FINspeak

Sometimes I wonder, can the dynamics of the Investment market be deemed as rational? Or do rational investments guarantee success??? We see it everyday, with a slight hint of negativity in the air we see markets going down by as much as 10-15% in a day and with a little positive news the money comes back to the markets!!! I find it hard to believe that the market fundamentals have changed in 24 hours!!

For me a lot of this to the 'sentiments' of the market which are very often driven by pure emotions of the investors. Behavioral finance seeks to answer this irrationality of the financial markets by highlighting how humans behave in given situations. In the words of The New York Times, 'It is brand of economics that tries to explain the market in terms of the way humans behave - both rationally and not."

It's not uncommon to find an investor buying a stock about which he/she knows nothing or little; but is simply buying it as everybody else in the market is!! This behavior is also known as the Herding Behavior, where people tend to follow what others are doing, thinking it is the best thing to do. This in turn leads to a portfolio composition which is not really in sync with the risk profile of the investor and thus creates a mismatch in the future. Like buying a high priced stock as everybody else is, but not really having the 'Liquidity' to hold it in case of a market correction. It is important here to know, what you buy and how much to buy, given that most retail investors have to also pay taxes, rents and bank installments every month!!

Also often investors map a certain price of the stock based on there purchasing cost or the peak price of the stock. They tend to 'Hold On' to the stock till the time that price is reached.  This often leads to bigger losses in the future when the asset price declines further. This behavior is known as Loss Aversion.

Another common mistake which investors make is 'listening only what they want to listen' and closing out all other information, also known as 'Selective Perception'. Recently when the markets were on all time highs most experts were warning of a correction coming soon, to which many investors did not pay heed and suffered huge losses during the long period of correction which followed!

'Diversification' is another term which is often misused. People tend to buy too many stocks in its name but what they don't realize is that sometimes these stocks have high correlation. Thus adding only Bulk and not value to the portfolio!!!

Behavioral finance has been around from the 1970's, but it is only now that Wealth managers are looking at it to expand business and to reach out to clients. The latest buzz in the market is Wealth Managers combining the Behavioral finance principals with the financial market ones to market products and understand there customers better. They try and sell the 'Concept' to the investor rather than a product or stock, underlying the data & reasoning with the behavioral profile of the customer.

But the question is still open does rationality guarantee success? Or Irrationality for sure leads to loss? Let me know what your views are....

Posted by Navdeep Gill at 3:55 AM | Permalink | Comments (9) | TrackBacks (0)

What would you do if you had a time machine to travel back in the past?  Show Da Vinci an iPhone? Invest in the start-up Google? Hang out with yourself chatting about your life in the future? Accelerate singularity by teaching science to cave men? Well, the list is endless...

But, if BCBS had travelled back in time with Basel III, what would have become of the financial ecosystem that surrounds us? Would the crisis have been averted? An assessment of what was lacking in Basel II and hence a wish-list in its newer successor would explicate this.

As we know, reliance on credit ratings to determine the purportedly low Basel II capital, through RWA led to the 'manufacture' of AAA-rated CDOs backed by lousy sub-prime mortgages, which fuelled the crisis. In Basel III, while specific problem areas in risk weighting (addressed through increase in risk weight for super-senior tranches of (re)securitization products; elimination of regulatory arbitrage between banking and trading book, by treating securitization exposures on the latter on par with the former; and strengthening requirements on OTC derivatives and repos through capital for MTM losses, rather Credit Valuation Adjustments) and quantum & quality of capital (addressed through higher tangible common equity, capital conservation and counter cyclical buffers) have been dealt with, the larger issue pertains to the concept of risk weighting itself. This approach still urges the banks to "find" apparently risk-free assets which can be leveraged much higher than their riskier counterparts - We may be witness to some whacky financial engineering, yet again!

While zero risk weight assumption for AAA and AA-rated sovereigns (which caused the Sovereign debt crisis), has been acknowledged as faulty, yet, it has been let be. Well, the governments which put Basel III together needed some incentive, didn't they? - Cheap borrowing!

While oligopoly of rating agencies and the Gaussian Copula-powered symbiotic growth of CDS' and CDOs played their part in harmonised synchronicity, the use of internal rating models finished things off. The dumbed down simplification of VaR garnered attention in expressing and interpreting individual and firm-wide risk as a single figure for any asset class, its limitations were however forgotten. The assumption that the bank was in the best position to measure its own risk, when coupled with VaR's "normal", no-extremities market, failed to pay-off. Risk-based compensation in this case proved counter-productive, further encouraging managers to paint a low-risk picture.

The back-stop non-risk based measure viz. leverage ratio is a step in the right direction, albeit low. If the past is any indication, Lehman was levered 31-1, whereas the current Basel III rules peg the requirement at 33-1. Ultimately, this treads on a fine line - What cost of economic growth is a fair price for curbing risk?

Lehman's folding was a result of liquidity problems from unwinding of huge derivative positions. The 30-day stressed Liquidity Coverage Ratio; encouragement of medium to long term funding through Net Stable Funding Ratio; and the variety of monitoring tools do well here. However, there are arguments implicating that the LCRs bias toward government bonds could hamper credit to small businesses, which is also interesting given that they are the ones who do not have access to capital markets, and hence turn to banks for fundraising, where their 'unrated' status again tend to extend the 'halo effect'.

Let's assume BIS travels into the future with Basel III, would it have avoided a recurrence? There's no telling Black Swans, much like Miles Dyson did not know his neural-net processor would create Skynet and bring upon the Judgement Day - no one ever sees it happening, that's why it does! That really explains the two Basel accords prior and the ones after...hopefully not!

All said, Basel III is one of swiftest and smoothest regulations in modern history.

Posted by Vikram Srinivasan at 4:09 AM | Permalink | Comments (5) | TrackBacks (0)