This is why investors behave irrationally

Aug 27, 2013

In this issue:
» Infosys' corporate governance questioned again
» Relation between crude oil and global stock markets
» Why food security bill is just plain bad economics?
» What PSU banks should do to bolster their commission income?
» ...and more!

Unwillingness to book a loss is a typical phenomenon present in every investor. If our investments go down we continue holding on to them in the faith that they will recover. In other words, the willingness to book loss is absent. We try to look out for reasons that justify holding onto the stock and overlook fundamentals.

However, after a prolonged time when the investment does not recover and stock decays, we regret. The sense of regret comes from not selling earlier. Many investors face the same situation multiple times. Yet they are not equipped to deal with it completely.

But what stops them from exiting earlier and accepting a mistake? It is their emotional mindset we believe. Most investors have displayed emotional incapacity to deal with such situations. They are unable to digest the fear of booking losses and thereby regretting a failed investment. However, what they forget is that a further fall in stock price will eventually turn regret into disappointment. And when this happens, it results in distress sales.

Again it should be noted that distress sale is also an outcome of emotional incompetence. Earlier there was an unwillingness to sell the stock. Now there is willingness to exit something at throw away prices.

In this entire emotional cycle, a typical investor buys high and sells low! This is exactly opposite of what needs to be done. This trap is called endowment effect in behavioural finance. Basically it is a practice of attaching more value to what you own than what you do not.

Unwillingness to sell when fundamentals deteriorate and the price starts falling reflects endowment effect. You sense that the current price quoted in the market is way too low than what it should fetch. Hence, you continue to hold. But once the price falls further, the endowment effect diminishes. And this results in distress sale to avoid regret.

However, why investors fall prey to such traps?

Not paying heed to fundamentals is one reason. Investors must remember that stock price reflects current sentiments. But it is earnings that drive stock prices. Further, valuations provide important signal to buy and sell. Ignoring these parameters while investing is akin to playing darts when one is blindfolded. Results could be disastrous.

In short, investors should do well if they overcome their emotional side and focus on fundamentals and valuations while investing. This will ensure that margin of error is low and success is high.

Do you find difficulty in exiting loss making stocks? Please share your comments or post them on our Facebook page / Google+ page

---------------------------- Lifetime Access to 4 of our top services... (It's now or never) ----------------------------

The registrations to our Equitymaster's Wealth Alliance lifetime membership will close at midnight today.

As you know, through Equitymaster's Wealth Alliance, you get lifetime access to 4 of our best research services, a lifetime Portfolio Tracker account, a free copy of the Equitymaster Stock Market Yearbook every year, free access to Equitymaster Webinars with renowned investing experts...

And a lot more!

However, we don't open registrations to this membership often. And the current round of registrations are closing at midnight today!

So if you'd like to give our highest level membership a try, act now! Click here for full details...

I promise that if you sign up and don't like it, we'll refund your FULL payment without any questions.

 Chart of the day
Rising current account deficit (CAD) has an effect on a nation's forex reserves. CAD arises when imports are more than exports. And when this happens, any country's forex reserves get drained as you need to make payments for imports while slowing exports means that forex earnings do not grow at a sufficient pace. As such, forex reserves start getting depleted. Today's chart shows India's forex position over the last 4 quarters. While the forex reserves increased marginally in December 2012 quarter compared to the previous quarter they have been declining sequentially over the last three quarters.

In fact, the latest figure stands at just US$278.8 bn which is considerably lower than what prevailed in the past. And there are quite a few reasons behind it. For one, rising gold imports has worsened CAD and thus forex position. However, steps taken by the government to curb imports are likely to yield some results. Slowing exports is another reason for worsening forex position. However, with growth in Euro Zone and US showing signs of improvement exports should gather momentum. Weak rupee is further likely to help the matters. Thus, if the CAD situation improves, forex position is likely to show a much better picture in future.

Data source: RBI

Indian policymakers just made a very big blunder. A blunder that is likely to derail India's finances like never before. The Lok Sabha has cleared the Food Security Bill. What explanation did Sonia Gandhi offer for her ambitious program? As per Hindustan Times, she seems to have said, "There are people who ask whether we have the means to implement this scheme. I would like to say that we have to figure out the means. The question is not whether we can do it or not. We have to do it. "

Only Mrs Gandhi can get away with such unreasonable explanations. It just goes on to show that politics, as always, triumphs over the economic well-being of the nation. As per the latest proposed law, up to 75% of the rural and up to 50% of the urban population would be the beneficiaries of the highly subsidized food. That's roughly two-third of India's 1.2-billion population!

