Investing logic

The road to financial prudence is straightforward: invest systematically and don’t get carried away by emotions. Unfortunately, like many well-known rules, this one too is observed more in the breach. In fact, so influenced are investors by emotion and sentiment—of the general market kind as well as those sparked by social interaction—that investment decisions are usually dependent on emotion hotspots. But as investors have often found, it is at their own expense.

Now with the global financial crisis having dipped confidence levels to a new low, even a slew of stimuli has failed to lure edgy investors back to the stock markets in large numbers. In such circumstances, 50 Psychological Experiments for Investors reveals valuable insights into investor behaviour. A compilation of research exercises conducted across the world, the book deconstructs the effect of biases, interaction and emotion on investor activity. Using a question-answer format, author Mickäel Mangot draws conclusions from experiments conducted by researchers of behavioural finance. Even though the studies have been carried out mostly in western countries, the learnings are for everyone to pay heed to.

Beginning with momentum investing, the book highlights a number of fallacies in human behaviour. For instance, investors turn optimistic when the markets are bullish and become pessimistic in bear markets. If a particular asset class generates positive returns for some time, investors increase their exposure to it. This, says Mangot, is due to momentum bias. “Increases of 15% in real estate or of 30% in the stock market are extreme phenomena that are much less probable than more modest changes confirming to historical averages. Betting on them is like betting on snow in Beijing in October,” he notes.

He also points to a weekly survey conducted by the American Association of Individual Investors during 1987-1992 to understand how past performances determine investor expectations. The study found that investor expectations are more directly linked to the performance of the index in the week prior to the survey. Coming to an investment conclusion based on immediate past results, instead of more concrete historical data, can be less than fruitful.

Another behavioural aspect that is more applicable to current times is the disposition effect. Investors tend to keep loss-making securities for a longer period than the winning ones. The popular tactic is to book profits in winning stocks and hold the loss-making ones, a strategy that has proved expensive for retail investors.

A study of 6,380 investment accounts of individuals from 1987 to 1993 by Odean for the book Are Investors Reluctant to Realize their Losses? found that the investors tend to sell gaining stocks more than the losing ones. The study also found that the winning stocks which were sold, outperformed the market on an average by 2.3% in the following year, while the losing stocks which were retained, underperformed the market by 1.1%.

“Thus, if the investors studied had kept the securities sold and sold the securities kept, they would have increased their annual performance by 3.4%,” points out Mangot. The author calls this a “sunk cost fallacy”. This fallacy induces the investors to go right till the end, that is to keep the stock until it reaches the break-even point.

Another discovery is that psychologically, owning a home increases selfesteem and autonomy in investment decisions. Also, children of homeowners tend to be more successful than the children of renters.

The studies also track the gender difference in financial behaviour: women are found to be fiscally more prudent than men because of higher risk aversion. They also prefer bonds to stocks and change their portfolios less often compared with men.

Even the effect of the lunar cycle on human behaviour is dealt with, albeit in a realistic manner, by taking inferences from studies conducted during these periods.

While most of the results and outcomes cited in the book make for an interesting perusal, readers could get bogged down by the number of references for each question. But for the sheer width of psychological insight into investment behaviour patterns, this book is probably unmatched. It’s a very useful tool to introspect one’s investing history— and to correct the way i n which one makes investment decisions in the future.

BEHAVIOUR DECODED

How we choose information on fallacious criteria

Q. Why do you think you have to invest in the stock market when prices have skyrocketed?
A. Investors think that what’s occurred in the recent past can recur, but it is necessary to observe phenomena over a long period to get an accurate picture.

Q. Why do you buy stocks when the market has gone up, and bonds, when it goes down?
A. The better the recent performance of stocks, the more they attract investors. When the market goes down, investors turn pessimistic and invest in bonds.

How loss and regret aversions inhibit our behaviour

Q. Which stocks do you sell quickly and which are the ones that you retain?
A. The stocks that are gaining are sold more easily by investors than those that are losing. Studies show that the stocks sold subsequently outperformed the market, while those that were held, underperformed.

Q. Why do you reinvest in losing securities?
A. Investors put time, energy and money in investment decisions, so they try and average out the purchase price by buying more of a losing stock. All this increases the overall risk to the portfolio.

How purchasing real estate affects financial performance

Q. Do owners live more happily than renters?
A. Research shows that ownership of real estate produces satisfaction. Owners, therefore, enjoy better psychological health than renters.

Q. Are children of homeowners more successful than those of renters?
A. Studies show a positive impact of ownership on the present and future behaviour of children through geographic stability and a better living environment. They also tend to be more successful in school.

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