Human beings are endowed with the power of thinking and discrimination. So we are quick to ascribe rationality to our actions. But how many of our actions are really rational? The fact is that many are not, not even in finance and investments! This is one domain that seems to indicate that the mind will reign supreme but ground experience indicates otherwise.
Surprisingly, a large percentage of financial decisions are not based on rational conduct. However, we offer a plausible and seemingly rational explanation for every decision we take. There is now an area called behavioural finance which studies theses aspects of investor behavior.
The first of such behavior is herd mentality. There are very few who are immune to this. People have an inherent desire to conform. No one wants to stand out and be subjected to ridicule. The pressure to conform and fall in line is so much that those who have contrary opinions start questioning their own wisdom, negate their thoughts and fall in line. Lot of the rallies we see are simply coordinated buying or selling which take the markets higher or lower. This can easily happen in the absence of fundamentals to support it.
Gold had a rally in the past decade. The rational explanation is that people were running towards it as a safe haven asset. Possible. But, when the whole world started running towards it, the prices zoomed. That was the reason for still others to start buying gold and a virtuous cycle was set in motion. The same has happened for stocks in the past. People were willing to invest when the markets were overheated. The risk perception is somehow lower when one moves along with the herd.
Between June 2006 and Sept 2008, over Rs.1 lakh crore had flown into equities*, when the markets were overheated. So, it was nothing about rationality or any rigorous evaluation of the investment and return prospects. It was all about going with the prevailing sentiment at that time. From that point equities have given -1.44% CAGR (from Jan 2008 till mid March 2013)*.
Now, look at the time between October 2008 and March 2009. The sentiment had weakened considerably by that time and there was a net equity outflow in this period to the tune of over Rs.2, 000 crore*. But the returns for those who had invested in this period is 20.21% CAGR (from Nov 2008 till mid March 2013)*.
(*Data from IDFC MF tool, which looks at the PEs at which investors have invested and their returns)
Again, now is a good time to invest, if we look at the historic PE multiples of the Sensex. But, no one is investing in equities. The herd mentality and greed is what drove people to equities during 2006-2008. The same mentality drove people to gold & real estate in the past few years. Such investments ends in grief for the majority, as it is not based on fundamentals, but based on greed supported by paper headlines and anecdotal evidence.
The next investor behavior when they are proved wrong is that they never meant the investment to be for the short term at all. It suddenly became a generational wealth transfer gambit!
Another inexplicable investor behavior is to save taxes at all costs. That is why we find people even from lower tax brackets beg, borrow (though hopefully not steal!) to invest to save taxes. RGESS scheme which is meant for those in the lower tax brackets, can effectively give 5-10% effective tax relief on the amount invested. But, still some invested, in spite of its lack luster appeal.
The other surprising conviction among investors is that they have the divine ability to time the market. I have looked with awe, at people who claim that one should invest now in a property and see the same double by the next Diwali! Such clairvoyance! Lay investors believe strongly that the only way to wealth creation is timing the investments. But reams and tomes have been written about the futility of attempting that and the unnecessary costs associated with it. But the myth lives on.
Doubling money has such a magical quality that draws immediate attention. Schemes, good and bad, have been sold on the “doubling” plank. The surprising thing is that investors are disappointed when some scheme doubles in 7 years. They are excited if it does in 18 months. But, do investors ask the questions about how someone can offer such returns? Mostly no. Even if they do, the seller glibly tells them of how so many people have doubled their money in the past so many years. Surprisingly, such general assertions, garnished with some anecdotal evidence are enough to convince investors to plonk their savings in schemes of dubious merit.
Investor behavior is strange. It has been manipulated from time immemorial. Investor psychology is something we advisors need to understand well and ensure that they stay on the straight and narrow path. Else, you may find one fine day that your client has been sold an elephant that lays golden eggs! We need to be vigilant to avoid such eggs on the face of our clients.
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.