How much will the food security programme cost? Government estimates put the number at about Rs 1.25 trillion per year. But many believe these estimates are too optimistic. The Commission for Agricultural Costs and Prices (CACP) of the Ministry of Agriculture has pegged the expense at Rs 2.41 trillion for the first year and Rs 6.82 trillion for the first three years together.

How will the government pay for this? The government receipts for the fiscal year 2013-2014 are projected at about Rs 11.23 trillion. This means that the food security program will account for about 10 to 20% of government receipts. But this could even go up further. In the current fiscal so far, tax and non-tax revenue collections have been dismal. So if government receipts are lower than projected, the fiscal deficit could go for a toss.

The government would then be forced to heavy borrowing or money printing. Both are not great options. The Indian economy is already struggling. The rupee is touching new lows. All in all, we believe that the Food Security Bill is going to be disastrous for the Indian economy.

Nepotism. The word is associated with the practice of favouring personal family members in business or politics. On one hand, some consider this an unethical practice as it could lead to unprofessional and/or under qualified personnel running a company. But on the other hand, some argue that there is nothing bad in it as it creates a natural line of succession. The point could be debated ad-infinitum. Nevertheless, when a company that has prided itself for its corporate governance shows signs of nepotism, it does raise questions. The company we are referring to is none other than Infosys Ltd.

Questions on nepotism were first raised when the erstwhile founder Mr Narayana Murthy was re-appointed earlier this year. At that time, Mr Murthy's return was accompanied by the hiring of his son, Rohan Murthy, as his executive assistant. Also, then the senior Mr Murthy had said that this appointment is only temporary and that his son would not be looking at any leadership role in the company. However, just a few months down the line, things seem to have changed. Rohan Murthy has been appointed as a Vice President in the company. The company has stated that this is subject to the approval from the ministry of corporate affairs. The point is that it does reflect that Rohan Murthy could be taking on a leadership role in Infosys without having proved his mettle for the same. This has raised questions with regards to Infosys' corporate governance standards which were considered to be a benchmark in the corporate world. The question now is will Murthy Senior stick to his own principles and reinstate investor belief in the ethics of his company? Or will he stick to promoting his son and compromise on ethics?

What's the biggest concern facing global stock markets? It's the whole idea of the Federal Reserve tapering its bond buying program, isn't it? Wrong. If moneynews is to be believed, the risks arising from tapering are well and truly appreciated by the market and thus, have already been accounted for. What can derail the markets therefore is not tapering but a commodity that answers to the name of crude oil.

As per the article, the West Texas Intermediate Crude oil is currently perched above the psychologically crucial level of US$ 100 per barrel. And once it crosses the US$ 115 per barrel mark, it really starts exerting negative influence on the economy and the stock markets. Thus, just as it happened in 2007 and 2011, uncontrollably high crude oil prices could once again lead to a stock market meltdown.

When exactly this would happen is anybody's guess. Besides, looking into historical trends and extrapolating them is not exactly foolproof. Simply because historical price movements have a certain economic context to them that may not be the same this time around. All in all, it is extremely difficult to predict where crude oil prices could be few months from now. Thus, investors would be well advised to focus on things within their circle of competence and not stray too far outside.

Just yesterday we wrote to you about how RBI's deputy governor KC Chakrabarty has criticized the poor performance of PSU bank chiefs. But the disappointment with regard to the PSU performance is not just in terms of asset quality. Even on several other metrics, the PSUs pale against their private sector counterparts. Their size and scale are considered the biggest strengths of PSU banking majors. Take the case of State Bank of India (SBI). It is not without reason the country's largest bank is called a behemoth. Its balance sheet size may be a fraction of the biggest bank in China. But its network of over 15,000 branches is double the franchise of the top 3 private sector banks in the country put together. Yet, the bank cannot monetize its reach enough.

