5 Psychology Traps that Investors Need to Avoid

Benjamin Graham once said that “an investor’s chief problem and even his worst enemy- is likely to be himself.” 

When it comes to investing, humans go through a ‘roller-coaster of emotions’ as shown below.

The Roller Coaster cycle of Investing (Courtsey : Credit Suisse)

This has led to the emergence of behavioural finance, a new field that aims to shed light on investors’ behaviour in financial markets.

5 important and common biases amongst investors 

Anchoring Bias 

Anchoring Bias occurs when people rely too much on a reference point in the past when making decisions for the future- that is they are ‘anchored’ to the past. 

For example, if you had a favourable return on a stock when you first invested in it, your perception on the future returns of stock is positive even when there may be clear signs indicating that the stock might take a dive. 

Herding

Also known as the mob mentality, is a tactic that was passed on from our ancestors and believes that there is strength in numbers. 

Ironically, this herding mentality among investors is the major reason for ‘bubbles’ in the financial markets. 

However, people are quick to dump stock when a company receives bad press or go into a buying frenzy when the stock does well.

As an investor, you should perform your own analysis and research on every investment decision and avoid the temptation to follow the majority.

Loss Aversion

Loss Aversion is when people go to great lengths to avoid losses because the pain of a loss is twice as impactful as the pleasure received from an investment gain. 

As emotional beings, we often make decisions to avoid a loss, this could involve investors pulling their money out of the market when there is a dip which leads to a greater cash accumulation or to avoid losses after a market correction investors decide to hold their assets in the form of cash.

Superiority Trap 

Confidence is an asset when it comes to investing in the stock market, but over-confidence or narcissism can lead to an investor’s downfall. 

It is important to remember that the financial market is a complex system made of many different elements and cannot be outwitted by a single person.  Overconfidence is the most dangerous form of carelessness. 

Confirmation Trap 

Confirmation trap is when investors seek out information that validates their opinions and ignores any theories that refute it.

When investing in a particular stock that believe will result in favourable returns, an investor will filter out any information that goes against their belief. 

For instance, an investor will continue to hold on to a stock that is decreasing in value simply because someone else is doing the same. The investors help validate each other’s reasons for holding on to the investment, -this, however, will not work in the long-term as both investors may end up in a loss. 

(Disclaimer : This blog is for information purposes only)

Asset Allocation and Risk Tolerance, the two important facets of investing

What is Asset Allocation?

According to Investopedia "Asset Allocation means spreading your investments across various asset classes. Broadly speaking, that means a mix of stocks, bonds, and cash or money market securities."

Maximizing Return & Risk 

The goal of allocating your assets is to minimize risk while meeting the level of return you expect. To achieve that goal, you need to know the risk-return characteristics of the various asset classes. The figure below compares the risk and potential return of some of them:

The rule of thumb is that an investor should gradually reduce risk exposure over the years, in order to reach retirement with a reasonable amount of money stashed in safe investments.

6 Golden rules of Asset Allocation 

Well known studies by Brinson et.al. (1986, 1991) concluded that "More than 90 percent of the variation in a portfolio's performance over time is due to its asset allocation". The studies further assert "… investment policy dominates investment strategy (market timing and security selection)." 

These findings have become the bedrock of financial planning discourses and have their fans and critics alike.

1. Rules over views : Views are beliefs formed over time and involve predictions about markets. They are based on assumptions about future outcomes. These views differ depending on one’s ‘conditioning’ and may or may not hold true. However, an asset allocation plan based on ‘rules’ or some pre-determined scientific formula which uses actual parameters, is likely to triumph over views and market outlooks.
2. Understanding Behavioural Biases : Investing is more behaviour than Math :Investment decisions are driven by biases and not necessarily facts. Empirical theories assumed that investors were rational beings and made economically sound decisions based on data. However psychologists who studied investment behaviour, realised that investors make decisions based on biases and emotions.
3. Low correlation amongst Asset Classes is important : When constructing a portfolio is very important to look at the correlation of the asset classes. Investing in positively correlated asset classes, is not advisable as both asset classes are likely to deliver similar returns and will carry similar risks.
4. Discipline to Rebalance weights systematically : Asset Allocation must never be at the mercy of ‘last one year returns’. With regular rebalancing across asset classes one can maximize the benefits of asset allocation.
5. Risk Tolerance and not just age : Risk tolerance is a combination of various factors such as one’s income, liabilities, number of dependents, financial goals, need for cash flows, savings, and age.
6. Taxation : Taxes are happy outcomes. In the obsession to avoid taxes – one may end up taking undue risks. 

