As you can see in the slide, when the economy is doing well, the stock market also does well and vice versa. If you want to judge the strength or weakness of any economy the long-term chart of the country stocks market will give an accurate picture. Please note, I said the long-term chart. In the short-term, the stock market does not reflect the economic health or lack thereof of any country or economy. What happens over the short-term? Why do the stock market and the economy diverge over the short-term? On any given day the Nifty 50 can rise of fall by a couple of hundred points. With the benchmark index now trading clearly above 11000, 100 points on the Nifty 50 is not even 1 per cent. We all know that nowadays, the Volatility exceeds one per cent of the index in terms of the number of points taken on a cumulative basis, i.e. up moves and down moves in the benchmark.

Every move in Stock Market makes it to the headlines, and unless a concerted attempt is made, it is almost impossible to ignore the news cycle. What does one make of the news? How correlated is the Indian Stock Market to the Indian Economy? How closely and accurately do the benchmark indices track the economic development (or the lack thereof) of our country?

Some of us like to think or are convinced that the Stock Market is the most accurate barometer of the country’s health. In reality, it is a half-truth. In other words, it’s not always true. As a result, one cannot take investment decisions based on the gyrations of the Stock Market. I like to use the analogy of a man or a woman taking their dog for a walk as one that explains the relationship between the Stock Market and the economy.

• When you see a man or a woman walking a dog in the park, what do you see? You see that the man or the woman is taking typical steps and generally walking in a straight line. Please note that the man/woman and the dog are walking in the same direction.
• What is the dog doing? The dog is straining on the leash, barking at butterflies, chasing birds, sniffing, peeing, digging; the dog is generally all over the place and not moving in a straight line for any length of time.
• The dog is the stock market, and the man or woman is the economy. The stock market and the economy are connected just like the woman and the dog – but they do not act the same even if they are walking in the same direction. Both the humans and the dog are walking in the same direction, but the deviations in their paths differ materially. Over the long-term, they both end up at the same place.
• In practically every calendar year you’ll find a divergence between the growth rate in the GDP of our country and the growth rate in the stock market.
• The dog cannot control its emotions, and if we can control ours, it gives us a Behavioral Edge.
• The question is why does the stock market behave like the dog? And the answer is – human behaviour. (I should hasten to add that over the long-term, the stock market does reflect the economic development of any country).The most important take away from all of the above is that even if one were to be privy to inside information about what the economy is going to next year, you would not be able to predict the direction of the market or to profiteer from it.
• What about the reverse? Is the Stock Market a leading indicator for the economy? At times it does accurately predict the economic landscape, and the rest of the time it is wrong. In reality, it is impossible to predict whether the stock market is giving us an accurate indication of where the economy is headed in real-time.
• The moral of the story is that if anyone starts predicting where the stock market is going based on how they think that the economy is doing, he or she is wasting his or her time. It’s important to remember the following: (a) there are too many variables that determine stock prices like geopolitics, interest rates, tax rates, natural disasters, fiscal policies, legal changes, it’s nearly impossible to point to even one metric (b) one has to identify whether the commentator is looking at the dog or at the walking couple, to guess how accurate the forecast is; those who watch the dog are letting stock prices influence their predictions – they are biased whereas those who set monetary policy are not interested in what the dog is doing.
• What one can do is to remember that the Stock Market is forward-looking and not based on historical data. Expectations are what drives stock prices. The following four Behavioral Tips work much better than anything that you’ll see or hear:

ONE: The Street does not care about good or bad; it only cares about better or worse than expectations.

TWO: Even if you knew what a company’s future fundamentals would be in advance, there is no possible way you could be sure of the expectations of your fellow investors, or how they might react once the news you already knew about became public.

THREE: On the other side of every single trade you make, there is someone else making the opposite trade, and you will not be the one who knows the most during every one of these showdowns.

FOUR: Randomness explains a great deal of what happens from day-to-day. Markets are made up of people, so they’re biological, despite our best attempts to turn them into mechanics or physics, where set rules define actions, reactions and interactions. Anything can happen. There doesn’t always have to be an explanation.

For the above reasons, the study of Behavioral Finance has gained in prominence. So, I am here to tell you about what is Behavioral Finance, how it works and why to works the way it does. I’ll also give you some tips about how all us can acquire a Behavioral Edge. What is an Edge? In the Stock Market, as in life, we require some EDGE. An edge is something that we have, but others don’t.

Investing Edge

An Investing Edge is defined as ‘a technique, observation or approach that creates a cash advantage over other market players. It doesn’t have to be elaborate; anything that adds a few points to the winning side of an equation builds an edge that lasts a lifetime.

In the investing game (in so far as it relates to the stock market), what we are trying to do is to profit from the ignorance of others and if that is true (and it is), it translates into the need for an investing edge. In a world where there are over 300,000 Bloomberg Terminals and over 200,000 professionally qualified analysts, the importance of an investing edge cannot be understated. Investing is essentially a zero-sum game. When we buy or sell a stock, the odds are that someone far smarter than we are is selling it to us (or buying from us, in case we are selling). However, we don’t know who is on the other side of the trade. Hence, the question: What is our ‘edge’ over the person who is selling to or buying from us? In a market that is now dominated by institutions, the competitive aspect has ensured that markets are now far more efficient than they were at any time in the past.

The fact of the matter is that most investors don’t understand that they require an edge to succeed in the market. So, if you don’t have an edge to start with it doesn’t matter. Knowing that you need an edge means that you are already ahead. All of the above does not mean it is impossible to build an edge. It is tough, and as an investor, the greater sin is in not trying. If the market seems efficient, one has to look for inefficiencies, and sure enough, we will find them, if we try hard enough.

There are broadly four kinds of investing edges.

Informational Edge

It is the one most of us concentrate on, but it has disappeared with the advent of the internet. Since information is disseminated in real-time and is mostly free, there are practically zero informational edges that can be acquired as a result of possessing information. Most of the information is already public, and the price discovery is over by the time we read it. The news media cycle follows the price action and not the other way around as most of us would want to believe. If you are privy to insider information that is not public, using it to gain an undue advantage is illegal and against the law.

Moreover, changes in the corporate law have meant that companies have to disclose all material information in real-time thus ensuring a level playing field for all market participants. Pursuing an informational edge means that you are short-term oriented and looking to profit from intra-day or intra-week price action. The idea is to look for hidden information that the market is unaware of.

Analytical Edge

All of us can acquire an analytical edge by crunching numbers and doing the hard work. In financial markets, things are not what they seem: Much of what most people think is treasure is, in fact, trash. And much of what they think to be trash is, in fact, treasure. To succeed we need to develop a ‘variant perception’. In other words, as investors, we must be able to process information in a superior manner as compared to other market participants. Over time, as our perception starts differing from the common perception of the market, we tend to acquire an analytical edge. The most important point that is worth remembering is that even if we have all the information and are superb at analysis, there is no way in which we can predict how the market will behave in the immediate term. Just look at the current situation, the BJP is expected to win, suppose it does happen, can anyone predict the closing price of the Nifty 50 on 23 May 2019 with a more than 50 percent degree of accuracy with skin in the game – how much is the person willing to bet on his or her prediction, that matters more than anything else. The stock market is essentially a zero-sum game, please don’t ever forget that. In the stock market, all of us are inherently trying to make money from the ignorance of others. In other words, it’s the relative skill of each individual participant that matters. As a result for us to have an analytical edge over the long-term we have to find weaker games and/or easier opponents. At the same time, our opponents (the persons who buy from and sell to us) are getting even more skilled with each passing day. It is called the ‘Paradox of Skill’. Net net, it is very difficult to acquire a sustainable analytical edge.

 

Time Horizon Edge

Since most investors are short-term oriented, it is easily possible to acquire this edge by just changing your time horizon. Instead of being focused on the next quarterly earnings, focus on the bigger picture and the long-term. Just imagine, by simply elongating the time horizon of your investing landscape, we can acquire an investing edge; simply because nobody else is doing this. The time horizon of our investments matters a great deal. And arguably time horizon variability is what the formation of bubbles is all about. Consider the following:

Behavioural Edge

It is the one that can be attained by controlling one’s behaviour. Gaining a behavioural edge means being well-behaved and it’s a critical edge that almost nobody seems to focus on. It’s also pretty easy to acquire. The most important feature of a behavioural edge is that once acquired; it’s more or less permanent, it stays with you since it becomes a way of life. By contrast, the other types of ‘edges’ are inherently ephemeral or temporary.

