In an interview with ETMarkets, Chandan said: “It is better to think independently from the narrative and verify whether the crowd is overreacting or underreacting,” Edited excerpts:
With the markets reaching all-time highs, many retail investors may experience “FOMO” (Fear of Missing Out). How can investors manage this emotional urge to invest at peak levels without considering fundamentals or long-term goals?
Neuroeconomics says we are naturally inclined to think short term and prone to emotional reactions and biases. FOMO during such markets is hence expected.
Additionally, some investors who might have booked profit early and hoping for a correction to re-enter the market may be driven by regret.
Good planning and disciplined execution are required to navigate these markets. Firstly, create an asset allocation plan or a financial plan that addresses your long-term goals.Consider the base rate of long-term returns in the equity market and volatility. When crowd is excited about some theme or sectors, it takes those areas to high valuations.
At the same time, there will be other areas which market has ignored (due to short term troubles) where you may find good long-term investment opportunities.
One can also take professional advice to design a long-term investment plan to help on this wealth creation journey.
Retail investors often exhibit herding behavior, following the crowd during market rallies. What steps can be taken to avoid this tendency and make more rational, data-driven investment decisions?
It is tempting to be part of the crowd and indeed painful to avoid the herd instinct. Contrarian investing (going against the crowd) is more about the emotional strength (Behavioral Edge) than knowledge (Information Edge).
Swaying with the pendulum of market mood can compel the investor to buy during a bubble and sell during a crash. But it is important to understand that such behavior will not lead to superior returns.
It is better to think independently from the narrative and verify whether the crowd is overreacting or underreacting.
This requires research on businesses for valuations and megatrends; and then developing an investment process that helps independently access these aspects.
Market highs can lead to overconfidence bias, where investors believe their recent gains are a result of their skill rather than market conditions. How can retail investors remain grounded and avoid making risky, speculative decisions driven by overconfidence?
Overconfidence leads to mistakes in investment decisions and to investors taking too many risks. Overconfidence is a consequence of a few basic biases.
The first is confirmation bias, which can be addressed by seeking out counter arguments to our own ideas.
Another important source of overconfidence is the Availability Heuristic: a tendency to assume that our memories are a representative sample of reality.
To handle this heuristic, investors need to follow a set process which involves collecting the right data and calculate probabilities of risk and return correctly.
Being successful at one investment can lead to illusion of superiority and overconfidence in the ability to consistently deliver favorable results.
It is important that investors keep an investment journal to later analyze and dissect the outcome between luck and skill thereby aiding better decision-making.
During market booms, investors tend to anchor their expectations to recent market performance, expecting the trend to continue. How can investors break free from anchoring bias and adjust their expectations realistically for future market movements?
Anchoring bias may not be avoidable, but decisions can be guided to the right data with conscious effort. Some of the ways to handle anchoring: Assume that one is always vulnerable to anchoring to noise and hence consciously remove irrelevant information or noise from discussions.
Fundamental investors are better off focusing on fundamental values rather than anchoring on technical data. Always, try to find a counter argument.
Make an independent estimate of the company before looking at market valuation. And finally, use long term trends and base rate to forecast.
Many retail investors may feel the urge to chase high-performing stocks or sectors due to recency bias. What strategies can be implemented to avoid this short-term focus and instead maintain a diversified, long-term portfolio?
Investors must understand that stock markets are a combination of business and sentiment cycles. To understand these completely, one must use long term data.
Short term patterns or recent data show only a part of the picture and often do not represent long term data. There are many studies that show the impact of momentum and reversal.
Some of these tools can be used to see if the crowd is overreacting to good news or bad news. Overreactions lead to reversals and underreaction leads to momentum. After a good understanding of these aspects, prepare a long-term plan and implement it with discipline.
In times of market highs, confirmation bias can lead investors to only seek information that supports their bullish outlook. How can investors cultivate a more balanced perspective by considering contrary viewpoints and potential risks?
Once we make an investment, we actively search for reassurance and confirmation for our actions. We love meeting people who have something good to say about it.
This is confirmation bias, and it has a significant impact on our investment decisions. There are two important tools to manage confirmation bias. The first is having a friend or a team member act as a “devil’s advocate”.
Here the person will help you with all the counterarguments and risks about the investment made. This will help understand and prepare for those risks. The second method is called “premortem”.
As the name suggests, it is the opposite of post-mortem and involves thinking back from an imagined future. It is like creating a bull case and a bear case scenario for the investment and helps understand the risk and rewards better.
Investors may face the “disposition effect,” where they hold on to losing stocks for too long and sell winners too quickly. How can retail investors overcome this bias and make more objective decisions about when to buy or sell assets?
Disposition effect is a result of a problem in the sell discipline of the investors. Unfortunately, not much attention has been given to this aspect in the investment literature.
Pre-commitment is an idea that can help handle disposition effect. Whenever an investment is being considered, make a scenario analysis and design stop-losses or triggers that will make you change the stance.
It is better done before the money is committed to the investment and when one is not emotionally attached to the asset. Set up automatic stop-losses, portfolio shifts from one asset to another and event triggers to avoid falling into the trap of disposition effect.
Market highs can cause a “wealth effect,” making investors feel wealthier and more inclined to spend or invest aggressively. What are the potential dangers of this mindset, and how can investors ensure they stick to a disciplined financial plan?
This impact is also called the house money effect. A nonprofessional gambler will typically have money in two mental accounts: the own money account and the ‘house money’ account.
The profits from winning are kept in ‘house money’ account (casino being called the house). The gambler treats this money differently as she assumes that her own money is safe with her, she is just gambling with the money she has taken away from the casino.
Unfortunately, the risks she takes with this money will be higher than amount in the own money account. This effect is seen in traders too. After an initial success, the house money effect makes them take larger risks.
This stops them from moving smoothly towards their financial goals. Ultimately, they lose the money back in the market. Investors need to stick to the investment plan even when they make more returns than they expected.
With markets at record levels, many retail investors might struggle with “loss aversion,” fearing future corrections or losses. How can they manage this fear without prematurely exiting the market and missing out on further potential gains?
In the long-term equity markets generate good returns for investors. However, many keep looking at short term movements and fall prey to “myopic loss a version”.
They are worried about corrections in the market and hence exit prematurely. It is difficult to time the correction. Rather than looking at prices and basing your decisions on price fluctuations, focus on fundamentals and only change the stance if there is a material change in your forecasts on fundamentals.
How can investors maintain emotional discipline especially at a time when markets are hitting record highs almost on a daily basis?
Prices are more volatile than fundamentals, stocks are more volatile than portfolios. Have a broad framing view of the asset allocation plan. Plan long term and stick to the plan.
Don’t refresh and reevaluate the portfolio on a daily basis. Understand the difference between information and noise. Keep an investment journal to record your decisions. And finally, use a good investment process for your buy and sell decisions.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