Risk Tolerance 

Risk Tolerance is defined as the amount of risk the investor can tolerate before deciding to exit the market and usually depends on the investor’s financial situation, type, preference of asset class, time horizon, and purpose of investments. 

An investor needs to have an understanding of risk tolerance; otherwise, they may see a large movement in the value of investment and panic, which might cause to sell at the wrong time.

Individuals have different risk tolerances. 

Your risk tolerance is your ability and willingness to assume risk. 

Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs. 

In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime.

(Disclaimer : This blog is for information purposes only)

Risk and the emotional roller coaster of investing. Why Risk is behavioural also.

Risk particularly in finance and investment is often framed in cold and calculating terms, but such an approach can lead us to neglect its very human features.

More often than simply "an absence of certainty" risk is about our inability to deal with probabilities ( of gain and loss as markets go up and down) in a consistent and coherent fashion. 

This causes discomfort.

How we experience and perceive risk is uniquely personal but at the same time certain trends are obvious. 

4 common biases tend to exist among investors 

1. Overconfidence 
2. Reducing Regret 
3. Limited Attention Span; 
4. Chasing Trends 

If you see yourself in any of these biases then the best way to avoid pitfalls of human emotion is to identify the emotion. 

You cannot avoid all behavioural bias but you can minimize the effect. 

"Be fearful when others are greedy and greedy when others are fearful". Warren Buffet. 

Easier said than done - but then that's why execution is the key. 

Many authors have written on psychological or behavioral traps that lead people in the wrong direction with their lives in general.

Quite frequently, some classic forms of dysfunctional psychology are directly evident in investing behavior.

#1. Anchoring Trap 

This refers to an over-reliance on what one originally thinks. 

Imagine betting on a boxing match and choosing the fighter purely by who has thrown the most punches in their last five fights. You may come out all right by picking the statistically more-active fighter, but the fighter with the least punches may have won five bouts by first-round knockouts. Clearly, any metric can become meaningless when it is taken out of context.

In order to avoid this trap, you need to remain flexible in your thinking and open to new sources of information, while understanding the reality that any company can be here today and gone tomorrow. Any manager can disappear too, for that matter.

#2. Sunk Cost Trap 

The sunk cost trap is just as dangerous. This is about psychologically (but not in reality) protecting your previous choices or decisions — which is often disastrous for your investments. It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better.

#3. Confirmation Trap  

Similarly, in the confirmation trap, people often seek out others who have made and are still making, the same mistake. If you find yourself saying something like, "Our stocks have dropped by 30 percent, but it’s surely best just to hang onto them, isn’t it?" then you are seeking confirmation from some other unfortunate investor in the same situation. You can comfort each other in the short run, but it’s just self-delusion. 

#4. Blindness Trap 

Situational blindness can exacerbate the situation. Even people who are not specifically seeking confirmation often just shut out the prevailing market realities in order to do nothing and postpone the evil day when the losses just have to be confronted.

#5. Relativity Trap  

The relativity trap is also there waiting to lead you astray. Everyone has a different psychological make-up, combined with a unique set of circumstances extending to work, family, career prospects and likely inheritances. This means that although you need to be aware of what others are doing and saying, their situation and views are not necessarily relevant outside their own context.

Be aware, but beware too! You must invest for yourself and only in your own context. Your friends may have both the money and the risk-friendliness to speculate in pork belly futures (as in the movie "Trading Places"), but if you are a modest earning and nervy person, this is not for you.

#6. Irrational Exuberance Trap 

When investors start believing that the past equals the future, they are acting as if there is no uncertainty in the market. Unfortunately, uncertainty never vanishes.

There will always be ups and downs, overheated stocks, bubbles, mini-bubbles, industry-wide losses, panic selling in Asia and other unexpected events in the market. Believing that the past predicts the future is a sign of overconfidence. The investors who get hit the hardest — the ones who are still all-in just before the correction — are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won't turn on you is a sure way to get yourself gored. 

#7. Pseudo-Certainty Trap 

This phrase is an observation of investors' perceptions of risk. Investors will limit their risk exposure if they think their portfolio/investing returns will be positive – essentially protecting the lead – but they will seek more and more risk if it looks like they are heading for a loss.