To be a successful investor one should have at least two of these. The most important one is the last one. As I alluded to earlier, sentiment matters more than anything else. We may not have an informational edge, neither is an analytical edge an absolute necessity, but the other two are imperative. If we have an informational and an analytical edge but behave stupidly, these two are useless.

Life ≠ Chess

Almost all of us tend to equate the quality of a decision with the quality of its outcome. In Poker it’s called ‘resulting’.’ The term Resulting’ refers to a routine thinking pattern that bedevils all of us. When we are asked about the best decisions that we have made in our lives, our answers invariably veer towards ranking our results and not our decisions. What we miss is that a good decision may deliver a bad or undesirable outcome; the bad outcome in and of itself does not or should not be used for judging the quality of the decision. In other words, we can’t judge decisions as good or bad depending upon what their outcome is. Once we engage in ‘resulting’, we also tend to engage in hindsight bias (which is the tendency, after an outcome is known to view the outcome as inevitable). There are many occasions in our life when we make decisions, and they result in good outcomes; at all such times, we don’t try to assess the quality of the decision that we make. We link results with decisions even though it is so easy to point out that the two are not perfectly correlated.

In real life, we make multiple decisions like saving, spending, health care, lifestyle choice, raising children and nurturing relationships among many others. Life involves bluffing, deception, uncertainty, risk and forming opinions of what the other person is going to do or about how he or she is going to react. Life is not like chess wherein there is a pre-defined form of computation. Chess contains zero hidden information and very little luck. Chess pieces cannot randomly disappear from the board or get moved by chance. Losing a game of chess means there were better moves which one didn’t know or didn’t see. Chess is not a model for making decisions in our lives. Because our lives revolve around a lot of hidden information and spades of luck. Life is a game of incomplete information and involves decision-making under uncertainty over time, unlike chess. We treat life decisions as if they were chess decisions. And those of you who are very passionate about the Stock Market like I am, see a considerable amount of similarity between our lives and the behaviour of the Stock Market.

Stocks & the Socionomic Theory

Stocks don’t follow conventional economic theories. They follow the socionomic theory. What is ‘socionomics‘? Socionomics is defined as the study of social mood and its influence over social attitudes and actions.

More specifically, it seeks to understand how social mood regulates the overall tenor and character of social behaviour in areas such as politics, pop culture, financial markets and the economy. Unconventionally, the socionomic theory proposes that leaders and their policies are virtually powerless to change the social mood and that their actions in the aggregate express social mood rather than regulate it.

In the stock market prices reflect the current sentiment about the stock. And the sentiment is governed by the social mood or socionomics. Hence, when a stock goes up, we want to buy more of it. And when it goes down, we are in a hurry to sell. It is exactly the opposite of how it works with the traditional laws of supply and demand. In the normal world, humans don’t rush out to buy more when the prices go up. That is because we behave rationally, not so in the stock market. In the stock market, we are emotional and irrational; moreover, we tend to herd. If one were to understand how socionomics works, it could enable us to acquire an ‘edge’. For that, we must first understand how Cognitive Biases work in our decision-making. In this way, we can become rational in our investment process and not succumb to the laws of socionomics. In other words, we can acquire an investing edge by being aware and immune to the Cognitive Biases of other participants. It automatically enables us to take advantage of the biases in the market.

Did a decade of economic weakness that followed the global recession in 2008 result in Brexit and then the election of Donald Trump? What was the social mood when these two surprising events took place and what was the reason for the social mood?

Talk of how human behaviour is now so heavily studied that Behavioral finance professionals are being hired by non-financial businesses, prominent among them are technology companies. Machine learning means they will be able to do sentiment analysis on a million emails (‘show me anxious emails’), without needing to train that model on the data from your case, because the examples of sentiment to train that model don’t need to come from this particular lawsuit (or any lawsuit). Conversely, they can also do cluster analysis (‘show me emails that are about the same thing as this’) on your data without that going anywhere else.

The question is, how can human behaviour be such a potent weapon? To understand that, we need to delve into the evolution of the traditional finance function and how the behavioural angle has grown within it. Traditional finance is predicated on the following belief: human beings are perfectly rational. What is the definition of ‘Rationality’ or in more practical terms what is Rational Behaviour?. Being rational or exhibiting a rational behaviour would mean all of the following :

Rational behaviour is one that is based on (a) our ability to think clearly in a sensible and logical way and (b) one that shows the capacity to change according to the reasoning

Now the trillion-dollar question is: do human beings as a species exhibit the above-mentioned traits? The short answer is in the negative. In other words, it is safe to say that we are inherently irrational. The irrationality that is a part of human behaviour has its roots in the way we have evolved.

Behavioural finance aims to influence – and hopefully improve – our financial decisions. It helps us understand the gap between how we should invest and what we do. This ‘behavioural gap’ can come with a significant cost – sub-optimal investment performance.

An understanding of our behaviour should be at the forefront of every decision we make. We exhibit several biases in our decision-making. While we cannot remove these biases, we can seek to understand them better. We can build more systematic processes that prevent these biases adversely influencing the decisions we make.

Being Irrational is not always a bad thing

Humans are born irrational, but it does help us in many ways. Many a time, our irrationality makes us better decision makers.

Let me give you an example. Suppose you’ve gone for a trek or a hike in the forest and there are a lot of bushes and trees and you’re not using google maps, because there is no internet connectivity. The sun has set, and you don’t have a torch, just moonlight. You’re using the trodden path, and you hear a rustling sound. Now it could be the wind, or it could be an animal, maybe a tiger or a lion. A rational being will stand his ground, try to judge the wind speed and think of the probabilities, in the process he so she might get killed; that doesn’t sound like a prudent thing to do. Almost all of us will run. The probability of it being a tiger (that is making the rustling sound) is lower than the probability that it’s the wind. Since for the most part, we don’t think probabilistically, we run. Based on a pure probabilistic assessment, we would be making a wrong decision by running away, but it’s better to be safe than sorry. In the world of Behavioral Finance, this is known as a:

Type 1 Error – False Positive

If we were to stand our ground and embrace the risk of getting killed (incorrectly interpreting the rustling sound to be the wind, when it is a wild animal), it’s called:

Type 2 Error – False Negative

Type 1 errors are less grave than Type 2 errors. Our irrational behaviour helps us in many ways; we want to be safe rather than be sorry. The point is that irrationality that is baked into our system also helps our survival instincts. It’s not always bad.

What the above example illustrates is the way we make a decision when we are faced with uncertainty about the outcome of our decision. And in the Stock Market, as also in life, most of our decision-making involves situations where we are unaware of the outcomes of our decisions.

Heuristics v/s Probabilities

Instead of relying on probabilities to make decisions, humans tend to make decisions according to instinct. Often, these instincts rely on “heuristics,” or mental shortcuts, where we focus on one key factor to make a decision, rather than taking into account every tiny detail. Oil prices going up, some feel it is bullish, others think it is bearish. Whatever it may be, bullish or bearish we’ve made up our mind in under 30 seconds, based on something that we read or hear. In the ultimate analysis, it boils down to our beliefs. And all of our decision-making is predicated on our beliefs. In other words, our beliefs form the basis for all of our decision-making.

Beliefs & Filters

In the Stock Market, we trade our beliefs. In the real world, all of our decision-making is based on some world view that we have about what the objective reality is. And then we act accordingly. Each of us goes through life using our unique view of what the objective reality is. Each human being has an independent version of reality, an independent set of beliefs. Our beliefs evolve as we get older and experienced. Also, we have a different set of beliefs for the various decisions that we make. When it comes to investing in the Stock Market we have one set of beliefs when it comes to investing in gold, we have another set of beliefs, for buying a house again a separate set of beliefs, for spending on our own or our children education we have a set of beliefs. These vary from person to person; what remains common is that our beliefs allow us to gain a certain degree of happiness in the present moment and also allow us to make a prediction about the future. These two features are common across the belief system.

