Stocks are in fashion again as stock prices head northwards. Here are three behavioural biases that every investor should be aware and wary of.
An interesting aspect of stock market is that the price is a function of demand and supply. Hence, if there are more irrational investors compared to rational investors then the price of the stock will tend to be irrational. This irrationality will however not last forever. There have been instances where greed has led to asset prices increasing beyond expectations and then finally the asset bursting. Real estate bubble in the United States and dotcom bubble in India are examples. Some of the behavioral traits, which can be attributed to individuals investing in stock markets, include overconfidence, loss aversion and herding.
Overconfidence – defying gravity
Overconfidence refers to the situation where an investor in spite of knowing that the stocks are overpriced, keeps investing in them because he believes the stock prices will not fall much in the foreseeable future. At times the analyst community comes up with ridiculous methods to justify prices. For example in the case of State Bank of India the bank has its branches in prime locations helped justify its stock price increases. The fact that SBI has never sold real estate nor will ever sell it was ignored.Furthermore, in good times a lot of people invest in mid cap stocks expecting any business idea that looks different and promising would work. The best example is Suzlon Energy Ltd, the fourth largest player in the wind turbine generator segment.The company had negative cash flows and kept expanding business through acquisitions in an industry where there were already too many players. It was clearly a risky stock. However, it was one of best stocks to own in the 2005 to 2007 period. The fact that stock is now trading at less than Rs. 15 after recording Rs.595 on the first day of listing in October 2005 is a testimony of how stocks which rise without justification fall at exponential rate.
Loss aversion – it hurts to lose
Loss aversion is a state of denial where the investor does not want to accept that he has made losses. ICICI Securities has introduced a new derivatives product called I-Gain wherein it will charge its clients commission on transaction only when they make profit. The condition here is that the client should adhere to stop losses strictly. In simpler terms he should book his losses and not keep waiting for the tide to turn. According to ICICI Securities, it has realised by studying more than 3 million client portfolio over the last decade that losses happen because clients refuse to close their losing positions. An apt example would be of how Pandavas in Mahabharat continued to gamble when they were losing and finally ended up losing everything.
Herding – following the leaders blindly
When a person does not know how to trade and still wants to trade in the market the easiest way is to imitate other investors. However, herding is a dangerous phenomenon for novices as they might end up buying the stocks when the others are selling. In November 2011, the media reported three stocks that Amitabh Bachchan held. These were Neuland Laboratories, Birla Pacific Medspa and Fineotex Chemical.
Interestingly a lot of investors bought stock based on the assumption that Amitabh Bachchan would definitely have good advisers. Birla Pacific Medspa which was trading at Rs. 20 has no buyers and is languishing at 20 paisa now. Fineotex Chemicals which was trading at Rs. 160 reached Rs 16 in two years time by 2013.
Invest in only those businesses which you understand. Following others would only make you more nervous when the markets move southward. It is always good to know the basic financial terms which is easily available online. If you feel you do not have the time and patience to invest yourself invest in mutual funds.