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Tuesday, November 3, 2009

Some practical examples of Behavioural Finance

Some practical examples of Behavioural Finance will show a different aspect - more from the psychological point of view - at how and why investors buy and sell stocks. It goes against the grain of Efficient Market theory that is built upon rational decision making taking into account all available information.

One of the interesting advantages of writing a blog is that readers get an opportunity to react almost immediately and let the writer know what they think about his opinions. Thereby opening a direct window to the workings of their minds.

In a recent post, I had suggested that investors should bail out of the telecom sector stocks, instead of jumping in after the price correction. In another post, I suggested investors should sell the Punj Lloyd stock at every rise, after it posted awful Q2 '09 results.

The reactions were swift. While some agreed with my views, many did not. The arguments were strong and apparently 'rational'. But what about investment behaviour?

"Bharti Airtel is the best in customer service, has a pan-Indian network, is a leader with a stash of cash, will be less affected by the price war and number portability. So, the stock was a 'steal' at 350 and more should be bought if it slipped below."

Why 350? Because it was 30% lower than its recent high of 500? Possibly. The human mind likes to work with nice round numbers. A classic example of 'recency bias' in Behavioural Finance. The price of 500 had remained in the investor's mind as a 'recent high'.

A few more readers thought 350 was a good price to enter. An example of 'confirmation bias' - investors looking for confirmation of a 'buy' decision. What happened when the stock dropped to 340?

"I sold at 340 so that I can buy it back at 325", was one comment. An example of 'loss aversion'. This is one of the most insidious biases for long-term investment success. Instead of admitting a mistake and booking the small loss, an investor tries to take on additional risk to avert the loss.

I'm not sure what this particular investor did when the Bharti Airtel stock first fell to 325 and then went below 300.

A comment about Punj Lloyd was:

"I sold the stock at 290 and was happy to buy it back at 240. Will buy more if it goes further down. The company has a huge order book, has global operations and is a Larsen and Toubro in the making."

Now that the stock has dropped below 200, 'Regret theory' in Behavioural Finance suggests that the investor has probably avoided selling the stock and is holding on to it to avoid the regret of making a bad decision.

'Prospect theory' in Behavioural Finance postulates that investors behave differently in situations depending on whether they are faced with a loss or a gain. They feel more pain at the prospect of losses than they feel elated by an equivalent gain. In other words, a 10 point loss in a stock costing 100 may cause more distress, than a 10 point gain causes happiness.

In actual experiments with different groups of investors, when evaluating the prospect of a sure gain, most investors become risk-averse; but faced with sure loss, they become risk-takers.

No wonder, Benjamin Graham has written: "The investor's chief problem - and even his worst enemy - is likely to be himself."

14 comments:

Jasi said...

Very interesting observations but you have raised a very good question abt Punj Lloyd. I mean really, do you sell a share based on just one quarter of bad performance? And it is not like everyone else if reaping in gains, its still early days after recession. Should not you take a contrarian approach in such conditions and may be stand to gain? For sure a quarter shud not be enough to make or break a Punj Lloyd.
Disclaimer -> I have investments in Punj ;)

Subhankar said...

One bad quarter, Jasi? How about five years of ever-worsening financial situation?

Check the cash flows from operating activities - negative for the past 5 years (may be even longer). Right through the biggest economic boom in India, this company has been unable to generate a single Rupee in cash from its business!

How are they managing? By taking on more and more debt. Nearly Rs 3000 Cr as of Mar '09.

Either their business model is terrible, or they are siphoning off the cash. The management is definitely not the epitome of integrity.

Jasi said...

whoa! This IS scary. So, very quickly, what does a -ve cash flow indicate?

Subhankar said...