How do we form & change our Beliefs

Each of our beliefs meets two essential criteria; firstly they have to make us happy and secondly they should do an excellent job of predicting the future. For example, we teach our kids to pray and instil in them the fear of God. We too have gone through this. As long as the ‘God’ filter works, we use it because it makes us happy. As long as the filter that we use to form beliefs makes us happy and does a good job of predicting, we continue to use it. Once these two things fail to happen, we change the filter and form a new set of beliefs that meet our criteria above. In the example above, as we get older, our beliefs and perceptions about God change. They either get diluted, they may get stronger, or they may vanish altogether. The point is that we use ‘God’ as a filter for our belief system only to the point that it makes us happy and it helps us to predict. As we get older, the filters that we use to form beliefs change. This process continues throughout our lives based on our life experiences. A good way to think about beliefs is that they’re rarely just a calculation of how useful the belief is. In fact, beliefs are always formed within the context of how badly you want and need that belief to be true.

Experience is a hard teacher because she gives the test first, the lesson afterwards

There is a small twist in this narrative, and it’s important. And the twist is the fact that not only do all of us have a completely independent set of beliefs, all of us are also convinced that our version of what the objective reality is correct; all the others are wrong. We assume that those who disagree with us just need a better set of facts and perhaps better brains to agree with us. That filter on life makes most of us happy—because we see ourselves as the smart ones—and it does a good job of predicting the future, but only because Confirmation Bias, our tendency to interpret data as supporting our views) will make the future look any way we want it to look, within reason.

To reiterate, all of us trade our beliefs, be it the Stock Market or be it life. All of our decision-making is based on our beliefs. The important thing to remember is that our beliefs aren’t always correct. Let’s say that we are wrong 50 per cent of the time. The number is higher and would vary from one person to another, but let us go with 50 per cent. So far so good, but we need to ask the question: how do we form our beliefs and what makes us change what we believe?

What if someone or something were able to persuade us to change our beliefs? Effectively, that person or thing would be able to ‘influence’ our decision-making. Such a person or thing would be potent, wouldn’t it? To reframe the above would be to state that ‘Persuasion’ can be used by skilful minds to influence the decision-making capabilities of others and to change the decisions so made. ‘Persuasion’ can be used to ‘influence’ decision making in the following ways:

• We know that the human mind is easily influenced by emotion and once emotions creep in, irrationality follows.
• We love to predict and tend to follow those who can predict.
• It’s all about using techniques to change people’s minds.
• Fear is a powerful persuasion technique.
• People don’t remember what you say; they remember how you made them feel.

We all have a view of reality, and that view evolves continuously. We also convince ourselves that our view is the correct view and the others are wrong. This filter makes us happy. But the fact remains that reality might be something completely different from what we perceive. We keep changing filters as we age. Filters help us to feel happy. We don’t need to know the objective reality; all we want is to remain happy. We have a view that we are rational 90 per cent of the time, that’s wrong and quite the opposite of what the actual state is. We don’t make rational decisions; we make emotional ones. Since we are easily influenced by emotional and irrational factors, if we can learn how to influence others, we have a ready-made interface to use, and it forms our view of reality. It also allows us to predict, and any filter we use, we want to predict. The human mind didn’t evolve to understand reality. We never needed that capability for survival.

Filters are not intended as windows to reality. But our brains haven’t evolved to understand reality. All that matters is that your filter should keep you happy and it should also do a good job of predicting, the persuasion filter does both of these. Facts don’t matter. Modi didn’t give the policies that people wanted; he convinced the people that these are the policies that are good for them. Hence, the persuasion filter works the best. Persuasion is all about the techniques that we use to change people’s minds. It works even when the other person recognises the technique. Make a big claim with a factual error, wait for people to notice the error, see them spend hours talking about it; what happens is that when we dedicate focus and energy to an idea its importance rises in our mind. That’s persuasion. The error in your message will attract criticism, and it will rise in importance. Facts are weak persuasion, people have their facts, and when cornered they change the topic. We perceive ourselves as rational, that is incorrect. We think that we are using facts and reason, we aren’t. The stock market is a testimony to that. We think we are rational and that we understand reality, we are wrong on both counts. Facts and reason don’t count; we make decisions first and rationalise them later. Mass delusions are the norm, not the exception. Climate change and autonomous cars come to mind. We prefer certainty over uncertainty, even when the certainty is wrong.

To form our beliefs we use heuristics which are mental shortcuts. A Heuristic is a mental shortcut that allows us to solve problems quickly. Heuristics are rules of thumb that shorten the decision-making process. Are heuristics useful when we invest? The short answer is that it depends on how we use them. When a short-cut or a heuristic fails to work, it leads to one or more cognitive biases. Many a time they lead to wrong decision-making and hence result in what is known as an irrational decision or an irrational behaviour. In the world of behavioural investing, these are called cognitive biases. We are inherently irrational and suffer from innumerable Cognitive Biases. What are Cognitive Biases?

A cognitive bias is defined as a mistake in reasoning, evaluating or remembering, often occurring as a result of a deviation from our judgment and leading to irrational behaviour on our part

All of us have a view that humans as a race are very rational or that we are rational 90 per cent of the time. The reality is the inverse; we are rational only 10 per cent of the time; at all other times, we are irrational. We don’t make rational decisions; we make emotional ones. The question is – why do we make emotional decisions and not rational ones? And the answer is because of our Cognitive Biases. There are over two hundred Cognitive Biases, and most of them overlap. I’ll highlight just two of the most important ones. And these are Cognitive Dissonance and Confirmation Bias.

Cognitive Dissonance

Cognitive Dissonance is the mental condition in which people rationalise why their actions are inconsistent with their thoughts and beliefs

Cognitive Dissonance is the feature of our personality whereby once we have formed a belief, we try our best to stay consistent with our belief and refuse to accept that we are wrong. As a result, we behave in an irrational manner. We summon considerable reserves of wishful thinking and selective memory to stay consistent with our belief. When we are faced with disconfirming evidence, we are in the denial mode and work harder to stay wrong, effectively entrenching the wrong behaviour even further. Cognitive Dissonance is the mismatch between our beliefs and our behaviours. We know that we are wrong, but we refuse to accept it. For example, all of us think we are smart, and when we do something that is dumb, we hallucinate that there was a good reason for doing what we just did. Our brains almost instantly generate a delusion to rationalise the discrepancy in our behaviour. This is common to all of us, but we believe that it applies to others and not to us.

Five conditions have to be met for us to conclude that any one of us is a victim of Cognitive Dissonance. These are:

• A belief must be held with deep conviction, and it must have some relevance to action.
• The person holding the belief must have committed himself to it. He must have taken action that is difficult to undo. In general, the more important such actions are, and the more difficult they are to undo, the greater is the individual’s commitment to the belief.
• The belief must be sufficiently specific and sufficiently concerned with the real world so that events may unequivocally refute the belief.
• Such undeniable dis-confirmatory evidence must occur and must be recognised by the individual holding the belief.
• The individual believer must have social support. If the believer is a member of a group of convinced persons who can support one another, the belief may be maintained, and the believers may attempt to proselytise or persuade non-members that the belief is correct.

Examples of Cognitive Dissonance are all around us. One of the prominent examples was the miracle of Ganapati idols drinking milk. Everyone knew that it couldn’t happen. Thousands of devotees thronged temples with a bowl of milk in their hand. There were huge lines outside temples to offer milk to the Ganapati idols, and it received international coverage because Indians in the US were also following the script. A more recent example was Bitcoin. I can tell you confidently that the number of investors who got sucked into the Bitcoin mania was far more than is commonly believed. If you look at the way the Bitcoin mania unfolded, you’ll find it ticked off all of the above conditions:

• it was a belief that was held with deep conviction
• the person who held the belief had committed to the action
• the bitcoin craze was specifically connected to the real world; it is supposed to revolutionise the fin-tech world
• the disconfirming evidence was there for all to see and those who bought bitcoin were well aware of it
• there was huge social support with so much media coverage and groups that were formed to support the advent of bitcoin as the next big thing

What can we do to combat Cognitive Dissonance? The funny thing about Cognitive Dissonance is that we can spot it in others rather easily, but we are unable to see it in our behaviour. We can reduce our Cognitive Dissonance in the following ways:

• Change your behaviour. For a person who knowingly smokes or drinks, it might be difficult to change his or her behaviour. But in other cases where there is no substance abuse, it is easily possible to change one’s behaviour.
• Change your beliefs. It is possible to change one’s beliefs by being inquisitive and by reading relevant material that does not agree with your opinions. We are wired not to learn or seek anything that disagrees with our prior beliefs (our priors), and that leads to an increase in our Cognitive Dissonance.
• Justify your beliefs and your behaviours. I call this the ‘man in the mirror’ effect. If you believe in climate change for example, what are you doing about it?

