Mapping the Markets: Rationality & Emotions!!
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....
Comments
Navdeep,
1. Of course, fundamentals dont change overnight. I mean, if so, how would you explain the mass of people relying on technical analysis?
2. A person buys a stock for a price. And there is another who is willing to sell at that price. So, perception, holding period, risk tolerance, cost of funds and carry, all play a role. If not there would be no trades at all. You have just looked at sentiments which is only partially correct. I may have good faith in a stock, but yet lack the means or appetite to bet on the same.
3. I believe you may need to look at EMH - There may be systemic and non-systemic events which have an impact
4. A rational everyday investor only has a loss tolerance threshold; he doesnt really guage a 'Risk profile'. Risk profiling would be relevant only for WM and here herding doesnt apply
5. Diversification isnt really mis-used. Rather they dont diversify
Most of what has been described is from a retail investor pt of view; the linkage to WM at the end is ambiguous
Posted by: Anish malhotra | January 28, 2011 8:57 AM
Yes, the way in which wealth mangers are selling in the merging markets story, seems to be in sync....but whats more interseting are the implications this would have on client relationships and costs.
Posted by: Christina | January 28, 2011 2:56 PM
Are you implying that the adviser engages in herding and hence deviates from the risk profile and the targeted portfolio composition for his client? First, advisers dont engage in such activities or else they wouldnt be in business of professional advisory. Second, the client would be clearly aware thru various reporting mechanisms of what the adviser is doing hence such activity is kept in check. I do not agree with your views here
Posted by: Hendry | January 30, 2011 3:03 PM
Most of what has been recapitulated here are concepts that have been around for years; some of them have branched out as research areas in behavoiural finance. So, isnt it a bit rich for you say I think, in this case?
Posted by: Gillon | January 30, 2011 3:33 PM
From the retail propective what you are saying makes sense to me, but to bring this into the institutional setup is what would be challenging for the advisors to do in terms of feasibility and cost.
Posted by: Baldev | January 31, 2011 7:49 AM
Not all people in the market are there to behave on the fundamentals and not all the people will make money simply becuase there would always be another side of the trade.
The success is function of the economic growh when entire market is going up otherwise it's always normal curve for success versus failure.
And we should not forget that stock markets are just indicator of economic performace and they do not add any value to country GDP/production.
Posted by: Nikhil | February 3, 2011 1:48 PM
I am not sure of success or failure but would like to understand the impact of these new products on the customers and the kind of customization Wealth managers do there to ensure product penetration and growth.
@Nilkhil not sure if we are talking about economic growth here.
Posted by: Martina | February 4, 2011 3:31 PM
@Nikhil, the discussion point here is not stock market adding value to an economy. Also it needs to be understood that behavioral finance is just a point of view to understand and interpret the market irrationality\patterns.
Posted by: Nestor | February 8, 2011 2:28 PM
@Nikhil: stock prices are a reflection of business performances which inturn contributes to an economy's GDP; therefore neglecting stock market's role towards GDP contribution may not be the right conclusion.
I agree that Indian stock market is to a great extent driven by emotions and the concept of EMH fades in Indian context. In a much more matured financial system, fundamentals definitely don't change overnight.
Posted by: Mayank Gupta | April 29, 2011 5:50 AM