money’ is ‘money’.

Tax Refunds

Tendency to treat tax refunds as a windfall gain and use it for discretionary spending.

Categorizing money as “Safety Capital” and “Risk Capital”

Investors often categorize portions of their wealth as “Safety Capital”, something that they can never afford to lose (example – salary) and “Risk Capital”, money that they OK to see depreciate, (example – windfall gains).

Money that you “don’t mind losing”

Investors, at times, invest in safe instruments and transfer the appreciation thereof to riskier asset classes, with the mindset that this component is something that they don’t mind losing?

Yearly bonus

Habit  of  treating  yearly  bonus  differently  to  monthly  salary  and  spending  it  lavishly.  This behavior is like that of a kid spending birthday money on immediate gratification.

Would you spend your EPFO corpus on a foreign holiday?

There is a guilt factor associated with spending money earmarked for an important goal like retirement planning on a lavish need.

Use Mental Accounting to Your Advantage

Invest with a Goal!

Once you attach a goal to a particular investment, you mentally allocate that money to a particular purpose. Further, it:

Mutual  Fund  schemes  are  available  for  specific  financial  goals  like  Retirement  Planning  and Children’s Education, as defined by SEBI in mutual fund categorization.

Herd Mentality

It  is  the  phenomenon  where  investors  follow  what  other investors  are  doing,  rather  than  following  their  own  analysis  and  risk appetite and is often driven by the fear of missing out

Fear of Missing Out – Have you felt that?

It is normal to get tempted by prospect of becoming rich quickly. When the markets are on their way up, it gets very frustrating for an onlooker to see people create wealth just by being invested in  the  market.  More  often  than  not,  a  prospective  investor  gets  enticed  to  invest  when  he  sees quick gains being made by others around him.

This mentality is often the result of a reaction to peer pressure which makes investors act in order to avoid ‘feeling left out’ or ‘left behind’ from the group. In the quest to earn quick gains from his investments, investors often chase returns by following the herd.

In the process of following the herd, investors usually end up with the portfolio that is more risky and may not be appropriate as per his/her risk appetite. The outcome has always been a disappointment in terms of returns.

A  classic  example  of  herd  behavior  occurred  in  the  late  1990s.   Investors  followed  the  crowd and invested in stocks of IT companies, even though many of them were loss making and were unlikely to generate significant revenues in the foreseeable future.

Herding = Lazy Thinking :-

It is often observed that investors confidence level, index level and equity allocation usually move in  tandem  and  the  result  has  been  the  largest  chunk  of  their  wealth  is  invested  almost  at  the peak of the cycle.

Investors that follow the herd are left disappointed to see negative returns at the end of the cycle. This is mainly because investors focus turn to the conduct of the herd in search of  earning quick returns instead of fundamentals of the economy, company, etc. that might be more relevant.

Let Asset Allocation Guide You to Overcome Biases :-

Who is happiest during this current episode of equity market volatility?

The answer to this question would be the one who had done asset allocation to some extent. An investor with higher than required equity exposure, obviously, has reasons to worry as the value erosion in portfolio would be felt the maximum. On the other  hand,  even  an  investor  with  zero  or  very  low  equity  exposure  has  little  reason  to  rejoice,  as  it  is  difficult  to  take  the emotional  decision  of  entering  equities  in  these  volatile  times,  in  fact,  the  investor  would  strengthen  her  resolve  to  never touch equity, an asset class that potentially erode in value in such quick time.

An investor with a more balanced allocation to various asset classes including, equities, fixed income, real estate, gold, etc. is likely to be happiest despite one particular asset class decreasing in value. The very reason to do asset allocation is the uncertain nature of each asset classes and is acknowledgment of preparing for rainy days in a particular asset class.

Source: Bloomberg. Data for last 20  fiscal years. Mar ‘98 to March ’20.

Proxies used for asset classes: Equity – NIFTY 50, Debt – NIFTY 10 year benchmark G Sec, Gold – Spot Rate ₹10 /Grams

Emotional Attachment to Inherited Wealth: Endowment Bias

causes  individuals  to value  an  owned object   higher, often irrationally

How to treat Inherited Investments?

You recently inherited a flat worth Rs 3 cr from your grandfather.

Investors  are  emotionally  attached  to  the  inherited  asset  and  give  a  higher  weightage  to  such asset in their portfolio and without considering its usefulness in the overall asset allocation, they continue to hold on to the asset.

In the above example, an investor had inherited a flat worth Rs 3cr from his grandfather; continuing to hold on to the flat changed its asset allocation significantly.

Investors  should  treat  the  inherited  investment  under  one  portfolio  and  “gradually”  change  the asset  allocation  as  per  his/her  risk  profile.  Investors  should  ask  “Would  they  make  the  same investment with new money today?”

Asset Allocation is Key to Financial Success

• Asset  Allocation  helps  overcome  emotional  attachment  to inherited assets
• Each asset class has a different Return-Risk-Liquidity profile
• Diversification  is  needed  to  achieve optimal  balance between rewards and risks
• Asset  allocation  decision  is  the  most  important  factor  for long-term wealth building
• There is no “one size fits all” formula for asset allocation. One needs to take professional help during this important step of financial planning.