Confirmation Bias

The second common bias that all of us have is Confirmation Bias.

Confirmation Bias is the human tendency to see all evidence as supporting your beliefs, even if the evidence is nothing more than coincidence. Again we believe it happens only to others and not to ourselves.

It doesn’t take much for any of us to believe something. Once we have formed our belief, we tend to protect what we think. The more you believe something to be true, the more you will have accumulated evidence to support it; we need to be very careful while forming our beliefs. Confirmation Bias is the human tendency to search for, interpret and remember information in a way that confirms one’s pre-existing beliefs. We tend not to change our behaviour, even though the fresh evidence may be contradictory to our opinions. We look for evidence that confirms our prior beliefs. In this way, we aggravate our bias. When we are confronted with evidence that contradicts our beliefs, we have two choices: (a) change our opinions or (b) ignore or even discredit the new information. Nobody likes to be wrong. Hence most of us chose (b). Moreover, any information that contradicts our beliefs is an assault on our ego, and we work hard to swat it away. If new evidence aligns with our pre-existing beliefs, we lap it up.

There are two commonly believed fallacies regarding Confirmation Bias; these are:

• Many of us tend to believe that Confirmation Bias happens only to others and not to us. Each of us suffers from Confirmation Bias, and for the most part, we are not aware that our inherent bias is active. We are under the mistaken impression that we have our Confirmation Bias under control, and more often than not we are wrong. I can tell you very confidently that it does work in this way. I deal with clients, and I tell them to keep the television on mute when they watch the financial channels so that what they hear and see doesn’t affect them. More often than not, the clients tell me that they are not affected by what they see and hear. Ditto for entering your portfolio in money control or any such free portfolio package. Effectively, more than once every day we see how our portfolio is moving, what is green and what is red. It spurs us into taking a decision when for the most part it is better to do nothing).
• It has been proved that our Intelligent Quotient (IQ) is positively correlated with the number of reasons that people find to support their side of the argument. In other words, individuals with high IQ’s are more susceptible to Confirmation Bias than those with low IQ’s. This too is true. I have a client who trades huge quantities in Idea, and he is permanently bearish and mind you he is a CA final rank holder. For those of you who are, CA’s and there are many here; you can imagine his IQ. But he is adamant and says that it’s going to zero. Any which way you tell him or argue with him, it’s no use. I also had a senior citizen client who had a ton of Ranbaxy, and someone told him that the stock is lying idle and not earning anything apart from a paltry dividend, so he should trade it. I don’t need to tell you what the outcome was.

Effects of Confirmation Bias

• It encourages homogeneity of thought and leads to poorer decision-making.
• We tend to gravitate towards others with similar viewpoints as ours, and this happens even to lawyers, judges and scientists.

Remedies to Confirmation Bias

Just by being aware of one’s biases does not ensure that we can overcome them. The only way to escape from Confirmation Bias is by being actively open-minded. Being actively open-minded means looking out for and seeking diverse viewpoints and dissenting opinions. In other words, encourage viewpoint diversity. Viewpoint diversity is a situation where each person’s views act as a solution to someone else’s Confirmation Bias. Viewpoint diversity is the most reliable way to get rid of Confirmation Bias. Being mindful instead of being mindless is what it is all about. We have to actively look for opinions and people who don’t agree with us. Despite my teaching Behavioral Finance, I still fall prey to both of the above biases; it’s almost uncontrollable.

Filter Bubbles

Filter Bubbles are defined as: a phenomenon in which a person is exposed to ideas, people, facts, or news that adhere to or are consistent with a particular political or social ideology.

Eli Pariser coined the term Filter Bubble to describe the process of how companies like Google and Facebook use algorithms to keep pushing us in the direction that we are already headed. By collecting our search and browsing data as also our contacts, the algorithms can accurately predict our preferences and feed our Cognitive Biases.

The slides show how the Google predictive algorithm works to accentuate our biases. You too can try this, and for each of you, the predictions will differ depending on how much Google knows about you. In other words, these tools, be they FB, WhatsApp or Google search, are now directly controlling the process or manner in which we form beliefs. We would be better off, without the constant nudge that these algorithms tend to provide. Effectively, a substantial number of internet users are in Filter Bubbles. Is there a way out?

The question is what’s happening? And the answer is that this is life in the age of the inscrutable, opaque algorithmic feed. I may decide whom I friend or follow, but Facebook, Twitter, Instagram, YouTube and the rest decide what I see. Ostensibly, the point of these algorithms is to show you what you care about. In general, one word rules the way your feed is sorted and presented to you: engagement. The more you click, like, comment, share and read, the more likely you are to keep checking back in. Your feed is carefully ordered to make sure you never get bored. The invisible sorting systems start with a few obvious things: whom you follow, friend or subscribe to influence what you see in your feeds heavily. If you double-tap to like an Instagram post or comment below it, that’s another positive signal. If you tend to watch a lot of videos, the platforms will show you more videos and fewer photos. If you don’t like a post, but stare at it for a while, you’re still adding a tick to the “show me more!” column. Effectively, social media is more dangerous than cigarette smoking only because they are playing with the way we think. Our cognitive function is what they control and that is not to be taken lightly.

Motivated Reasoning

Francis Bacon summed it up in 1629, as succinctly as any modern behavioural scientist: ‘The human understanding when it has once adopted an opin­ion draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects or despises.

What is remarkable about the quote above is that it is dated 1629. That would mean that human behaviour hasn’t changed one bit. Once we are in a Filter Bubble, we refuse to update our beliefs, or we are not led down that path (due to algorithms). As a result, we fail to update our priors; once an opinion is lodged, it becomes difficult to dislodge. As our pre-existing beliefs decide how we process information, these beliefs get strengthened, and since we are not looking for disconfirming evidence, our bias feeds on itself forming a vicious circle. In this way, our beliefs take on a life of their own, and our confirmation bias draws us more and more into our echo chamber. Once we are in our echo chambers, we assume that everyone else thinks like us; we are blind to the fact that our beliefs might be wrong. This irrational, circular information processing pattern is called motivated reasoning. In other words, informing and updating our beliefs has an undesirable snowballing effect on our cognitive function and our decision-making capability. These self-serving delusions are examples of what social psychologists call “directionally motivated reasoning”, a dull, academic phrase for one of the greatest challenges we face, for two reasons.

• First, we now can filter our world and only see what we want to an extent unthinkable until very recently. At the same time, unseen algorithms push us more of what we like, so that we’ll spend more time on the host sites. It’s a dangerous feedback loop, where the system is built to prey on one of our deepest biases.
• But, paradoxically, the same system gives us more fleeting glimpses of different viewpoints than we used to get – the exaggerated takes from outriders or controversialists, or an opposing view shared within our group to ridicule. Filter bubbles may not seem that real to us, because we see these views from a distance, but that is not real engagement and does more harm than good.

Greed & Fear

Let me give you an example. Suppose, the mall that you visit be it Central or say Amazon or Flipkart, announce that on the occasion of Christmas, they are going to have a sale and prices will be marked down by 25 per cent. What would we do? We would go to the mall, tell our friends and family and would buy what we wanted. We would end up buying unwanted stuff as well. In other words, lower prices lead to an increase in demand. In the stock market, it works oppositely. The stock market is the only place where when prices go down, we tend to panic, and we don’t celebrate. In all other instances, we want lower prices; we are more rational. When stocks go higher, our confidence rises and vice-versa. It is a form of cognitive dissonance. Why does this happen in the stock market and not in the shopping mall?

