BEHAVIORAL FINANCE

Insight into Indian Stock Market Realities

“When others are greedy be fearful and when others are fearful be greedy” – Ill timed bouts of greed and fear among investors make stock markets volatile.

Rational & Successful investing is all about restraining ad channelizing these emotions and understanding behavioural finance. And not company behaviour , market sentiments and crowd behaviour.

In this complex environment ,BEHAVIORAL FINANCE comes as an antidote to investor anxiety and a guide to sane and safe investment decisions.

2 sources of returns from equity :

1. FUNDAMENTAL

2. SPECULATIVE

The fundamental element concerns the earnings behind the enterprise along with the dividend paid out during the holding period.

The speculative element concerns the changes in the appraisal of the current performance and prospective profitability by the market participants. In order to calculate speculate element , following formula may be applied

EPS at the end of the year x change in PE ratio ______________________________________

Price Paid

What is BEHAVIORAL FINANCE

Behavioral Finance is an emerging field that combines the understanding of behavioral and cognitive psychology and financial decision making processes.

This school of thought argues that markets are not efficient in short run and people do not make rational decisions to make profits. People are susceptible to numerous behavioural anomalies, which become counter productive to the wealth-maximization principle leading to irrational behaviour.

“Intelligence and Brilliance carries the day , but it is Wisdom that endures”

This wisdom is a product of various factors

1. Learning from mistakes and experiences.

2. Using common sense.

3. Wisdom from the literature of past successful investors like Benjamin Graham, Peter Lynch , Warren Buffet to name a few.

4. Ability to control one’s emotion and understand the emotion of others.

5. Discipline and ability to stay in the course in spite of all the temptations.

HEURISTICS are the short cuts that brain takes when processing information.

Some valuation heuristics are

1. PRICE/EARNING

2. PRICE/BOOK VALUE

3. PRICE/SALES

Though the best way to project a company is analysing its discounted cash flows and ratio analysis, it becomes all together important to consider other behavioural aspects in foray.

What an Investor demands ?

1. The dividend from the stock.2. The capital appreciation of the stock.

However , both these sources of returns are dependent on the price one pays when one acquires the stock. If one buys a stock in a bull market when prices are high , then one takes a hit on the dividend yield and capital appreciation would take much longer as the base price is higher.

It is very important that the acquisition price is lower for one to have a healthy stock return.

Hence , buying stocks without taking into consideration the value of stock and the price one is paying for that value is a sure way to take a hit on one’s long term returns.

What is Contrarian Investing ?

A contrarian investor can be defined as one who attempts to profit b betting against conventional wisdom but only when the consensual opinion appears to be wrong.

Difficulties in following Contrarian Investing

1. False Consensus Effect : It highlights a tendency common amongst us to overestimate the percentage of people we think would agree with us.

2. Group Thinking : All will think alike, even if they don’t agree with something and fear of reprimanded in the group they hide their true perspective.

3. Buyer’s Remorse : It is expressing remorse after committing our capital to anything , which triggers out self doubt or a remorse like feeling that I may have done something wrong.

4. Myopic Loss aversion : Mr. Warren Buffet says , “ If you cannot stand 50% paper loss on your stock , stay away from the markets.” People are more concerned when they experience losses as compared to the satisfaction the derive from a similar gain.

“Investing is most intelligent when it is most business like” – Benjamin Graham

The basic idea to invest in a business is to calculate , how much we are getting for our money’s worth as compared to other oppurtunities.

Following parameters would be very important for a company

1. Market Leadership2. Low Cost Producer3. Eye on Earnings/Share4. Level of Debt

Lessons for INVESTORS !!

1. Investors end up paying crazy valuations for stocks when they chase stocks in current hot sectors.

2. When a sector is hot , new companies taking advantage of the market conditions enter the market with IPOs to cash in on investor fancy.

3. Be wary of your favourite stock market TV show.

4. Rapid growth in a sector does not mean good investment returns for the investor.

5. Sector Bubbles are a warning to investors to reduce their allocation to the sector.

SUCESSFUL INVESTING IS ALL ABOUT BUYING WHAT OTHERS ARE SELLING AND SELLING WHAT OTHERS ARE BUYING