While SBI does have a very healthy CASA base, the same is not sufficient to make each and every branch profitable. Especially, during periods of low credit disbursal. Hence it is important for banks with large network to enhance commission income as well. However, not just SBI's, but the fee and commission income of all PSU banks is India are paltry compared to private sector peers. As per Business Standard, PSU banks earn just a tenth of the private sector's commission for mutual fund sales. While it is not necessary for every bank to have a sizeable treasury portfolio, focus on commission income cannot be sidelined. And the same need not be just through sale of mutual funds and third party financial products. But these banks that have the mandate of financial inclusion must make an attempt to educate depositors and investors about financial products.

In the meanwhile Indian stock markets have extended their losses and are trading at day's low. At the time of writing, the benchmark BSE-Sensex was down by 444 points (2.39%). All the stock indices apart from IT were trading in the red. Banking and Capital Goods stocks were the biggest losers. Most of the Asian stock markets were trading lower led by Japan and Hong Kong. The European markets opened on a negative note.

 Today's investing mantra
Individuals who cannot master their emotions are ill-suited to profit from the investment process- Benjamin Graham

Today's Premium Edition.

Recent Articles

All Good Things Come to an End... April 8, 2020
Why your favourite e-letter won't reach you every week day.
A Safe Stock to Lockdown Now April 2, 2020
The market crashc has made strong, established brands attractive. Here's a stock to make the most of this opportunity...
One Stock that is All Charged Up for the Post Coronavirus Rebound April 1, 2020
A stock with strong moat is currently trading near 5-year lows.
Sorry Warren Buffett, I'm Following This Man Instead of You in 2020 March 30, 2020
This man warned of an impending market correction while everyone else was celebrating the renewed optimism in early 2020...

Equitymaster requests your view! Post a comment on "This is why investors behave irrationally". Click here!

7 Responses to "This is why investors behave irrationally"

Vijaya kumar.K

Sep 12, 2013

sir kindly do not send the 5 minute wrapup to my e-mail. please stop & unsubscribe me from the services of 5 minute wrapup



Aug 28, 2013

Agree but no one should apply simple mathematics with their investment & emotions(especially confidence) may also benefit you. Markets are speculative and business / economic cycles are repeated time is an important factor. Investor should understand greed of brokers and current technologies(IT).


N.M.Rajugopal Shreeedhar

Aug 28, 2013

I think the decision to exit loss-making stocks is always a tricky one-- should the stock bounce back, you would be cursing yourself not only for selling but also for not buying more at the lows. The problem seems to be because the markets don't always reflect the fundamentals--when the stock starts the downward slide, many analysts see and recommend a "buy", by the time that changes to a 'sell" the stock has already sunk--in fact, it maybe a good "buy" for someone entering afresh.As an investor, if the stock is fundamentally sound, all you can do is watch closely for any unfavourable news --be it about the management, or a regulatory authority raid, or any product reject/recall -- and sell the moment such news emerges. Of course this is easier said than done.regds

Like (1)

CA R N Patel

Aug 27, 2013

You are absolutely correct about food security bill.
Mrs Sonia Gandhi has given unreasonable explanations to the house about means to meet the exps of food security bill in the presence of Hon. Prime minister Manmohan Singh, an experience economist and head of the country, who has chosen silence. Why ?

Opposition and regional parties have proposed very good suggestions and amendments to the bill. Surprisingly, almost all the suggestions have been thrown away though there were very good suggestions. Why ?

Even after bill is passed with the consent of opposition. Why ?

A famous quote :

"You can fool all the people for some time. You can fool some of the people for all time. But you can not fool all the people all the time."

It appears that quote will have to be changed : (Last Sentence)

"But Indian politicians can fool all the people all the time."

Also refer ever changing statements of Coal Minister Mr. Jayswal and Defense Minister Mr. Antony.

Like (1)

Sudhir Neroy

Aug 27, 2013

It is really a good analysis. One should always put a stop loss while trading in volatile scipts.

Like (1)


Aug 27, 2013

Well narrated article. Every investor/trader should read this and emulate in their trading.

Like (1)


Aug 27, 2013

You have preached Buy& Hold strategy all along and it became Buy & Bust. Now U r preaching about sell side for a loss. U should have alerted readers when the valuations reached high and unsustainable or when the fundamentals started deteriorating. U have given an article about why we stopped buying but not a single article on why we should not sell. Then people would have clapped U.

Like (1)
Equitymaster requests your view! Post a comment on "This is why investors behave irrationally". Click here!