One of the pearls of wisdom in the dialogues of the movie Wall Street, was, 'Don't get emotional about stock.' Top Gun had a similar gem: 'Your ego's writing cheques your body can't cash.' However, most individual investors tend to do precisely that. While ego does not allow them to walk away from a losing proposition, insecurity makes them foolishly rush into situations they do not fully understand. Let's examine some of the common errors that can be avoided.
1. Being spontaneous
There's nothing more dangerous than taking investment decisions without doing your home work. If you rely on luck for earning returns on investment, better have really deep pockets. In cricket, a 'blind shot' can get the batsman six runs or make him lose his wicket. Such hit and miss strategies can't sustain you, especially given the volatile market scenario and dynamic nature of instruments. You need to define your approach towards investment and have a proper plan to ramp up your finances over a period of time.
2. Risk runner?
Are you risk-averse? Or comfortable playing the market and sitting it out till the next cycle? There's no point in displaying false bravado to impress someone and investing in a high-risk instrument only to exit it with a loss when panic hits. Be honest about your capacity and stick to investing in instruments that fit within it.
3. Great expectations
If you wish to quadruple your investment in two years here's a newsflash - it only works in the movies. In real life, you have to be patient and build up you investment gradually. There are benefits like the power of compounding but these are only available to those who stay invested for the long-term. Similarly, even the equity market offers real returns to those who display the ability to wait and watch.
4. Following tips
Whether its the race course or the stock market, remember that tips are only given to draw in more people and stack up the odds. Once that is done, the situation changes abruptly and the apparently chosen one on a 'winning streak' suddenly collapses. Those who followed the tip find their investment nosediving in value while market manipulators will already have exited a long time ago.
5. Timing the market
Every investor has a dream. To buy shares in a company just before the price begins to rise and sell it at the absolute peak, just before the decline begins. What happens, is that in trying to time the market, one may enter when a stock starts to plummet and exit just before it regains upward momentum. Overconfidence, especially in this aspect, is strictly avoidable.
6. Riding the waves
The same logic applies to those who try to invest based on past performance. In fact it is future potential that you need to focus on as that alone will decide whether your investment appreciates or decreases in value going forward.
Psychology of investing
History is replete with stock market anomalies, market bubbles and crashes across the world. So, the obvious question to ask is - if man is a rational being and the markets are efficient, why did all this take place? The answer would probably lie in the vagaries of the human mind such as greed, fear and hubris. This is exactly what has been a focus area for a growing body of work over the past two decades. Labelled ‘Behavioural Economics or Finance”, this field has attempted to better understand and explain how our emotions and cognitive errors influence our investment decision-making process.
A study conducted by William Samuelson and Richard Zeckhauser gives an insight into our reluctance to change when dealing with financial issues. A group of students were asked how they would invest a hypothetical large inheritance. Half of them received their inheritance in low-risk bonds and the rest received higher-risk securities. Common sense would suggest that individuals would reassess their asset allocation based on their risk profile and time frames, but both groups chose to leave most of their money alone. The students’ fear of switching into securities that might end up losing value could have prevented them from making the rational choice: rebalancing their portfolios.
Thaler and Tversky noticed a related bias called the endowment effect during their studies. This reflects the tendency of people to attribute a higher value to things that they own, in comparison to the price they would pay for buying the same things. These two biases combined with loss aversion contribute to poor investment decisions.
Sr VP and Portfolio Manager - Equities, Franklin Templeton Investments, India