Behavioural finance holds clues to market madness

MARKET MOODS - I

Why do stock prices fluctuate so violently even though the underlying fundamentals do not change so rapidly and why do smart people lose money?

After spending a lifetime looking at stock tickers, Parag Parikh, Chairman, Parag Parikh Financial Advisory Services, is now looking up at behavioural finance for answers.

In an interview with Business Standard, Parikh talks of behavioural finance, fashions and fads in the capital markets and the current initial public offer craze.

What led you to study behavioural finance?
I strongly felt the need to get answers to some questions. The natural conclusion of my quest led to a fledgling, little-known field, termed behavioural finance (BF).

A field where anthropology meets economics and psychology intersects with finance. Untaught in MBA curriculum across the world, it remains the domain of a few scholars and special interest groups.

Does it hold any clues to the Indian markets?
Behavioural finance holds definite clues and appears apt in the current IPO craze. The herd mentality is evident in the scramble for shares. As the positive information of excess subscriptions comes, more investors enter the bandwagon.

Prices of these stocks start soaring. Alas, everyone one is thinking of the same thing: I am going to sell on listing and book the profits. Can money making be so simple? Is life and the financial markets so predictable? One will see investors selling the stocks as soon as they get the allotments.

Herd mentality will be at work with people trying to sell faster than the neighbour, thus eroding stock values at a faster rate. Only bankers and financiers, who loaned out money, will end up laughing.

Greed thus becomes the graveyard. One needs to understand that there are no shortcuts to earning money. One has to work hard and have patience.

Can BF be applied to day-to-day market activities?
After an extensive study of the literature on behavioural finance, I believe that its perfect application could make you a successful investor making fewer mistakes.

Even if you learn to identify some common psychological and cognitive errors that plague even the wisest investment professional, it may be enough.

Simply put, standard economic theory starts with a flawed basic premise that the investor is a rational being who will always act to maximise his financial gain. Yet, we are not rational beings; we are human beings.

An integral part of this humanness is the emotion within us. Indeed, we make most of our life decisions on purely emotional considerations.

Our logic and rationale only retrospectively justify these decisions; they do not determine them. Frequently emotions prompt us to make decisions that may not be in our rational financial interest.

Behavioural finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs.

In stock markets, behavioural finance can help explain situations such as why we hold on to stocks that are crashing, foolishly sell stocks that are rising, ridiculously overvalue stocks, jump in late and buy stocks that have peaked in a rally just before the price declines, take desperate risks and gamble wildly when our stocks descend, avoid taking the reasonable risk of buying promising stocks unless there is an absolutely 'assured' profit and never find our right price to buy and sell stocks.

Can you explain this with an example?
Let's take the example of the recent discovery of gas by Reliance industries. The stock starts spurting as everyone starts buying on this news. Newspapers start flashing stories as to the size of such a discovery.

But let us analyse the situation without becoming a prey to mental heuristics. Gas has been discovered but the same needs to be drilled which takes a lot of time and money.

What is the quality of the gas? How many wells would be needed for drilling? How much time will it take? How much money would be required and what are the plans to finance the same? How easy it is going to be to extract the same?

These are all important and pertinent questions. In this time lag there are so many uncertainties the company will have to go through, before the profits are reaped.

However, analysts have started predicting the future profitability of Reliance and on such hopes investors start buying the stock at rising prices.

This is how mental heuristics work when the brain takes a shortcut in processing information and does not process the full information and its implications. The tech boom is built on the same logic and we know the damage it has done.