When the Sensex peaked the popular belief was that the market would go further up and investors queued up for a slice of the action. Now, with the index much lower and valuations close to the equivalent Sensex level of less than 5 digits, investors have lost interest altogether.
It is important to break free of this herd mentality a prudent investor is one who can rein in his emotions and resist popular market sentiment. While nobody can predict the bottom of the market, serious money can be made only if one buys cheap when the market is in distress. But the sea of negative market sentiment often drowns out individual investor perception and induces an aversion to equity.
By far, the best approach for an investor is to rely on his/her own judgment, common sense and due diligence (mining company information from business papers and magazines) to invest in the market. In theory, markets are efficient, but in practice, they never move efficiently.
For instance, the announcement of a bonus issue or share split often boosts the share price, though it has no impact on the company’s balance sheet. Alternately, if a company announces a buy-back or any major capital expenditure plan, it is sufficient to move the stock price because investors flock to the counter, without looking into the prospects, returns or factors prompting the announcement. Thus, due diligence by an investor is essential and must precede any investment decision.
It is reasonable to accept that most of us are not blessed with the intellectual competence or access to resources of the various market players (fund managers and analysts). Hence, it’s best to simply follow a long-term investment policy and stick to it in effect, ignore the emotional lure to make a quick buck. This is a very straightforward approach and may seem unappealing, but it works in the long run.
Traders may make windfall profits, but in the long run, their gains are similar to those made by long-term investors. This is because, a large amount of their profits are paid out to brokerage firms as commission. Further, a trader takes an enormous amount of risk to earn his profits and thereafter, must pay short-term capital gains tax. In contrast, long-term investments do not attract any tax and the right stock selection can yield similar or even higher returns at a much lower risk.
While a well-defined stock buying approach is crucial, it is equally important to know when to let go. The cost paid for a stock should never be the basis on which a decision to sell the stock is taken; but in reality, cost becomes the most important variable. Investors tend to hang on to their losing stocks because they do not want to feel the pain of cost-loss discrepancy.
Aversion to losses is more pronounced than costs. For example, a manager who underperforms his benchmark in a sharply rising market is less likely to be fired, than a manager who underperforms by the same margin in a falling market.
Superiors view underperformance in a rising market as a cost, whereas they view underperformance in a falling market as a loss. In the actual sense, both are the same, but the perception varies.
Lastly, it is important to note that investors often ignore the role of chance, and are under an illusion of control by exaggerating both their own skill and the importance of that skill. This concept is called positive testing, which effectively means that people believe the methods they employed to achieve any positive results are inherently sound. The problem is that they then reject alternate methods that may also work well, if not better.
To conclude, one must remember a few points on human behavior when making investments. First, both individual and institutional investors are susceptible to a herd mentality, a tendency that is at the root of many bubbles and crashes.
People tend to put emotional weight on the price they have paid for the stock, relative to its current position. The pain of a rupee lost is generally much greater than the pleasure of a rupee gained. People tend to be more optimistic when the market goes up and more pessimistic when it goes down. Lastly, overconfident investors tend to trade too much and under perform the market.