Tune emotions for a fair analysis

Tune emotions for a fair analysis
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Highlights

It’s to be noted that it’s not what the actual risk that causes the damage but is largely dependent upon how we respond to the expectation of this risk. The domino effect of people’s assumption of any bad news to turn worse and extrapolating it to a scenario of doom results to steeper falls

Would access to better data and analysis be sufficient to achieve higher performance in stock market investing? For instance, one may have all the data and analysis, but the result of an investment is always dependent upon the decision one makes or made. This is because, despite having full information about a particular stock and its prospects, one may still hold the decision to invest or divest which is to do more with emotions than analysis. With the advent of technology, the flow of information is quick and reachable while most of analytical tools are accessible to general public, mastering the control of emotions however is tough if not impossible.

Daniel Kahneman was once asked how we should respond when we make an analysis mistake. He said, "Whenever we are surprised by something, even if we admit that we made a mistake, we say, 'Oh I will never make that mistake again.' But, in fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That's the correct lesson to learn from surprises: that the world is surprising."

The other prominently misunderstood concept is in assessing the risk of an investment or a portfolio. As Carl Richards said, "Risk is what's left over when you think you have thought of everything else." Whenever we consider planning an extreme scenario, we try to create a model that would withstand our greatest or least possible anticipation. But, as the events unfold most of the times, we are caught unaware of. Imagining an extreme risk is a function of imagination and to device how a particular risk would impact the investment is a detailed work.

Most risk profile questionnaires wouldn't be able to bring out the actual risk tolerance of an investor because, the questions turn hypothetical. But, when put with context, say, if the same questions are posed on how would an investment risk reduce their retirement corpus by so much quantum or if they have to postpone their retirement by a few years, then would the respondents understand the gravity of the risk they're taking.

It's to be noted that it's not what the actual risk that causes the damage but is largely dependent upon how we respond to the expectation of this risk. If we were to consider the various painful events of the past, it's not the actual risk that wrecked the havoc but it's the assumption of events that would unravel in case of the risk happening. This was plainly at display at any of the selling cycles in the stock market. The domino effect of people's assumption of any bad news to turn worse and extrapolating it to a scenario of doom results to steeper falls.

For instance, during the recent turmoil of Non-Banking Financial Institutions (NBFC) crisis, the default of IL&FS has triggered a series of events which hurt the liquidity further in the system escalating the whole situation. This panic induced liquidity crunch among all the participants of this sector triggering more defaults. Investors panicked leading to price erosion across the sector irrespective of the fundamentals of specific companies. That's the expectation of risk at play.

And the opposite is true in the case of speciality chemicals, couple of years ago, when the optimism soared high and despite the higher valuations, investors kept on pumping more money into these stocks. The news of China shutting some of these shops to reduce pollution has elevated the expectations of business migrating to Indian companies, etc. The valuations went sky roof and stocks of companies with lesser fundamentals also participated in the rally. This shows how the optimism and pessimism (in the NBFC's case) are extrapolated at higher levels and look irrational in the hindsight. Observe that it doesn't mean that some investors are irrational but in the eyes of those people with different goals and expectation things seem irrational. This mismatch actually creates an opportunity for investors to act - be it to divest or invest depending upon their motivations.

Though, when backed by relevant data the conviction over a particular bet only further increases for an investor. But, to come to terms with the behavioural side of investing i.e. biases, fear, greed, intuition, etc. can't be taught on the lines of analytics and that's where most of the investing experience differs for individuals even for the same investment. The only possible way out is by observing, identifying, acknowledging these characteristics and make use for our own advantage.

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