Check out my blog post of Oct 20 '09 ("A Parable about Cash Flows").

tax_trp said...

sir,
This was one of the most difficult post i have ever read because i hold both the scrips discussed here, not large holdings but 5% each in my portfolio, bought recently,also honestly i acknowledge in me the behaviour mentioned in the said post,anyhow truth is always truth how bitter it may be.
Now let's wait, watch and pray for the respectable exit, i hope u dont write one more blog on my behaviour called "WAIT, WATCH AND PRAY"
mansoor panjwani

Sumanta said...

Sir,

Thanks for another good post, practical one. You nailed it exactly right as to how we don't act rationally while investing in stock markets. This post reminded me of the good book "Predictably Irrational" by Dan Ariely. Although that book talks about human behaviour in other life situations and also provides tools & techniques for better decision making.

Coming to the topic on the post, do you think the following action would always help especially when we invest in the stock market?

1. Whenever we buy (we always buy to start with), we should straightaway decide on the loss that we are willing to take beforehand and apply a stoploss accordingly? This looks like a simple thing to do but i have not been able to do it in a disciplined manner.

2. Are there any other tools & techniques for better decision making against some of the bias you talked about in your post? Any good books/references on Behavioral Finance in Stock investing would also help.

Thanks,
Sumanta

ms said...

Good article sir. I wish to do my Ph.d in Bevavioural Finance.

Subhankar said...

@tax_trp: The article wasn't targetted at you, Mansoor. It was to point out behaviour patterns that cause losses in the stock market.

'Waiting and Watching' is a great strategy for stock investments. It should be interspersed with occasional but decisive buying and selling. 'Praying' should be used only to meet spiritual goals.

@Sumanta: Thanks for your comments.

It is always a good idea to set a stop-loss when you buy. For fundamentally strong stocks for the core portfolio, the stop can be at 30%; for speculative stocks for the satellite portfolio, it can be at 5% or 10%. A bit of trial and error may be required, because volatility of each stock is different.

Follow Graham's thumb rule of buying stocks only if P/E < 15, or P/BV < 1.5, or P/E x P/BV < 22.5, to avoid over-priced stocks.

You can read Hersh Shefrin's "Beyond Greed and Fear" and Robert Schiller's "Irrational Exuberance".

@ms: Appreciate your comments.

Rishi said...

Dear Subhankarji,

Behavioural Finance sounds interesting. Thanks for the article with examples, it helped in understanding the concepts better.
Could you please suggest a rule of thumb for investing in FMCG stocks as they generally dont fit into the Graham P/E * P/BV < 22.5 rule.

Thanks
Rishi

Subhankar said...

Appreciate the kind words, Rishi.

You have been perceptive about Graham's thumb rule not working for FMCG companies. The 'defensive' nature of such stocks (they rise less and fall less) due to little debt and strong cash flows, cause high valuations.

Technical analysis can help by studying long-term price charts. Since 2006, ITC has made several lows in the 140-180 range; HUL made bottoms in the 160-190 range. That gives you indicative entry levels in those two stocks.

ruby said...

Hi Subhankar,
I think you should take a long term view on Bharti Airtel...

Just because its falling doesnt mean we should avoid....

Subhankar said...

If you read some of my blog posts, Ruby, you'll learn that I only take long-term views.

The telecom sector in India - and around the world - have had their day in the sun. As growth slows and ARPUs continue to tumble, telecom services is turning into a commodity - with per second billing and number portability, and no longer deserve the valuations they have received so far.

Value-added services might be the next growth area in telecom, but the service providers haven't nailed down a strategy yet.

Caesar said...

Hi Subhankar ,
Very good article and you have a great knowledge base. Presently I am working on my Phd on: " Behavioural Finance " Do you know of some books / persons who can guide me how to start the practical part of showing the impact of behavioural finance in Indian market scenario? I am waiting for your answer....Caesar

Subhankar said...

My knowledge of behavioural finance is based on what I've read combined with my years of investing experience. Not sure if that can be translated to a PhD thesis.

Here are a couple of article links that can help you along in your research:

http://www.behaviouralfinance.net/behavioural-finance.pdf

http://www.psychonomics.com/research/a&s/bflinks.htm