23 April, 2009

Investor's psychology

Many of the Investors have a love-hate relationship with the stock market. Currently, they are hating it. Investors need to appreciate the common mistake many of them are prone to, avoid them and embrace good habits & thought patterns which will allow them to enjoy life, instead of being a prisoner to nagging fears about their future.
Going with the crowd - Investors typically do not want to be the lone tiger. They instead want to belong – want to be a part of the crowd which moves as a pack. Following the herd has problems, though. Many times, the crowd moves in a direction that may not be right. Also, it can never be that one type of investment behavior is going to be good for all – obviously, many of them are doing it as the next man is doing it. When following the crowd, one also gets into a false sense of security - since everyone is doing the same thing, it cannot be wrong – the majority can’t be wrong. Indeed the majority can be wrong.
Lack of moderation – Alan Greenspan calls it “irrational exuberance” to describe people getting carried away and pushing the markets upwards, inspite of no compelling reason to do it. This takes the stock prices over the moon. But the optimism in investors heart still continues to rage. They invest all they could and even take loans to invest. Lot of them are licking their wounds today. And they have swung to the other end of the emotions spectrum – “enveloping gloom”.
Retracting into a shell - When the markets have deeply corrected, the equity & MFs get back into “good value” zone. So, are the investors celebrating? Not a chance. They are infact scared that it may fall further. But there was a chance of fall even at 20000 points ( of Sensex ). Yeah-right. If anything, the chances of falling after a dizzying climb is much more than at 10000 sensex. But somehow, investing at the height of the bullrun looked different. The gut-wrenching correction has scared the wits out of them. No one is talking of this opportunity to invest, now that it is low. On the contrary, there are any number of theories as to why the markets will go down further. So, many have got scared and have pulled out at a loss – out of sheer paranoia. Moderating their Investment when they should not invest and not investing when they should, is a common enough problem with investors.
Watching from the sidelines – Investors who have been scalded by the meltdown would typically wait and watch, even though they may realize, at an intuitive level , that the valuations are attractive. This is the fear factor at play. There would be many around the investor who will dissuade him/her to move ahead and invest. After a point, they would even forget to follow the markets. The markets in the meanwhile will mend, overtime. And like a roller coaster on the upcurve, people will hear the rumbling later again and notice the beast on adrenaline. And they would enter - again. This has been happening over and over again and again in cycles, over time. Some are eternal fence sitters and will keep wondering whether it is the right time to invest - in all markets.
Going after the flavor-of-the-season – Another typical investor trait is to go after the latest fad – be it Gold, Midcaps, Goat farming, teak plantation... Again the investors find solace in the collective wisdom of those around them. That’s why you will suddenly find a pyramidal marketing scheme, all the rage. Decision is easy if it just has to be a ditto of what their neighbor or friend has done. But that does not mean that the decisions are right or even suitable to the investor. Most investors do not spend the time to study and understand the investments that they are getting into, which is vital.
Investments for investment sake – Many investors just invest without any thought of where the money is being put. Sometimes it is in insurance, at others in chitfunds, bonds, some IPOs etc. Sometimes, they invest in pension funds and at other times in a child policy. Random investments like this becomes unwieldy, undesirable and may not give the investor the returns that they need to meet their goals, may have more risks than the investor had bargained for and may not meet the liquidity requirements.
Going after favourites - Some investor play favourites. They know certain asset classes and are convinced about them. These investors will only invest in them. For instance, there are many I have come across who are sold on real estate. These investors will only invest in real estate to the exclusion of all others. That leaves their portfolio concentrated and vulnerable.
Lack of diversification – A concentrated portfolio is vulnerable to shocks due to the huge exposure to specific asset classes. This kind of a portfolio can make or break a person. Though some may be lucky, even with a concentrated portfolio, it is a better idea not to push ones luck too much and instead have a well-balance portfolio. The huge risks involved in a concentrated portfolio, is not fully appreciated by many investors.
Asset allocation – Risk, return & effect of tax and inflation is not commonly factored in while investing. Proper allocation of assets decreases risks, increases portfolio return, makes it more suitable to the investor concerned in terms of liquidity, tenure, timing of payments, ease of operation etc. A proper asset allocation and rebalancing them from time to time, brings in the discipline and ensures that the investor does not go overboard, due to their personal prejudices.
Post tax returns – Most talk about just the gross returns as if it is their effective return. So much money would probably not flow into fixed deposits and other small savings investments, if the effect of tax is understood and factored.
Risk factoring – Stock markets are always risky – but the risk in the system varies at various points. For instance, the risk of the markets doing a dive is comparatively lower now, as it is gyrating around 10000+ sensex levels. At higher levels, risks were higher. Yet investors were happy to invest when the index was near it’s zenith , than now. Also, risks have to be taken in relation to one’s age, situation in life, time horizon, proportion of assets that will be exposed etc.
I hear from people that they are scared because they do not know, what to expect. True. The most important dampener at this point is the uncertainty enveloping the environment. The economic outlook, the extent of any further economic shocks, job scenario, market performance - are all uncertain right now. But then, the investor needs to follow the basic principles even more diligently than ever, in this market, to survive and emerge stronger. Most importantly, one should avoid the pitfalls.

Published in Business Standard on 19/4/2009

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