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The emotional investor

Investing in the stock market is often influenced by your own personal emotions and short-term market movements. But you can still take control and choose.

Clifford Alvares        Print Edition: April 5, 2009

If you are caught in a dilemma whether to further invest in a weak stock in which you have lost, say, more than Rs 1 lakh, so that you can average out your investments or put your money in a promising company that could reap you rich dividends, which would you choose? It’s a dilemma that faces many of us and often comes in the way of making a rational investment decision. Very often, investors choose the former to cover up losses in their portfolio or just hold on to the stock in the hope that it will bounce back soon. Behavioural finance experts say investors tend to behave in this way because the pain of loss far exceeds the pleasure from gains. It’s this emotion of “loss aversion” that many investors unwittingly succumb to when making investment decisions. Often, not understanding one’s emotions when investing in the stock market leads to big financial losses for investors

Plenty of research has gone into how emotions affect investment decisions of individuals. Emotions are shaped by a lot of influences in our daily lives, including basic things like how we react to money or how our parents reacted to money. Emotions also determine how we react to different situations. Says Parag Parikh, stock broker and author of Stocks to Riches (Tata McGraw-Hill): “It also stems ourselves and seek immediate pleasure or whether we can postpone pleasure.” It’s how you deal with these emotions that will determine whether you will make money or lose your shirt during these tough times.

Weigh your emotions
Consider the “gambler’s fallacy” that nearly everyone—from housewives to corporate head honchos— falls for. Say, you are playing a game of coin tossing and nine times out of nine, the coin shows heads. What are the chances that it will show heads on the next toss? Many might think it’s slim because it showed heads nine times out of nine previously. Yet, the chances are fifty-fifty—the same as the last coin toss or the previous nine coin tosses. Each wager is unique to the chances that it gives an investor and it has got nothing to do with the previous results. This is where investors can recognise that each investment is different. If you had been winning on a particular stock before, it does not mean that you will win the next time you invest in the same. It calls for a fresh understanding of the market conditions and the circumstances that will allow your stock to do well.

Investors get easily swayed by another similar emotion: the “sunkcost fallacy”. This means that investors are throwing in good money after bad. On the other hand, if your investment is in a weak stock, then no matter how much you invest in it, chances are that you will still lose money. But sometimes you can use this psychological effect to your advantage. Let’s say you buy a gym membership for a year rather than for a month. Here you sink the money for a year, but it psychologically forces you to go to the gym rather than forego a huge sum. In investing, it works when an individual investor rupee costaverages on a good stock.

A common trap investors fall into when they are driven by emotions is when they try to recover a loss. At such times, an investor has to commit a bigger sum of money to recover his loss in the market. In doing so, he fails to recognise that his risk capital and exposure to the market has increased.

“Markets are not efficient in the short term”
Long-time broker Parag Parikh and author of Stocks to Riches explains how individual investors behave in the short run and how they can use emotions to their advantage.

On emotional biases
People are influenced by various emotions and one of them is “sunkcost fallacy”, which results in putting good money after bad. You essentially want to justify your earlier decision and soothe your ego. If you bought a bad stock and bought more after its price fell, it’s this fallacy at work. When you average out, you may be prone to “sunk-cost fallacy”. On the other hand, you can use the effect to your advantage by averaging downwards in a good stock.

On investing today
Often, people find it difficult to understand stock markets. It’s said that markets are efficient. But behavioural economists believe that markets are not efficient in the short run. It’s precisely in such times that people don’t make rational decisions. When these days a liquidator is selling stocks at any price, can you imagine the potential you have when you invest today? Right now, everyone wants to avoid a loss while it may be the time to buy.

On market emotions
If I sell a share after the market falls, I make a loss. So, my actions have produced a loss for me. But other shareholders, by merely holding the same shares, too, see their values plummet. It’s when you don’t do anything and yet there’s a reaction, then you get confused. This is when greed and fear overcome us. Right now, everyone wants to avoid a loss, which is known as “loss aversion” in behavioural finance. This is the time to buy.


Balance the decisions
The first step to clearing the mental cobwebs is to make a note of why you are taking the decision in the first place. There are some key questions you should ask yourself before taking a decision to invest. Do you want to recover your losses? Do you find the investment worthy at the current market prices? Are you keeping away from the stock market for fear of losing money? Or are you investing right now because you find stocks very attractive? Are you afraid of losing money or are you afraid of taking risks?

It’s not difficult to understand your emotions over time. Question every investment decision you make with your own experience. Ask hard questions about the prospects of the company and whether the price you are paying for it is right. Circumstances can change for a company (as the Satyam episode has shown), so not every investment might turn out to be right. Shrug off your losses and move on to the next story. As Parikh puts it: “Don’t get married to your stocks.”

On the other hand, don’t latch on to every new idea that comes your way at the cost of your old ones that might still have potential, but rather weigh your investment decisions before you take a call. The key to wealth building is to balance your investment decisions with your objectives and the circumstances of the market. Exploit the emotions of the market when there’s an opportunity. Chances are that it will leave you better placed than the rest of the market—and well-prepared for further opportunities or downturns.

Straight or Crooked Thinking?
Questions you can ask yourself to understand how personal emotions affect financial decisions.

Quiz 1
You are given Rs 1,000 and two options:
A: Guaranteed win of additional Rs 500
B: Chance to flip a coin.
If it’s heads, you receive another Rs 1,000, if it’s tails, you get nothing.

You are given Rs 2,000 and two options:
A: You are guaranteed to lose Rs 500
B: A chance to flip a coin. If it’s heads, you lose Rs 1,000, and if it’s tails, you lose nothing
Investors tend to take more risk when faced with a loss and are more conservative when it comes to locking in sure profits

Quiz 2
You have been gifted a souvenir jug worth Rs 100. Someone offers to buy it from you. What is the least you expect?
A)100 B) 80 C) 70 D) 50

Your neighbour received a souvenir jug worth Rs 100. How much would you pay for it?
A)100 B) 80 C) 70 D) 50

The value of goods increases when it’s a part of your own endowment. Likewise, investors tend to overvalue their own shares.

Source: www.ppfas.com

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