Basically, investors avoid risk when their portfolios are performing well and could bear more, and they seek risk when their portfolios are floundering and don't need more exposure to possible losses. This is largely due to the mentality of winning it all back. Investors are willing to raise the stakes to "reclaim" capital, but not to create more capital. How long would a race car driver survive if he only used his brakes when he had the lead?

#8. Superiority Trap 

For some people, the superiority trap is extremely dangerous. A lot of investors think they know better than the experts or even the market. Just being well-educated and/or clever does not mean you wouldn't benefit from good, independent advice. Also, it doesn't mean you can outwit the pros and a complex system of markets either. Many investors have lost fortunes by being convinced that they were better than the rest. Furthermore, these people are easy prey for some of the other traps mentioned above.

The Bottom Line  

Human psychology is a dangerous thing, and there are some alarmingly standard mistakes that people make again and again. It is very easy in the heat of the moment, or when subject to stress or temptation, to fall into one of these mind traps. The wrong perceptions, self-delusion, frantically trying to avoid realizing losses, desperately seeking the comfort of other victims, shutting out reality and more can all cost you dearly.

Be aware of the nature of these traps and always be honest and realistic with yourself. Furthermore, seek advice from competent and knowledgeable people of integrity who will bring you back to reality before it is too late. 

DISCLAIMER :  THIS BLOG IS FOR INFORMATION AND NOT TO SOLICIT ANY BUSINESS. PAST PERFORMANCE IS NOT AN INDICATION OF THE PERFORMANCE OF STOCK IN FUTURE. EQUITY STOCK INVESTING IS A WITH RISK INVESTING INCLUDING RISK ON CAPITAL INVESTED. PLEASE TAKE AN INFORMED DECISION BEFORE INVESTING IN A EQUITY STOCK

Porters 5 forces model and the key to investing in stocks

Moat - What is it?

According to Warren Buffet a successful company is one which is having a "MOAT" 

Companies that are performing well are constantly challenged by competitors but with a deep and wide "MOAT" these companies are able to sustain competition.

Porters 5 forces model 

The five-forces perspective is associated with its originator, Michael E. Porter of Harvard University. This framework was first published in Harvard Business Review in 1979.

The state of competition in an industry is decided by five forces. 

These are 

1. Threat of entry,
2. Threat of substitution,
3. Bargaining power of suppliers,
4. Bargaining power of buyers; and 
5. Intensity of rivalry.

Application

1. A successful company's strategy is aimed to best defend itself from such forces.  Deep dive into each of these forces is required to determine the competitive strength of a company.
2. A company which is able to score well on all these forces is able to consistently deliver good profits and growth.  It is able to handle these forces much better than competition. Hence its stock is able to provide consistent returns to its shareholders. 
3. With time the status of companies keeps changing with respect to these five forces and hence a careful study goes a long way in determining whether the stock is attractive or not. 
4. Porter's analysis framework defines the important criteria to determine the stability of a corporation. High threat levels typically signal that future profits may deteriorate and vice versa. 

For example, a hot firm in a growing industry might quickly become obsolete if barriers to entry are not present. Likewise, a company selling products for which there are numerous substitutes will not be able to exercise pricing power to improve its margins, and it may even lose market share to its competitors.

The qualitative measures introduced by Michael Porter in Porter's five-force framework allow investors to draw conclusions about a corporation that are not immediately apparent on the balance sheet but will have a material impact on future performance.

 Although quantitative factors such as the price/earnings and debt/equity ratio are often the primary concerns for investors, qualitative criteria play an equal role in uncovering stocks that will provide long-term value. 

DISCLAIMER :  THIS BLOG IS FOR INFORMATION AND NOT TO SOLICIT ANY BUSINESS. PAST PERFORMANCE IS NOT AN INDICATION OF THE PERFORMANCE OF STOCK IN FUTURE. EQUITY STOCK INVESTING IS A WITH RISK INVESTING INCLUDING RISK ON CAPITAL INVESTED. PLEASE TAKE AN INFORMED DECISION BEFORE INVESTING IN A EQUITY STOCK

Behavioural Biases in Investment Decision Making

What Is Bias? 

According to Investopedia - A bias is an illogical preference or prejudice. It's a uniquely human foible, and since investors are human, they can be affected by it as well. Psychologists have identified more than a dozen kinds of biases, and any or all of them can cloud the judgment of an investor.

