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Thursday, October 22, 2009

Are you an irrational investor?

Otherwise perfectly logical and rational people tend to become irrational when they become investors. Why does it happen? An entire field of academic study has grown around this riddle - called Behavioral Finance.

One of the questions I often face goes like this: 'I bought XYZ Co. at 450 and was thrilled to see it go to almost 550 but didn't sell. Now its at 100. Should I buy more to bring down my average cost? When can I expect to get back my original price?'

A rational investor should have sold when the price rose 100 points in a short period, or when it came down from 550 to 450. At worst, he should have sold when the price dropped to 400.

Instead, he hung on till the price dropped to 25, but didn't buy then. Now that the price is up past 100 he wants to buy again. If I'm brutally honest, my answer to the two questions would be 'No' and 'Never'. He would be better off getting out now. Unfortunately, loss-aversion - another irrational trait - may keep him from doing just that.

That may be an extreme example, but it isn't that far fetched. Here is another one. Say you've bought a stock at 250, following which the stock drops to 175. You decide to hold on because you've done your homework and the fundamentals are strong.

Eventually, the stock starts rising again and reaches 225. What would you do? Sell and book a small loss? Or, hold on at least till you get back your cost price of 250? Chances are, you'll opt for the latter - only to see the stock hit 230 and start falling like a brick. You eventually book a loss at 200.

Let's look at another situation. You buy a stock at 50, and within a week it starts to soar, and soon reaches 80. You decide to ride the wave. Within 6 months, the stock hits 110. More than double your original investment! You are elated, and book profits.

The stock consolidates for a while, and then takes off again. You watch in horror as it scales 150, 200, 250, 300 within the next few months. The person who bought from you at 110 made more money, though you had entered at a much lower cost.

Holding on too long when a stock is falling, or getting out too soon when a stock is rising, or expecting to get back the cost price are common mistakes that tend to get repeated. But such irrational investor behavior can be corrected through awareness and experience.

A little more complicated behavior pattern but equally disastrous for your wealth is not knowing that you don't know something. An example of that happened after a recent post on the telecom sector. I had suggested that the best of the telecom sector may be behind us and investors should switch to other sectors.

I received several arguments about Bharti Airtel being a great company that looks after its customers, plenty of growth is still left in the sector, buying Bharti after the recent correction would be a smart move, and so on.

Did the telecom sector suddenly turn bad? No. But the signs of saturation were clearly visible. Introduction of even lower call rates and delay in 3G spectrum auction were the last straws. Poor subscriber additions for the leading players confirmed that the tide is turning.

Most investors, particularly those who had entered the sector early and made huge gains, may find it difficult to accept that a major shift is happening in the telecom sector. It is gradually becoming a slow-growth stalwart sector from being a fast-growth sunrise sector.

Accepting and learning from your mistakes and acknowledging that you may not know as much as you think you know are the steps towards becoming a rational investor rather than remaining an irrational investor.


cvrk said...

A good one, particularly the switch which made you to share the thoughts- telecom industry. such a behavior of conscious logic overtaking unconscious hope would continue to exist even after reading such articles.

SG Money Mind said...

What I have learned through my investing experience is to invest where things are obvious and are considered not so fancy. All other types of investment opportunities become a bet which can go wrong before you realise the mistake.

PowerMF said...

Interesting post. But, dont you think the heading should ideally have been 'irrational trader' instead of 'irrational investor'.

Madhu said...

Very good piece.
One of the best example of making money from understanding behavioral finance is by being contrarian.
Can u suggest me some good books on behavioural finance?

Subhankar said...

@cvrk: Thanks for your comments. Hopefully, investors will read such articles and take more rational investment decisions.

@SGMM: Sensible approach. Troubles start when we step outside our 'Circle of Competence'.

@PowerMF: Appreciate the suggestion. My view is that trading is an irrational activity. Why would a rational person do stock trading when the odds of success are less than 50%?

@Madhu: Thanks. To be a successful contrarian, one should be able to distinguish between a temporary setback for a company, and damage of a more permanent nature.

You can read books be Shefrin (Beyond Greed and Fear), Shiller (Irrational Exuberance), Shleifer (Inefficient Markets).