Availability Bias

is a mental shortcut that

• Relies heavily on information that is easily available to the investor or
• Places undue   emphasis on immediate examples that come to mind when evaluating a decision.

Availability bias

Availability  bias  is  the  human  tendency  to  think  of  events  that  come  readily  to  mind;  thus making such events more representative than is actually the case. Naturally, things that are most memorable  can  be  brought  to  mind  most  quickly.  People  tend  to  remember  vivid  events  like plane crashes and lottery wins, leading some of us to overestimate the likelihood that our plane will crash or, more optimistically — but equally erroneously — that we will win the lottery.

A  study  by  Karlsson,  Loewenstein,  and  Ariely  (2008)  showed  that  people  are  more  likely  to purchase insurance to protect themselves after experiencing a natural disaster than they are to purchase insurance before such a disaster happens.

Similarly, in investments, negative events that have led to severe market corrections are always at the top of investor’s mind. However, investors tend to ignore market performance post the sharp correction.  Few  examples  of  such  events  –  DoT  com  burst,  2004  crash  after  formation  of  new Government, Global Financial Crisis, Greece Sovereign Crisis, Chinese devaluation in 2015.

‘Perceived Risk’ is often higher than ‘Real Risk’ during such events.

Implications of this bias

Investors tend to stay away from markets during such scenarios which leads to:

 

How to deal with such bias?

We  have  seen  a  significant  fall  in  equity  markets  over  the past  few  weeks  as  Covid-19  has  become  the  single-point matter of focus among investors. These are, no doubt, tough times  as  entire  humanity  is  battling  the  virus  pandemic deploying  every  tool  at  its  disposal  to  save  lives.  With  a significant  chunk  of  the  human  population  in  lockdown, the global economy is expected to take a major hit, and the impact of which is being felt across global stock markets.

This is neither the first time or nor will it be the last time, the Indian stock markets are undergoing such sharp corrections. 1992, 2001 and 2008 were years in which, markets saw even sharper   crashes,   with   underlying   reasons   different   from one another. However, one common variable among these instances  was  the  bounce  back  witnessed  by  market  in each of these occasions over a period of time. This leads us to a question.

Do we expect Covid-19 to grab headlines one year from now like the way it is doing now?

As  the  virus  scare  alleviates  over  a  period  of  time  with  the economy  coming  back  to  normalcy,  the  stock  markets  are also expected to stage recovery. This makes a strong case for investing  in  equities  by  spreading  them  over  the  next  few months.   Investors   should   use   such   events   as   buying opportunities and invest with a long term view.

As a case in point, an investor who simply invested through SIPs throughout the ups and downs of the 2008 crisis and subsequent  recovery  would  have  performed  well  without undergoing much of the emotions.

Investors  should  consult  their  financial  advisors  on  how  to deal with such events.

Missed best days !!

The above chart shows that if you had stayed fully invested in stocks (as measured by the S&P BSE Sensex) from January 1, 1990 to March 310, 2020, you would have earned compounded annual returns of 12.73%.

However, if you had tried to time the ups and downs of the market, you would have risked missing out on days that registered some of the biggest gains, and the CAGR would have dropped drastically: 9.06% if you missed 10 best days, 6.56% if you missed 20 best days, 4.46% if you missed 30 best days and 2.56% if you missed 40 best days during this period.

CAGR – Compounded Annual Growth Rate

Best days means the days on which the markets have given highest returns. Daily returns are considered for determining best days.

Recency Bias

is the tendency to weigh recent events more heavily than earlier events.

How Recent events overtake our investment decisions?

Investors often overemphasize more recent events than those in the near or distant past.

Thus,  shifting  focus  towards  the  asset  class  in  favor  today.  This  happens  as  investors  have the  tendency  to  extrapolate  recent  experience  into  the  future  which  can  have  disastrous consequences. The result is, it skews our view of reality and the future.

We have seen many such events in India and investors either tend to be overweight or shy away from the trending asset class. Few recent events in Indian context are mentioned below:

Implications of this bias

Investors get swayed by recent events and tend to be either overweight or underweight the asset class in favor/out of favor; thus leading to inappropriate asset allocation.

The overall risk in the portfolio also increases drastically as investors often swing their portfolios to extremes during such situations with the hope that the trend will continue in future.

Recency Bias: Lane Changing doesn’t work

Investors  often  focus  only  on  the  recent  1  year  track  record  of  returns  when  selecting  a  fund, rather  than  analyzing  the  process  of  investment  manager.  Thus,  making  investment  decisions based upon the outcome and ignoring the process that led to that result.

The above chart depicts the ranking of the funds over the past 10 years; it can be observed that chasing the best performing fund of a particular year does not work in the long run.

How to deal with such bias?

Investors should follow the advice of a professional, should not invest directly and should have an asset allocation strategy.

