Month: April 2010

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Third Theme – Inefficient Markets

Market Efficiency: All investors have the same information, interpret it the same way and make same projections based on it. It implies that the assets are perfectly (efficiently) priced.

However, the behavioral traits exhibited by investors contribute to the inefficiencies in the market. The major ones and their resulting impact on the markets are as below:

a) Representativeness:

  • By basing decisions on stereotyping past information and/or incidents incorrect projections can be made.
  • Stocks can be temporarily over/under priced.
  • Over-priced “winners” will underperform (as they would have been wrongly over valued).
  • Under-priced “losers” will over-perform (as they would’ve been wrongly under valued despite credible fundamentals).

b) Anchoring and Adjustment:

  • This is put simply, conservatism.
  • Positive news would lead to positive surprises (due to not being fully incorporated in the revised forecasts).
  • Similarly negative news would lead to negative surprises.

c) Overconfidence:

  • The biggest pitfall due to this is not realising one’s limitations.
  • As a result investors tend to make “unjustified” bets, thereby resulting in mispriced securities.
  • It can also lead to excessive trading.

d) Frame Dependence:

  • Information is not objectively analysed but viewed as per the “frame” it is received through.
  • It results in the tendency to change risk tolerance per market direction.
  • Investors get over-active in upward markets.
  • But become hesitant/inactive in slow/downward markets.
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Second Theme – Frame Dependence

Frame dependence reference to the phenomenon of information not being analysed objectively but through the frame it is received. Some major issues in this regard affecting the investment decision-making are as below:

a) Loss  Aversion:

This is the reluctance to accept a loss, since a loss can lead to the feelings of regret (will be dwelled on more in point c).

Instead of cutting the losses, investors tend to hold on to the losers for too long and/or don’t sell the winners fearing they may lose further “gains”. This can lead to risk-seeking behaviour.

b) Self-Control:

Instead of viewing the whole portfolio as one investors tend to psychologically divide the portfolio into sub-portfolios in line with different goals.

This gives them a sense of control and is more to do with emotions. For example a young affluent investor may want to avoid the dividends for tax purposes while an elderly may want high dividend paying investments so they can use the cash flows to meet their needs and do not have to sell any investments.

c) Regret Minimization:

Regret is the feeling associated with making a bad decision in hindsight. In order to avoid and/or minimize regret investors may stay in comfortable “safe” investments (e.g. stocks and bonds) which can lead to a lack of variety.

Another issue can be that they may not sell profitable investments but rather use their cash flows for expenses.

d) Money Illusion:

This ties in with the concept of “Real Money”. When considering performance the real return (which takes into account the inflation) should be considered and not the nominal return.

As people normally think in terms of nominal, in high inflation environments they may think they are getting a higher return when actually they may not be due to the inflation effect.

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Pshycological Biases in Investment Management – First Theme – Heuristic Driven Biases

a) Representativeness:

This is put simply, stereotyping. It happens when current/potential decisions and/or expectations are based on some past experiences.  E.g. All green firms are good investments, Strong past performance is indicative of strong future performance, e.t.c.

b) Over-Confidence:

Placing too much confidence in one’s abilities (to forecast) often makes the confidence intervals too narrow. This tends to lead to surprises.

c) Anchoring and Adjustment:

This refers to making an orignal forecast and not revising it fully in the light of the newly available information, thereby anchoring on to the original projections. This also tend to lead to surprises which are in the direction of the newly available information. If for example there was new positive info made available but not fully incorporated, it will lead to a positive surprise and vice versa.

d) Aversion to Ambiguity:

It can be explained as “fear of the unknown”. Investors (and even people in general)  prefer to have some sort of assurance. They feel comfortable having something to “rely” on even if it is the forecasts and projections which though are not certain gives a sense of lesser ambiguity. When faced with uncertainty, investors tend to stay away. This can result in market inefficiency as we will discover later.

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Some Thoughts

It often happens and happens with the best of us. Somewhere in our lives it happens with all of us that even the inspiration needs to be inspired to overcome the emptiness and realise the full potential of ones’ self.

In such times always remember your goals and set some if you don’t have any. For the simple reason that a sense of achievement and passion are what underlines a successful person and keeps us going.

And I’d finish this post by saying that backup your dreams with actions and live like there’s no tomorrow and the sky’s the limit for you.

Best of luck to all of you ………………….