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Tuesday, Apr 27, 2004

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Behavioural finance as investment concept

Virendra Verma

Mr Parag Parikh

BEHAVIOURAL finance is a new subject in the field of finance and is very popular in stock markets across the world for investment decisions. However, in India, this subject is not used too much in the stock market. But Mr Parag Parikh, Chairman of Parag Parikh Financial Advisory Financial Services, has been applying the concept of behavioural finance while investing in the stock market. Mr Parikh, who has studied behavioural finance at Harvard University shares his views and experiences on this emerging field .

Can you explain what behavioural finance is and how it works?

Behavioural finance is the study of investors' psychology while making financial decisions. Investors fall prey to their own and sometimes others' mistakes due to the use of emotions in financial decision-making.

Behavioural finance tries to understand how people forget fundamentals and make investments based on emotions.

How does it work in the stock market?

Stock prices move up and down on a daily basis without any change in the fundamentals of the companies. I call this crowd behaviour. If you see people in the stock market you will observe that they move in herds and this influences stock prices. To put it slightly different, theoretically, markets are efficient but in practice, they never move efficiently. For example, if a company announces mega investment over the next few years in an emerging area, the stock price of the company starts moving up immediately without looking into the prospects, returns or the amount of investment to be made in this project. That is how the behaviour of investors moves the stock price.

You mentioned about crowd behaviour, how does it work in the stock market?

Most of the crowd (investors, analysts, fund managers) is constantly involved in beating the markets. They try to do this in a number of physically difficult ways. They come to the office early and stay late.

They read a large number of reports very rapidly. They are always busy with meetings throughout the day and even more meetings over dinner. They are on the telephone making calls and receiving more calls through most of the times. At office they try to catch the CNBC news and at home they are again excited about the Nasdaq movements. They carry huge reports home determined to read them at night or before the next day. When they are mobile they are busy on their mobile phones. In every way they put tremendous amount of physical energy and effort to try to beat the market by outworking the competition. But they don't realize that this is the most mediocre thing to do, since everyone is also doing exactly the same.

Then what one should do to maximise returns or beat the markets?

Most of us are not blessed with the intellectual or physical competence of the various market players (fund managers and analysts). Therefore, one should simply work out a long-term investment policy, which is right and be committed to it. This is a very straightforward and an untiring approach. At the same time it is an emotionally difficult approach.

What about the short-term traders who buy and sell regularly?

If you look at the traders and their overall profits, you find that in effect, they make similar profits as long-term investors. This is because they pay large amount of their profits to brokers as brokerage fee and other transaction charges. In addition, they pay short-term capital gains tax, which is higher than the long-term capital gains tax. But if you are a patient long-term investor, your portfolio in most case is likely to give similar returns. In some cases it can be much higher, not to mention, less tiring.

Can you tell some of your experiences where crowd behaviour has helped you make good profits from stock market?

In the late 2002 and early 2003 when the debt funds were giving good returns and the stock market was down, I observed that there had been increased inclination towards debt. Even equity mutual fund schemes were investing in debt and this clearly showed that the market was ignoring equities. At that time, when the stock prices were at rock bottom compared to current prices, we started buying into equities and also advised our clients to go for equity. The results are now in front of everybody.

Investors are always eager to take stock tips from their stockbrokers, friends and neighbours. In this situation to what extent does behavioural finance help?

When your friends tell you about a great investment opportunity, which could be a ten bagger, and they feel that it is a great time to buy else an opportunity will be lost, don't buy. Be absolutely uninterested. When they tell you that the market is going to crash and the stock prices will nose dive, don't sell. Be absolutely disinterested. Here you do not require any intellectual effort or any physical effort. Just control your emotions. Do not get carried away by market sentiments. They only help you make blunders. Believe in yourself and the investment policy you have committed yourself to.

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