Some of the well documented biases that are observed in Investment Decision Making are 

Optimism or Confidence Bias -: Investors cultivate a belief that they have the ability to outperform the market based on some investing success.  Investing on objective information tends to remove this bias. 

Familiarity Bias -: This bias leads investors to choose what they are comfortable with.  This may be asset classes they are familiar with, stocks or sectors they have greater information and so on. This bias can lead to concentrated portfolios. 

Anchoring -: Investors hold on to some information that may no longer be relevant and make their decisions based on that.  New information is based as incorrect or irrelevant and ignored in decision making process. 

Loss Aversion -: The fear of losses leads to inaction.  Studies show that the pain of loss is twice as strong as pleasure that felt at a gain of a similar magnitude.  Investors prefer to do nothing despite information and analysis favouring a particular action that in the mind of the investor may lead to a loss. 

Herd Mentality -: This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. 

Recency Bias -: The impact of recent events on decision making can be very strong.  This applies equally to positive and negative experiences.  Investors tend to extrapolate into the future and expect a repeat.  A bear market or a financial crisis lead people to prefer safe assets.

Choice Paralysis -: The availability of too many options can lead to a situation of not wanting to evaluate and make a decision.  Too much information also leads to a similar outcome on taking action. 

(Disclaimer : This blog is for information purposes only)

QUALITY INVESTING - an investing style which has worked well.

Quality investing includes identifying value stocks of companies with the characteristics of good businesses.

Benjamin Graham, considered the father of value investing, put an emphasis on finding quality value stocks. 

His studies found that the biggest peril of buying bargain stocks was settling for low quality companies that were unable to compete.  He argued that finding quality stocks was the key to successful value investing.

Piotroski Score

Some analysts have chosen to use the Pitroski Score (to know more Read here)  for a quality stock screen. The Piotroski Score concentrates on profitability, capital structure, and operating efficiency in evaluating the quality of a company.

Characteristics of Quality Stock are : 

1. Good Management 
2. Strong Balance Sheet 
3. Enterprise Life Cycle 
4. Economic Moat 
5. Earnings Stability 
6. Operating Efficiency 

Quality Investing beats Index Returns by significant margin (past 10 year data)

(Source www.asiaindex.co.in)

Quality investing requires a different way of thinking. 

Too many investors go for the volatile higher risk investments instead of the quality investments.  

Investing is a marathon, not a sprint.

(Disclosure : For educational purposes only and not to solicit any business.  Please be aware that stock market investing is a with risk investing including risk on the principal invested. Please take an informed decision)

MARKETS RISING DURING CORONA CRISIS. WILL IT WORK?

Markets world over have strongly recovered from the lows.  Markets crashed anticipating economic slump and slowdown due to lockdown - largely world over - because of corona virus. 

The reaction to Corona Virus (also called as Wuhan Virus or China Virus since it came from China) was a) Lockdown and b) Fiscal Stimulus.

Wikipedia defines Fiscal stimulus as to increasing government consumption or transfers or lowering taxes. Effectively this means increasing the rate of growth of public debt, except that particularly Keynesians often assume that the stimulus will cause sufficient economic growth to fill that gap partially or completely.

As this stimulus takes effect - the largest one being in the USA - it will result in more monies/incomes (given by the govt!!) in the hands of ordinary Americans. The belief is that this will increase spending by people and hence increase consumption.  

Currently  talks between European leaders aimed at securing a mammoth stimulus package (again!!) are continuing. The two main outstanding areas are finding a mechanism to ensure funding is used properly, and whether to make distributions contingent on adherence to democratic standards. 

While the European stimulus deal is close to being finalised in Washington meetings are on to formulate another package to counter the effects of the pandemic. 

Further an article in the medical journal Lancet published today (Read Here ) gave hopes of a Covid Vaccine being a possibility - perhaps earlier than expected. 

Markets are a forward discounting mechanism -they will rally or fall in anticipation.  Maybe markets are anticipating the global economy to turnaround sooner. Many economists however feel that it will take time for the global economy to rebound. 

If these economists are right - then the markets should correct.  That is the risk - which we watch out for and hence remain cautious. Can we do anything more? Quite frankly No. 

(Disclaimer : View expressed here are my own and in no manner are to be interpreted as soliciting business of any kind or any kind of investment advise.  I am an investor in equity markets and hence please be aware that my views can be biased.  Please make your independent analysis before investing in equity markets. Investing in equity markets is a with risk investing including risk to capital.)

