– November 30, 2017
According to classical economics theory, people are rational “wealth maximizers”. However there have been many instances where emotions & psychology have influenced decision making causing us to behave in an irrational manner. Behavioural finance, a relatively new field, seeks to combine behavioural and cognitive psychological theory with conventional economics and finance to get an insight into why people make irrational financial decisions.
Heuristics are mental shortcuts derived from previous experiences that are often used for decision making. Heuristics can work well or turn into harmful biases. Let me cite some examples that we have faced during investing –
- The heuristic that “If it ain’t broke, don’t fix it”. So if NBFCs have worked as an investment idea, one continues to invest in stocks of NBFCs as it has worked in the past. So there is a bias against anything new. Many excesses in the market place take place because of this.
- The heuristic that a high P/E ratios means that we are in for a big market decline. If you are only looking for supporting evidence then you will find that most market declines have come at elevated P/E ratios. However market declines have also come when P/E ratios are average.
- In the last three years the “buy on dip” heuristic has worked. However this could easily turn into a harmful bias as we saw in the year 2008 when investors bought the dip from January 2008 upto August 2008 and were then faced with a vertical market decline in October 2008. The opposite of this starts playing out when investors totally shun buying when in fact, you have the opportunity buy near market bottoms.
- The heuristic that “this pattern looks like a trend”. We are tempted to equate a given time in the market with one of the previous years that we have experienced. How often we hear people saying that this looks like the March of 2003 or the December of 2007, or the March of 2009 or August of 2013. The bias is about outguessing randomness i.e. seeing patterns where none exists.
- The “Optimism” heuristic, where everyone is gung ho about a particular project or a particular theme. In the year 2007, the prevalent theme was infrastructure and realty. The market capitalization of a particular real estate/infrastructure company was more than the market capitalization of all companies in the pharmaceutical sector. We know what happened thereafter. The bias is chasing the dream while ignoring the risks.
- The “Pessimism” heuristic, where the world looks like going down the black-hole. During the early months of the year 2009 when the effects of the Lehman Brothers crisis (The Great Financial Crisis or GFC as they call it now) where percolating through, people were very pessimistic. We again know what happened in the coming few months. The bias is missing out on opportunities when there could be light at the end of the tunnel.
By guarding against these tendencies, we can improve the chances that our heuristics, which are often useful, will yield good judgements.
—- Parag Telang