Greed & Fear. In the stock market, Buffett says that be Fearful when others are Greedy and Be Greedy when others are Fearful. There are many reasons why this behaviour is prevalent in the stock market. The primary reason is Greed and Fear syndrome. As prices edge higher, we get greedy and want to buy more of what is appreciating. But when prices start falling, fear takes over, and we want to sell just to quell the fear. There are many other reasons that can be ascribed to this Greed and fear cycle, but they all the reasons have one thing in common – human beings are inherently irrational – and that applies to all the investors all over the world. Don’t think that the Americans or the Europeans or the Japanese or the Chinese are any different; they are not. Everyone behaves in an identical fashion and follows the Greed and Fear cycle, barring a few who are more rational than the rest. The important point to remember is that greed drives prices higher and fear drives them lower.

Let me illustrate this. Take the example of Tata Motors. Exactly one year ago, the stock was quoting at 202, before it was cut in more than half. If you switch on the television and watch the analysts, not a single one will have a buy recommendation on the stock as on date. The question is, was Tata Motors riskier at the current price of 115 as against when it was 200? If it were to go to zero, we would lose less today than we would have if we had bought it one year ago. This is fear. A couple of months back Tata Motors touched an all-time low. They announced a massive write-off; it was a book entry and had zero effect on their cash flow. The Stock Market is supposed to be forward-looking, we shouldn’t be looking at the rearview mirror when we invest, we should be looking into the windscreen. The stock tanked, and it was already near the lows, but it made an even lower low. It’s a classic instance of how emotions affect the price discovery process. And the behaviour of the experts confirmed this. Nobody wanted to touch the stock; it was being thrown away, literally. Since hitting a low of it has now recovered by almost 50 per cent. This was a purely behavioural call, but it’s difficult to time. Hence, time in the market is more important than timing the market. Again, look at the discount at which the DVR trades. What justification is there for a discount of almost 50 per cent? Nobody knows. The most rational explanation of the discount, in my opinion, is that it’s not convertible into TTM shares on the NYSE. It’s completely irrational, the DVR gets a higher dividend, yet the discount continues to be what it is. There is a clear arbitrage if one owns Tata Motors shares. If you look at other DVR issues, they too quote at a discount, but none of them has such a large discount.

Today, you won’t see any buy recommendations for Tata Motors. Fear and greed override or overrule our rational thought process, and it affects even the experts that you hear on television. This is the classic Type 1 error that almost everyone made. What would a rational investor do? All of you have learnt valuation methods. A rational investor would look at the Balance Sheet, study the ratios and the cash flow statement, try to find out the market potential for trucks or cars, do a DCF or compute the PEG or whatever. Then a rational investor would look at the risk-reward ratio, study the probabilities and then make a decision. What do we do instead? I can bet that none of us in this classroom even attempt to do any of the above. We rely on gut feel, or we phone a friend, or we might even go short based on our beliefs. Our beliefs are in turn formed by WhatsApp and Money Control etc. Something similar happened at the time demonetisation was announced, and nobody bought the Nifty 50 when it was 7300.

The Experts are not immune from Behavioral Biases

It is a myth that the so-called experts that we see opine on media channels are immune from behavioural biases. That is far from true. Hence the saying that ‘keep the experts on tap and not on top’. Consider the following:

• Humans are all status seeking monkeys. It is the basis on which Facebook’s ‘Like’ button is built. We want social approval and yearn for it in different ways. Since we are born with this status-seeking trait, we seek out the most efficient path that will maximise our social capital. Once we engage in status-seeking, it sets up a feedback loop which we then try to optimise. You can take the monkey out of the status-seeking game, but you can’t take status seeking out of the monkey.
• FB and other social networks are built on the principle, ‘come for the tool, stay for the network.’ The news feed algorithm in FB is built-in such a way that it acts as a beauty contest. We compete with every person we have ever met for eyeballs. What matters to us and for our status is how we compare with others in the pecking order, our absolute status does not matter in the least.
• The Signal to Noise ratio or SNR (also depicted as S/N) measures the quantity of useful information (signal) as compared to bogus information (noise). The higher the ratio, the better the signal is. In the case of social networks as also with the markets in general, the SNR is pretty low and it seems to be getting lower with every passing day. The problem is that everyone and their great-grandmother are competing for the user’s attention, and that is a scarce commodity. Since the competition for this scarce resource is very high, the SNR is low. In other words, most of what we hear and read falls under the ‘noise’ category. To be able to separate the signal from the noise, we have to employ strong ‘filters’ when we access online information. We have to differentiate between information and news – the signal from the noise.
• When we hear commentators talking about their stock picks we forget that the majority of the people are lurkers. They have no skin in the game. The 1-9-90 rule for social media applies, whereby most of the people have no stake or a small one. The economists are the biggest culprits. In that sense, just like social media, the Stock Market is a spectator sport just like social media. Everyone is interested in what the other person is doing. Life may not be a spectator sport, but a lot of social media and the markets as well are akin to spectator sports.

Keynes Beauty Contest

John Maynard Keynes is known as an excellent economist for his work titled “The General Theory of Employment, Interest, and Money.” Regardless of his economic theories, unbeknownst to most is the fact that Keynes was one of the greatest investors of his time (1883 – 1946). Keynes was one of the first to recognise that investing is an exercise in mass psychology.

The Keynesian Beauty Contest is a concept developed by the late John Maynard Keynes to explain price fluctuations in the stock market. According to Keynes, investors do not make money by picking the best companies; they make money by picking stocks of companies that other investors will want to buy. The analogy was based on a contest run by a London newspaper where entrants were asked to choose a set of six faces from 100 photographs of women that were the most beautiful. The rules for the beauty contest were as follows:

• Each participant had to pick, not those faces which he (or she) finds prettiest, but those which he thinks likeliest to catch the fancy of the other participants.
• The prize was awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.

According to Keynes:

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.’ (Keynes, General Theory of Employment Interest and Money, 1936).”

Keynes used the beauty contest as a proxy for describing the behaviour of investors in the stock market. I think that most of us are now engaging in the conduct that Keynes alludes to. Consider the following:

• Many websites (and WhatsApp groups) glorify the latest exploits of investors who seem to be on a winning streak. Most of the stuff is pretty dated. These unverified write-ups of high-profile investor entries and exits do lead to almost immediate volatility in the prices of the underlying. Effectively, investors are motivated to guess what the other investors are doing to profit from short-term price movements. In other words, investors at different levels of the ‘investor pyramid’ are trying to second-guess or third-guess what the other guys (or gals) did.
• How does this affect price discovery? Investors aren’t looking for outstanding businesses or investing ideas. What we are looking for are stocks that other people believe still other people would want to buy. It does lead to herding and groupthink. As more and more of us participate in the ‘beauty contest,’ prices will tend to depart from their intrinsic value. In such a scenario, the fundamentals don’t matter, or instead, they progressively cease to matter. Effectively, rising stock prices seem to have become the only justification for owning a stock. Conversely, falling stock prices of stocks of unloved sectors are the reasons for not owning these names. It’s the greater fool theory.
• In an information-obsessed world, most of us are now keen on gaining an informational edge, rather than focusing on what matters (like fundamentals, earnings, etc.). The more information we manage to accumulate, the more confident we are; that doesn’t necessarily mean that we are correct. Inevitably, we end up investing based on stories. Stories can be misleading and more often than not, differ materially from what the facts are.
• As a result, today investors want to buy stocks that are going to be added to the benchmark indices. Alternatively, capital is allocated according to whether or not the stock is a part of the benchmark. Nobody is interested in learning about the business or looking at the valuation. This is completely behavioural.
• In today’s market, the risk for money managers is not overpaying for stock but looking stupid by not owning it. Looking stupid is worse than being stupid. Risk is in not being a part of or with the consensus or the herd. As on date, money managers are disproportionately worried about their short-term investment results; they do not want to risk short-term underperformance. It often leads to an exodus of investor money and lowers fees in the ensuing years for the affected managers. Relative underperformance is a disaster. Look again at the example of the Tata Motors DVR that I highlighted earlier.
• Selling stocks that have underperformed in the short-term is so much easier for these money managers, no matter how cheap the stock being sold is. So the mantra is not to buy what is cheap, but what is working; since what is cheap by definition hasn’t been working. In other words, stocks that have reported relative outperformance are the ones that will be chased, in today’s market, it is the Bajaj Finance and the Hdfc Bank types. It’s a slippery slope; any one-quarter of lower than expected results will not be taken kindly. When stocks are rising for the singular reason that they have risen, the greater fool theory is at work. And inadvertently it leads to money managers being fully invested at market peaks and grossly underinvested when prices are low.
• Benjamin Graham had pointed out that the Stock Market is a voting machine over the short-term and a weighing machine over the long-term. A necessary tenet of Behavioral Finance is that while investing, we must have more confidence in our own opinion than in the combined weight of all other opinions. Since this may be considered as arrogant behaviour, it is necessary to exercise extreme caution and stay within one’s circle of competence.
• Effectively the investment world has been turned upside down; what seems risky is, in fact, safe, and what seems to be safe is risky. As a result, Tata Motors is risky at 85, and when it goes to 110 Cognitive Dissonance kicks in, and the analysts continue to be bearish, they simply cannot accept that they were wrong, to begin with.

