After a crisis when the grass finally starts to look green, few prosper and a few lose. Why is there a disparity in the performance when they are all subjected to the same market conditions? Perhaps, the answer lies in human biases and how people react to them.
There is usually a general disconnect between actual risk and the perception of risk in the minds of people. Ironically, in real life, it is very straightforward. For instance, you know that if you touch a hot plate, you get burnt. So the heuristic is not to touch the hot plate.
In business and finance, risk is anything but straightforward. As Nathan Rothshchild said, "Buy at the sound of cannons and sell at the sound of trumpets." Most of the money is made through contrarian actions, which seem simple in hindsight, but involve difficult emotional decisions when they are taken.
In the past two decades, the emergence of the field of behavioural finance has seen a few very intuitive concepts, which deal with the perception of market risk. Some of these look at the deep-rooted biases of human mind, which emerge while dealing with uncertain outcomes.
The financial crisis saw a systemic failure of risk models and shook every perceivable industry. A lot of misery and bad press painted a picture of perma-gloom. Most people saw their portfolios shrink when the markets fell and those who stuck with cash seemed smarter. There is an equal element of luck and skill involved in this outcome. But what followed was the real test of behavioural tenacity.
The people who saw a belowaverage performance even after the markets recovered followed some traditional biases. The most important one is the representative bias, which dictates that when something looks bad, everything associated with it must also be bad. This heuristic is exactly why most people stayed away from businesses that were even remotely related with finance. Another bias at play was the recency bias, which says that if everything around you looks bad, then it must, in fact, be really bad.
This mental shortcut led some people to avoid investing their money in otherwise reliable businesses. The last, but not the least, bias they fell for was myopic loss aversion. This forced investors to think: 'If I'm losing money, it is wise to get out before I lose too much.' Most people, who had earlier taken rational calls on businesses they had invested in, bailed out when the stock prices started to drop like bricks from the sky. If they had stayed on or even averaged down, the cost of investment would have been very cheap when the markets sprang up again.
The investors who avoided these mental shortcuts and analysed the odds of an upside put in buckets of cash into good businesses that were available at juicy, cheap valuations. Nassim Taleb talks about the magnitude of success over its frequency, where it is usually wise to bet on rare events when the odds appear to be in our favour. When will rational investors get another opportunity to invest in good businesses at such throwaway prices? This was the rare event that they exploited.
Parag Parikh is Chairman, Parag Parikh Financial Advisory Services