Porters 5 forces model - Relevance for Investing in Stocks

According to Warren Buffet a successful company is one which is having a "MOAT" 

Companies that are performing well are constantly challenged by competitors but with a deep and wide "MOAT" these companies are able to sustain competition.

The state of competition in an industry is decided by five forces. 

These are 

1. Threat of entry,
2. Threat of substitution,
3. Bargaining power of suppliers,
4. Bargaining power of buyers; and 
5. Intensity of rivalry.

A successful company's strategy is aimed to best defend itself from such forces.  Deep dive into each of these forces is required to determine the competitive strength of a company.

A company which is able to score well on all these forces is able to consistently deliver good profits and growth.  It is able to handle these forces much better than competition. Hence its stock is able to provide consistent returns to its shareholders. 

With time the status of companies keeps changing with respect to these five forces and hence a careful study goes a long way in determining whether the stock is attractive or not. 

Porter's analysis framework defines the important criteria to determine the stability of a corporation. High threat levels typically signal that future profits may deteriorate and vice versa. 

For example, a hot firm in a growing industry might quickly become obsolete if barriers to entry are not present. Likewise, a company selling products for which there are numerous substitutes will not be able to exercise pricing power to improve its margins, and it may even lose market share to its competitors.

The qualitative measures introduced by Michael Porter in Porter's five-force framework allow investors to draw conclusions about a corporation that are not immediately apparent on the balance sheet but will have a material impact on future performance.

 Although quantitative factors such as the price/earnings and debt/equity ratio are often the primary concerns for investors, qualitative criteria play an equal role in uncovering stocks that will provide long-term value. 

DISCLAIMER :  THIS BLOG IS FOR INFORMATION AND NOT TO SOLICIT ANY BUSINESS. PAST PERFORMANCE IS NOT AN INDICATION OF THE PERFORMANCE OF STOCK IN FUTURE. EQUITY STOCK INVESTING IS A WITH RISK INVESTING INCLUDING RISK ON CAPITAL INVESTED. PLEASE TAKE AN INFORMED DECISION BEFORE INVESTING IN A EQUITY STOCK

Risks in Investing

All investments involve some degree of risk.

In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.  

In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.

Every saving and investment product has different risks and returns.

Differences include:

1. how readily investors can get their money when they need it, 
2. how fast their money will grow, and 
3. how safe their money will be. 

Number of risks which investors face 

1. Business Risk 
2. Volatility Risk
3. Inflation Risk 
4. Interest Rate Risk 
5. Liquidity Risk 

Business Risk : With a stock, you are purchasing a piece of ownership in a company.  With a bond, you are loaning money to a company.  Returns from both of these investments require that that the company stays in business. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds.  If there are assets, the company’s bondholders will be paid first, then holders of preferred stock.

Volatility Risk : Even when companies aren’t in danger of failing, their stock price may fluctuate up or down.  Large company stocks as a group, for example, have lost money on average about one out of every three years.  Market fluctuations can be unnerving to some investors.  A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events.

Inflation Risk : Inflation is a general upward movement of prices.  Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.  The principal concern for individuals investing in cash equivalents is that inflation will erode returns. 

Interest Rate Risk : Interest rate changes can affect a bond’s value.  If bonds are held to maturity the investor will receive the face value, plus interest.  If sold before maturity, the bond may be worth more or less than the face value.  Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones.  To sell an older bond with a lower interest rate, you might have to sell it at a discount.

Liquidity Risk : This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with the more complicated investment products.  It may also be the case with products that charge a penalty for early withdrawal or liquidation such as a certificate of deposit (CD).

Managing your investment risk

While you cannot avoid investment risk altogether, you can manage it and take steps to minimize your exposure. 

One of the best ways to manage your risk is to diversify your investments.  Both business and market risks can be mitigated to a certain extent by diversification -- not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holding periods (short- and long-term).

You can spread your international risk by diversifying your investments over several different countries or regions.

On top of that, you can manage your risk by doing your homework. Learn about the forces that can impact your investment. Stay abreast of global economic trends and developments.

If you are considering investing in a particular sector, read about the future of that industry. If you are considering investing in a particular country, be sure you understand the local market and political situation.

Finally, consider your options and your own risk tolerance.

Some investment products are more volatile and vulnerable to market risks than others. And some sectors and businesses face more business risks that others.