To conclude, stock market investors are always engaging in the behaviour described above. As a result, investors in the stock market tend to price shares not based on their fundamental value, but by what everyone else thinks their value is or what everyone else would predict as their real value. The fact that the current bull market has been pretty one-sided (thus far) has led to this ‘beauty contest’ behaviour becoming even more rampant and hence glaringly obvious.

Mindfulness v/s Mindlessness

You can read and learn all you want about human behaviour, but none of what you read will be useful unless you are mindful of your behaviour. That leads me to the next part about human behaviour – being Mindful as against being Mindless. They are antonyms. Let me define each of these two terms, and they are critically important definitions. Being Mindful is the process of actively noticing new things. It’s what our parents teach us, KEEP YOUR EYES AND EARS OPEN. Being mindful is being attentive and aware. Mindfulness is the broad term used for bringing our attention to the present moment in an open, kind and non-judgmental way. It’s a skill, a way of seeing and a way of being that allows us to engage with our surroundings. Mindfulness reduces stresses and increases happiness. We can develop mindfulness in two ways; one is meditation and the second is by aligning our thoughts with our behaviours in everyday life – what is called stopping to smell the roses. It means giving your attention to a person when engaged in a conversation, allowing the other person to speak, being a good listener and not interrupting the other person when he or she is speaking. Mindfulness is being an independent thinker. It leads to greater clarity. Being Mindless is being on auto-pilot – letting your thoughts and emotions drive your decisions and actions. It’s like being in the back seat of a car, not in the driver’s seat. For example when we forward WhatsApp messages or act on them without using our thought process. The best illustration of Mindlessness is our eating habits. For example when we eat popcorn in the movie theatre. Mindfulness is a work out for the mind. We engage in it when we perform an activity we love like say jogging. Mindfulness is bringing this calm and clear perspective to all our moments.

I think many of you may have read or heard of Sherlock Holmes? How many of you have or have not heard about Sherlock Holmes? Doesn’t matter, for the sake of those who haven’t, Sherlock Holmes was a fictional character created by an author named Sir Arthur Conan Doyle who wrote many books about this fictional character Sherlock Holmes. In all the books, Sherlock Holmes is the fictional private detective who helps Scotland Yard uncover many mysteries. Sherlock Holmes is caricatured as a rational mind. He is mindful and not mindless like his assistant who is another fictional character called Watson. For those of you who are interested in how a rational mind works, I urge you to read the book Mastermind by Maria Konnikova.

How to Think

“Intelligence is something we are born with. Thinking is a skill that must be learned.” — Edward de Bono

What is ‘thinking’? In the real world, thinking is not the decision itself, but what goes into the process of making a decision. The assessment, weighing the evidence, making sense of the data, speculating about the pros and the cons, using probabilities (not possibilities) before concluding, are all part of the ‘thinking process’. Most of the time, making a decision involves predicting future outcomes. In a world of unknown unknowns, predicting the future is difficult and trying to time it is next to impossible. In other words, the way we think is the basis for the way we form our beliefs. Based on our beliefs, we take important decisions. How come nobody has ever taught us how to think?

Thinking is an art and not a science. Somewhere, deep inside our minds, we are reluctant to think and tend to avoid it as far as possible. Thinking is slow, requires patience, is hard, and tiring, all at the same time; that’s why we do so little of it. Since thinking is an art, it is resistant to a strict set of rules, neither can one prescribe any do’s and don’ts for the thinking process. Alan Jacobs has written a book called ’How to Think: A Survival Guide for a World at Odds’. I’ve tried to distil the wisdom from the book into the following Nine points which can be used as a checklist for engaging in the ‘thinking process’.

• Instead of being impulsive, take five minutes before reacting. Examine your emotional responses. Before our impulses take over, try to imagine a situation where the roles between you and the other person are reversed; its called ‘method acting’. As some wise man has said: ‘do to others what you would have them do to you’. Once we engage in ‘method acting’, what we have to do is, for five minutes, in our mind, we have to speak someone else’s thoughts and for those five minutes, stop advocating our own. Religiously implementing the five-minute rule is almost guaranteed to improved decision-making.
• Seek out thoughtful people who disagree with you, but are rational thinkers. At all times, remember that we may be wrong about something. Being open-minded means that one has to be willing to re-examine one’s assumptions, and at the same time engage in civil discourse. If we do conclude that we are wrong, we should not stay wrong. Staying wrong is far worse than being wrong. Course correction is critical, and we should cultivate the ability to change our minds.
• Don’t argue to win, argue to learn. When engaged in debate, try to establish what the other person is trying to say, understand what the argument is all about. Try and differentiate your interpretation of the case with what the other persons mean to say. Most of the time, debates are just glorified communication gaps and highlight the difference between what is mentioned as against what is intended.
• Hear what others have to say and think over what is being said. There is a difference between ‘hearing’ and ‘listening’. Someone has rightly said, ’hearing is through the ears and listening is through the mind’. Most of us tend not to hear what is being said. In that case, the question of thinking does not arise. We cannot think if we don’t hear what the other person is saying. There are a couple of reasons why we are such bad listeners. These are (a) we love to talk and don’t want to give the other person an opportunity to do so, (b) we have an inherent bias against the person who is speaking, (c) we multi-task and don’t pay attention to what is being said, (d) we are impatient and frequently interrupt the speaker instead of letting him, finish speaking and finally (d) our ego comes in our way of being good listeners because we are reluctant to change. Listening is difficult, and one has to work towards being a good listener. Being a good listener is showing respect for the other person. It is imperative to the thinking process.
• Once we have heard the other person, always try to see if he or she is trying to divert our attention and preventing us from seeing something that is important. If someone is trying to sensationalize some event or action, be careful while forming judgements. It is often true while dealing with persons who have a loud voice or are unduly aggressive. Try and gravitate away from such individuals. Associating with the correct people will encourage thinking with the best. If one were to associate with undesirable elements, their thoughts tend to affect ours negatively. That’s why it is said that ‘you are known by the company you keep’.
• Avoid people who fan flames. If your peers demand you weigh in, ponder your choice of peers. Don’t feel you have to weigh in on every topic. Embrace the power of ‘I don’t know’. In the information age that we live in, everyone knows a little bit about everything. Warren Buffett has famously said: ‘I don’t worry about what I don’t know. I worry about being sure about what I do know.’
• Start writing a journal or a diary. Journaling as it is now popularly called, forces us to write what we think. Pencilling our ideas brings clarity to our thought process. Moreover, writing forces us to think. A significant upside of writing a diary is that we can revisit our thoughts at a later date and see what we got wrong (and why), or how we got things right, as the case may be. If we were right, we could repeat the same process in the future, and if we were wrong, we know how and why.
• As part of the thinking and journaling process, we ask ourselves a lot of questions and proceed to provide the answers to the same. Hence, to start with, we must be asking the right questions. Having done that, we must guard against our minds (System 1) playing tricks with us. Often, we substitute and proceed to answer an easier question, than the one that was asked. This process is known as ‘Question Substitution’. For example, we substitute the question ‘Is this fund manager skilled?’ with the question ‘How has this Fund Manager performed over the last three years?’. In the stock market, performance is a very poor and noisy proxy for skill, yet almost everyone seems to rely on it.
• Have the courage of your convictions and once you have ‘thought things through’, dare to act on your thoughts without getting distracted by the ‘noise of social media’. Social Media, inadvertently tends to replace our thoughts with our emotions. In other words, we have to develop an attitude of ‘not caring’ about other people’s opinions. Once we get distracted by social media, we are indirectly invested in ‘not thinking’.