Investors should not get swayed away by the past returns and should ideally look at risk statistics, the investment  process,  the  number  of  securities  purchased  and  other  fundamental  factors when selecting an investment manager.

Investors should follow a portfolio approach and diversify across various investments.

Unable to Bring Discipline in Investing !

Spending habits can impact long term wealth

Studies have shown that spending tends to be greater when consumers use credit cards rather than  cash,  due  in  part  to  certain  behavioral  cues  that  using  credit  cards  may  create.  One  effect is that a credit card “decouples” the act of purchasing from the consumer’s wealth – “get it now, pay later.” – study by RA Feinberg (1986)

People  do  not  act  in  their  best  long-term  interest  because  they  lack  self  control.  Often  people prefer  high  standards  of  living  in  the  present,  rather  than  saving  for  retirement.  People  who suffer from self-control bias often spend today and sacrifice their retirement, and do not invest in equities or take part in the benefits of rupee-cost averaging.

Recent  trend  in  India’s  household  savings  and  household  debt  also  confirms  such  behavior where investors prefer to live in the present, rather than securing their future.

The “save more tomorrow program” is a classic example to counter such behavior which automatically increased savings rates for plan participants each year. (80% remained in the plan through three pay raises). This is a great way to counteract the natural tendency of people who suffer from self-control bias.

Solution?

Again the magic tool – SIP

• The concept of SIP is in a way similar to “Save More Tomorrow” Campaign
• By  enrolling  into  an  SIP,  you  make  a  commitment  to  save a  particular  amount  of  money  every  month  for  the  next  ‘n’ number of months
• The  amount  that  is  mentally  earmarked  for  SIP  helps  us to  avoid  expenses  on  extravagant  /  lavish  needs,  thereby bringing in discipline
• SIP  Top  up  can  also  be  used  a  tool  to  overcome  this  bias  – SIP  Top  up  allows  you    to  increase  the  amount  of  the  SIP Installment   by   a   fixed   amount   at   pre-defined   intervals. This  facility  enhances  the  flexibility  of  the  investor  to  invest higher amounts during the tenure of the SIP

Is Short Term Thinking a Disease?

What Makes Us Think  Short Term?

Professor Walter Mischel, then a professor at Stanford University, conducted one of psychology’s classic  behavioral  experiments  on  deferred  gratification  named  “marshmallow  test”.  Deferred gratification refers to an individual’s ability to wait in order to achieve a desired object or outcome. The  study  concluded  that  individuals  that  tend  to  delay  gratification  were  less  likely  to  show extreme aggression and less likely to over-react if they became anxious.

Similar  analogy  can  be  drawn  to  the  field  of  investments  wherein  investors  over  react  to  short term market movements and tend to redeem their investments for short term gains.

 

What Makes Us Think Short Term?

Implications of this bias :-

Investors tend to invest with a short term view and focus shifts away from the goal for which investment was made

How to deal with such bias ?

Investors should do goal-based investing. Invest in equities with a long term view. For short to medium term goals, consider debt funds.

To Conclude

For all its limitless powers of imagination, miraculous artistic capabilities, never-ending endeavor for  excellence  and  boundless  achievements  over  the  millennia,  the  ‘human  mind’  is  neither free  from  its  delusions  nor  is  it  resistant  to  making  embarrassing  misjudgments.  Our  mind occasionally lets us down when it comes to data taking and analyzing in a complex world – the world of investing is no different.

When it comes to decision making, whether it is choosing a word in a game of Scrabble, zeroing- in  on  next  holiday  destination  or  whether  to  invest  in  a  stock,  we  try  our  best  to  rely  on  facts and data, while topping it up with a human touch in the form of our best judgments, hunches, intuitions and insights. It is undeniable that emotions like greed and fear are involved when an individual  investor  makes  decisions  as  represented  by  inflows  at  the  time  of  market  highs  and outflows during a market fall.

Even  great  investing  minds  give  in  to  emotions.  Harry  Markowitz,  father  of  Modern  Portfolio Theory and a Nobel Prize winner in Economic Sciences, was once asked as to what was the asset allocation  in  his  personal  portfolio.  He  famously  replied  “It’s  a  50:50  split  between  equities  and bonds  as  I  visualized  my  grief  if  the  stock  market  went  way  up  and  I  wasn’t  in  it—or  if  it  went way down and I was completely in it. My intention was to minimize my future regret”. This is an example of one of the best ever minds in the world of finance admitting and accepting human fallacies.

Thankfully  the  solutions  to  overcome  these  emotional  reactions  are  astonishingly  simple.  The key messages of this as detailed above is to embrace the basics like focus on asset allocation, investing through Systematic Plan, investing with a goal and to take help of an advisor. It is exactly these ‘sticking to the basics’ approach that can shield us from the urge to act frequently, to free ourselves from emotions while making decisions and help us stay focused on the path of long-term wealth creation.

Disclaimer

This   Content  is   for  information   purposes only  and   does not constitute  advice  or  offer  to  sell/purchase  of any company product.  The  information  and  content  provided needs to be read from an investment awareness and education  perspective  only.

Website: www.nayakfin.com