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Bias, greed and confidence: hurdles to investing

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Control these to ensure that wealth creation is not adversely impacted.

The term ‘investment’ can mean different things to different people. ‘Investing’ involves an initial outlay with the aim of recouping more than what we have put in. Investment objectives may be either monetary or non-monetary. The is one such avenue for investors.

While all investors want to earn huge profits, not everyone succeeds in achieving this objective. Just as in any other profession, only the cream rises to the top.

Unlike other professions, ‘investing’ is rather nebulous, as it does not involve a formal education nor correlates very strongly with high (IQ). The ones who fail may blame it on extraneous reasons and ascribe various conspiracy theories for their failure such as the presence of bear cartels, information asymmetry, the rigging of stock prices and so on. Rarely do they blame themselves and their irrationalities for it.

Greed and fear are the key drivers of markets. Most investors get swept away by these two strong forces and end up losing the battle of investing. If indeed we were rational, we should have acted in a diametrically opposite manner to that of the crowd. Sadly that is not the case.

Besides surges in adrenalin, cognitive and emotional biases lead to our downfall.

The former bias deals with errors of judgement. Prime examples of these are representative bias which leads us to purchase a stock merely because some other stock in the industry is performing well. Overconfidence bias leads us to believe that our performance is solely due to our investment skills.

During the recent run-up in software stocks, investors who purchased Wipro just because and were doing well, could be considered as victims of representative bias.

The latter deals with biases arising out of impulsive or intuitive actions. Examples of this include the endowment effect, wherein owners of a stock always feel that it is undervalued and often desire higher prices for their holdings.

In case of loss-aversion bias, investors are mentally unwilling to see a loss on paper as an actual loss. Hence, they may keep holding on to a bad investment in the hope that it will eventually recover.Investors who invested in banking stocks in early 2010 are currently experiencing both these emotional biases.

Often, these subtle biases act as roadblocks on the way to wealth creation. Also, counter-intuitive as it may seem, many a time, inactivity plays a big role in success. In simple terms, investing involves buying something cheap and selling it when it becomes expensive. Obviously it is not possible to get cheap stocks everyday. Astute investors wait patiently for the right opportunity to arise, conserving their capital in the meantime.

Surprisingly, most market players consider this to be an extremely difficult task. For them, investing is the art of making money by taking advantage of every microscopic wiggle in stock prices. Actually, between the two options, it is the latter which is more difficult. However, there is no dearth of players trying to win this seemingly difficult battle.

Amidst all this noise it is worth dissecting two few memorable quotes by two of the world’s greatest investors:

“In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine,” said Benjamin Graham. Meaning: In the short term, stock prices are slaves to popular sentiment but in the long run, prices usually reflect the true value of the company. That is why it is always suggested than investors invest with a long-term view as short-term jitters do not impact investments then.

has said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” The stock market is merely a vehicle to be able to purchase good companies when the price is right. After that there is no need to worry too much about prices. One must closely track the financial performance of the company he/she has purchased, rather than its stock price.

Other than our own inner devils, there are others who stand in our way.

* Brokerage houses who aim to make money by making others transact as much as possible by offering a panoply of stock ideas.

* Financial media which broadcasts expert opinions and conducts surveys of stock brokers. Most of them accord more importance to short-term market movements as compared to the long-term.

Allocating one’s capital efficiently is a difficult task. However, the task is further complicated by inconsistencies within ourselves as well as certain external stimuli, all of whom are bent on influencing our actions.

The writer is vice president, Parag Parikh Financial Advisory Services

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