Man in the Mirror

Behavioural Finance is not the study of how others behave; it’s the study of how all of us behave. And that distinction is critical because when we hold a mirror in front of our face, it shows us that the best place to begin our journey towards the discovery of Behavioral Finance. Generating ‘Alpha’ or investing outperformance is the ultimate aim of every money manager. Is there any such thing as ‘Behavioural Alpha’? Consider the following.

• Like I just said, Behavioral Finance is not a mirror that you hold onto the world; it’s a mirror that we must hold up to ourselves. And we must do so regularly. And if we look closely, we will see the image of a person who relentlessly falls prey to hindsight, over-reaction, framing, mental accounting, overconfidence and a host of other biases. So, what is the use of depressing ourselves with such sub-optimal data? The point is that if we can control our biases, we can gain a behavioural edge over other market participants.
• The point is that if markets can be beaten in this manner, why are so few managers doing it? If an understanding of the behavioural biases of the investing crowd allows a manager to take the other side of the trade, why aren’t there any headlines blaring out the names of managers with a behavioural edge? It’s apparent that very few of the investors understand their behavioural shortcomings; it follows that gaining a behavioural edge sounds like a silver bullet for Stock Market investing success and glory.
• The problem is that we are all sailing in the same boat and it’s difficult to take the other side of the trade because we too suffer from the very same biases. The table below shows the underperformance of Portfolio Management Schemes for the period from 01 April 2018 to 31 March 2019.
• What the above table shows is that it is difficult for money managers to profit from the behavioural errors of the uninformed investor. Now compare the above performance with that of a low-cost Index Fund. It is a startling difference, and among the many reasons for the underperformance, the one that is the simplest to diagnose is the overconfidence bias among the money managers.
• These money managers are talking to Promoters, using Bloomberg, employing research analysts and have so many tools that the layman investor does not possess, yet among the top 50 Portfolio Managers, just two or three have beaten the benchmark. And for those who haven’t the magnitude of underperformance is shocking. In the world of Behavioral Finance, these money managers seem to be suffering from the inverted expertise effect. In simple terms that means, the more you know, the more you think that you know more than you do. We just don’t know as much as we think we do; that is true for all of us without any exceptions.
• By making the statement that I just made it shows that I am suffering from the overconfidence effect. In other words, all of us suffer from overconfidence bias. In the world of investing, the more intensely you study a stock, the more invested we become in the stock. You start to think that you ‘know’ the stock because of the fact that its ‘your’ stock. As a result, we become emotional about it.
• All of us regret our errors of commission more than our errors of omission.
• When we get emotional about a stock that we hold, we tend to ignore the negative headlines about the stock. We suffer from the ‘disposition effect’ or what is called the status quo bias. We are afraid to sell because of the fear that after we sell it will go higher. The larger the trade, the more of your self-esteem you’ve invested in the stock, the more it costs you to unload it.
• We have to cultivate a sell discipline. Contrary to what most people believe, selling or rather the second leg of any trade, (the profit booking leg) is far more complicated than the first leg.
• In the olden days, there was a clear, informational edge in the market. Anyone who got information ahead of time could generate outperformance. In a way, you can call it time arbitrage. Just because a set of investors received information before the rest, they could profiteer in a disproportionate manner. There used to be whisper numbers that preceded earnings releases. On Dalal Street, what matters is not what a company earns, but what the street thinks street thinks a company will earn. That’s a roundabout way of saying that expectations matter more than the actuals. And it’s not about a company earning more or less; the metric is more or less as compared to what the street expects.
• With online tools available the definition of long-term has shrunk. Depending on who you ask, long-term could mean a couple of hours to a couple of days.
• Circling back to the earlier point about why money managers don’t want to pick stocks using the principles of Behavioral Finance, the reason is that the portfolio so chosen will not look anywhere like the benchmark that they track. In other words, tracking error over the short-term can be huge, but so can be the outperformance over the long-term. Portfolios based on Behavioral Finance will be unpopular names, not consensus candidates but are more likely to work over the long-term. So the risk for the money managers of today is a business risk. Underperformance in a year will be punished by redemptions. For those who are unable to take that business risk, the market can remain as inefficient as ever, and it wouldn’t help the manager concerned because he is unable to take advantage of the market inefficiency. To produce superior returns, we have to be efficient enough to take advantage of the inefficiency of the market. As a result, the best use of Behavioral Finance is not a study of other market participants but a study of our self. To beat the market, we have to invest differently than the market.
• We need to realise that the twin heuristics of representativeness and availability are what drives cash flows in and out of investments. Representativeness is the human tendency to consider a short series of data to be typical of long-term trends. Hence, a money manager who has beaten the market for say three years in a row is considered a genius, even though the probabilities would show that 12 per cent of all chimpanzees would be able to beat the market in any three-year period. Availability bias is the natural inclination to let recent and vivid events overwhelm our judgment about normally expected outcomes. Thus a manager who achieves 100 per cent returns in a 10 per cent market is considered a genius, instead of the more likely probability that he got lucky. Representativeness and Availability are the main reason why we buy high and sell low.
• To conclude, we can all view the world through a window, or we can view it through a mirror. The world of active money management looks at it through the window, and precisely, for this reason, we must look at it through a mirror. Our investment behaviour is the key to generating returns. If we learn to use the principle of Behavioral Finance as a mirror, we will have to pay the price in the short-term, but over the long-term its a price well worth paying.
• ‘And then when you get into psychology, of course, it gets very much more complicated.. But it’s an ungodly important subject if you’re going to have any worldly wisdom. And you can demonstrate that point quite simply: There’s not a person in this room viewing the work of a very ordinary professional magician who doesn’t see a lot of things happening that aren’t happening and not see a lot of things happening that are happening. And the reason why is that the perceptual apparatus of man has shortcuts in it.. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren’t there. Now you get into the cognitive function as distinguished from the perceptual function.. And there, you are equally—more than equally in fact—likely to be misled.. Again, your brain has a shortage of circuitry and so forth—and it’s taking all kinds of little automatic shortcuts. So when circumstances combine in certain ways—or more commonly, your fellow-man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction—you are the patsy. And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people. So the most useful and practical part of psychology—which I personally think can be taught to any intelligent person in a week—is ungodly important.’ – The above quote is extracted from the worldly wisdom speech by Charlie Munger

Asking the Right Questions

To combat our behavioural biases, we must cultivate a habit of asking the following three questions:

• What do I believe that’s wrong?
• What can I fathom that others cannot?
• What is my brain doing to mislead me?

With the advent of algorithmic trading there is now a fourth question that we have to ask ourselves:

• What do I know that a machine cannot work out?

What about Technical Analysis?

Technical Analysis of the Stock Market has now become a massive business. My experience is that 99 per cent of the investors and analysts who use or follow a technical analyst have never bothered to find out or research if the damn thing works and if it does, why? What surprises me the most is that even the most die-hard Technical Analysis guys, who swear by their trade, don’t have the foggiest idea about what Technical Analysis is.

What is Technical Analysis? Technical Analysis can be used to try to time our buy and sell decisions. The reason is that in the noisy world of markets, the price of a stock embodies the sentiment for the stock and at that moment in time, the price is always right. In a nutshell:

• Technical Analysis is based solely upon the data that is generated by the market. Market data is the sum total of what all the market participants are doing.
• The basic premise underlying Technical Analysis is that under identical conditions, human beings will behave similarly as they did in the past. The chart for any stock or commodity reveals the path that it has taken to get where it is.
• Just looking at this path helps analysts to try to time entry and exit trades. It’s not a foolproof timing method, but it can and does improve the probability of success.
• There are many technical analysts who have firm opinions about their reading of the chart. Every one of us will read a chart in a different manner. Many of us see things that are not there on the chart and miss those that are there, again that would depend upon our Cognitive Biases.
• In the Stock Market, they say that lose your opinion, not your money; this simple adage is for the most part forgotten by all investors. It is because of this that Technical Analysis arouses strong emotions among all investors. Those who are unable to perfect the art start bashing it when they lose money using charting tools. This set of chart readers are not willing to lose their opinion, they prefer to lose their money. The problem is behavioural; technical analysis isn’t wrong; it is the reading of the chart by the individual that is incorrect.
• Technical Analysis can be used for gauging market sentiment. When sentiments reach extreme bullish or bearish levels, Technical Analysis is pretty useful. And the reason it works is that humans behave in similar ways when faced with identical conditions. And history doesn’t repeat exactly, but it rhymes. And because history rhymes, technical analysis can be put to good use.
• Since the Stock Market is a mélange of emotions, prices that we see flashing on our screens represent mass psychology, the madness of the crowds, if you will. As a result, it follows that this mass psychology does manifest itself into some recognisable patterns.
• The problem with Technical Analysis is again behavioural. We see patterns where there are none, and then we extrapolate on them. Why does this happen? For a variety of reasons, many a time there are conflicts of interest – day trading calls by brokerage, they need any justification to make us trade, TA provides an excuse. Time horizon matter and non-temporal calls are the norms; none of the calls has time frames attached to them.
• If any of you do follow technical analysis, I have a suggestion to make. Use a strict stop-loss and most important of all, don’t read anything about the business model of the stock or the economy. The reason is that the market knows everything that you do and maybe more. So, all price sensitive information is baked into the current market price of the stock. Another tip is to keep the trade size small and reduce the number of trades.
• To summarize, technical analysis renders multiple forms of human behaviour in a pictorial form and can be useful if it used in the correct manner. What Technical Analysis cannot do is to predict how the stock will behave in the days to come. But then nobody can do that.
• The reason why Technical Analysis gets a bad name is manifold. A lot of it has to do with the behaviour of market participants. For example, many a time we find that a commentator says that the market has to do something or behave in a certain way. That misses the point completely since human behaviour is unpredictable, so are the markets. There is no such thing as “can’t,” “won’t,” or “has to” in markets. The market doesn’t have to do anything, and certainly not what you think it should do. The market doesn’t abide by any hard and fast rules; it does what it wants to do – when it wants to do it. That’s what makes it so hard and at the same time so interesting. And that’s why listening to the endless prophecies of gurus and pundits can be so dangerous. They don’t know anything more about the future than you or I, which is to say they don’t know anything at all. The range of possible outcomes is much wider than you think. You will need to suspend your disbelief at times to succeed because the market is forever doing things that it has never done before. There is no impossible in this wonderful game, only more or less probable. Truly understanding that can go a long way toward controlling your emotions and becoming a better investor.

How does Technical Analysis reflect Human Behavior

I think all of you will agree that price discovery in the Stock Market is a function of the demand and supply metric which in turn is a function of crowd psychology. Since the madness of the crowds manifests itself in the form of a graph, it follows that charts reveal the behaviour of the crowd. Chart patterns are the closest manifestations of crowd behaviour. There are many terms that are used by Technical Analysis. I’ll highlight some of them and point out how they reflect the behavioural angle.

• Not only do charts show crowd behaviour, but they also mirror the changes in what the crowd perceives. The intrinsic value of any business does not change every minute, every day, every week or every month. What changes is the perception of the crowd? The perception of how a business will perform in the future generates the demand or supply for the name. In other words, the Stock Market represents the combined perceptions of thousands of human beings responding to information, misinformation and whim. Perceptions matter and the chart shows us where and how perceptions meet reality.
• Since Technical Analysis works based on crowd psychology, it wouldn’t work in instances where the crowd is absent. For thinly traded stocks Technical Analysis wouldn’t work as well as it would for actively traded one. But algorithms are changing the importance of volume as an indicator.
• Think of a school of fish. If the fish on the right side of the school see a shark, they’ll veer to the left. It’ll cause a ripple effect throughout the school, and the fish on the left will also veer left, even though they haven’t seen the shark. The information about the presence of a shark starts to propagate throughout the school causing a discernible shift in the direction of the fish – ditto for the stock market. Information about a company creates a similar move and its called a trend. When we analyze a stock or the market, what we are trying to do is to analyze the direction of the primary trend; is it up, down or sideways.
• All trends stay in motion unless an outside force (like a shark) acts upon them. The imperfect flow of information like seeing a shark when there is none can cause an interruption or a break-down of the primary trend.
• A pattern is a market at rest before deciding whether it wants to continue in the existing trend or change course. A continuation pattern is when prices pause in an existing trend before resuming in the direction of the original trend. When prices reverse in a current trend, it’s a reversal pattern. When the crowd is undecided, it shows up in sideways trends. It is important to understand why trends and patterns break – because the crowd had decided to change course and not the other way around as is commonly believed.
• Resistance and Support for a stock are the tops and bottoms of any pattern. They represent supply and demand. At points of resistance, there are too many investors waiting to get even. At supports there are many investors who have their cost basis and as such these levels are considered to be bottlenecks. Unless the last investor had sold his stock at the resistance level and gotten even, there is a lot of friction for an up move. Once the last investor has sold out, the path higher is relatively smooth — ditto for support levels.

Benchmarking

I think one of the most serious behavioural mistakes that almost all of us make is that we use the wrong benchmark. What is the benchmark? In plain English, a benchmark is a uniform parameter or a yardstick that we use to compare performance. The problem is that there can’t be one single benchmark for everyone in the investing world; the reason is that the goals of every investor are different from one another; they are not aligned. If any of us are using benchmarks that are not aligned with one’s goals, it’s a huge waste of time. In other words, we should all have our benchmarks and not be following benchmarks that have been set for others. In the investing world, the Nifty 50 is the universal benchmark for measuring the performance of money managers, but that is an important benchmark for them. It is useful to judge the performance of a money manager, nothing else. With technology being what it is, it is now too easy to compare our performance across a broad range of benchmarks. Inevitably, we will find one or more that have outperformed our portfolio. While indulging in the benchmarking game, we pay zero attention to the time horizon. Unless your job is that of a money manager, we shouldn’t be comparing our performance with the Nifty 50 or the Nifty 500. If our job is to save for the education of our children or old age or whatever, even if we beat the benchmark and don’t attain our objective, it’s of no use. Each of us should be crafting our benchmarks and trying to outperform them.

If we benchmarked against what was acceptable in the fifties and sixties, we would all be ecstatic. We’d be like, “Holy cow! I have a computer in my hand and a polio vaccine!” But we don’t. We use relative prices. Relative to our reference group. Relative to what our neighbours have. Relative to what we see on Instagram. “Relative” means that by the time we arrive at our initial goal, the goalposts have moved. This is the problem with thinking that offering someone the data showing that they are better off will solve it. Data doesn’t care about your feelings. But the inverse of that is that your feelings don’t care about the data. We can track all we want along the axis of time. But people judge how they are doing not in comparison to the past but comparison to the now. The irony is that as we make progress, even if people’s lives get objectively better, their happiness can’t catch up because that progress changes the benchmark. The effect of the above is that it spurs us into action and we want to do something about it. Assuming that we have been diligent about our capital allocation and are meeting our benchmarks, for the most part, the correct thing to do is to do nothing. The reason is that returns in the Stock Market are lumpy, they don’t follow a straight line, and it is impossible to predict when and why a stock will move.

Power of Compounding

I think this is the most underrated tool in Behavioral Finance. All of us know that compounding is the eighth wonder of the world and yet we ignore it completely when we invest. A simple Public Provident Fund account compounds at an alarming rate over 15 years. Compounding is the incremental returns that we earn on our yearly returns from one year to the next. Assuming that there are no withdrawals and this is a very important assumption, then over time our investment returns compound every year and the principal amount on which we earn returns grows automatically every single year. The reason it works is that over time our returns compound.