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Big Story | Behavioural biases to be wary of in a bull market

Anand Kalyanaraman BL Research Bureau | Updated on December 15, 2020

Control your emotions — it will pay off

The market is on a gravity-defying trip, never mind the naysayers. At record highs, the Sensex is now up about 12 per cent year-to-date and 75 per cent from its March lows. It trades at about 33 times trailing price-to-earnings, higher than its past averages.

 

The sharp market run-up, especially in the past few weeks, seems to have been set off by better-than-expected September quarter results, copious foreign fund inflows, hopes of a win over the pandemic with impending vaccine roll-outs and consequent expectations of economic recovery.

 

But like many big bull runs in the past, this rally, too, could turn into a frenzy with many retail investors burning their fingers due to ‘irrational exuberance’. In this situation, a reminder on the behavioural biases that we all are prone to can be useful.

Behavioural finance principles are relevant across market conditions.

But they find more resonance in extreme markets — raging bull or bear — which induce severe bouts of greed or fear among investors.

Here are some key behavioural biases seen in raging bull markets like the current one, and how you can guard against these.

 

Herding, Recency

It’s little surprise that there has been a slew of initial public offerings (IPOs) and new fund offerings (NFOs) over the past few months.

This is a common phenomenon in bull runs, with fund raisers seeking to make the most of the cheery optimism among investors.

Retail investors often lap up these issues, not minding pricey valuations and risky business models. The heady over-subscription numbers (some even in triple digits) in many of the recent IPOs attest to this. Listing gains on many IPOs only adds to this trend.

Similarly, many buy ‘flavour-of-the-season’ stocks and sectors, lured by the quick, handsome gains made on these by the world and its uncle.

For instance, in the rally since March, the IT and pharma sectors have been among the market darlings, with the BSE IT and BSE Healthcare indices nearly doubling or more.

Sure, many companies in these sectors have benefited from the rise in demand for digital services and healthcare. Still, the rallies in some of these stocks seem surreal. Sample this: from their March lows, IT stock Tanla Platforms is up about 22 times, while Subex is up 15 times. Pharma stocks Aarti Drugs and Kopran are up 7-8 times. Tanla Platforms now sports a triple-digit price-to-earnings multiple, far higher than its 17 times average over the past three years. Subex, Aarti Drugs and Kopran, too, trade at much higher valuations than their historical averages. Also, it’s likely that many investors who missed the market bus earlier may now be tempted to hop on due to the ‘fear of missing out’ (FOMO) on the rally.

What is it?: Such investors may be giving in to two biases. One, herding — doing what others in the group are doing; in this case, buying stocks and IPOs that everyone is buying. Two, recency effect — giving more importance to recent events and expecting them to continue; in this case, the strong market rally and listing gains on IPOs.

This could cause harm. There is a good chance the majority could be wrong, as it often is, and the story may not have a happy ending. Many IPOs issued during market booms over the past two decades have eventually bitten the dust — for instance, Reliance Power and Ramky Infrastructure. Many stocks such as Unitech that were front-runners in earlier bull markets have lost over 90 per cent from their peaks. On the other hand, there is a possibility the majority could be right, too, and recent events could continue. So, how do you decide?

Mitigators: Don’t follow the herd blindly; make an objective assessment based on the stock’s valuation and the company’s prospects. A documented investment approach — the why, what, where, when and how of investing — can help build a suitable portfolio without giving in to fads.

If you can’t do this, you may be better off investing through a professional money manager who can — that is, in well-run mutual funds with a good track record.

Evaluate events independently; don’t assume continuity of recent events. Take seriously the disclaimer that past performance is no guarantee of future results.

Diversification across asset classes and within asset classes will help mitigate herding and recency. This can be done through a well- thought-out asset allocation plan (weightage among various asset classes such as equity, debt, gold, etc, that have different risks and returns) and periodic rebalancing of the portfolio, as necessary.

Overconfidence, Self-attribution

In bull markets like these, many fall to the illusion of having a Midas touch.

A bet on the Reliance Industries stock in late March, for instance, would have more than doubled the money by now.

So would have many other large-cap picks such as Infosys, Tata Steel, Motherson Sumi, Bandhan Bank, Bajaj Finance and IndiGo Airlines.

Among mid-caps, Adani Green has rallied about 700 per cent, Vodafone Idea has tripled, while Godrej Properties and Bharat Forge have more than doubled; there are a host of other big winners across sectors.

Ditto in the case of small-caps — besides Tanla Platforms that’s up more than 2,000 per cent since late March, stocks such as Ramco Systems, Aarti Drugs, Indo Count Industries, JP Associates, ADF Foods, Globus Spirits and Adani Gas have quadrupled or more.

The micro-cap space, too, has a long list of out-sized winners such as Subex, Mcleod Russel, Birla Tyres, Mangalam Drugs, Jet Airways and HDIL that have quadrupled or more.

In fact, more than 90 per cent of the BSE listed stocks have gained since late March. Most investors would have won in this round — almost like how a blindfolded monkey throwing darts at a long list of stocks would likely have come out trumps.

That’s not surprising given the depth of the market fall in March and the extent of the rise since then.

But many investors might wrongly attribute their success to their stock-picking skills, get cocky, take risky bets and finally end up losing big. They will pin the blame for the reversal on everything else except themselves.

What is it?: A rising tide lifts all boats — a truism that many investors overlook. Exhibiting overconfidence, they tend to confuse luck for skill and go for dangerous punts that backfire when the tide turns.

While they take credit for gains, the blame for loss is sought to be shifted to external factors in a display of self-attribution. Overconfident investors could underestimate risk and take on too much concentration risk, whether in stocks or sectors.

Mitigators: Make an impartial assessment of why the stocks you picked ran up — was it due to reasons you foresaw? Keep records, including reasons for investing and expected target returns, so that rationality can prevail on exits. Focus on the process, not on the outcomes. Set strict position limits in your portfolio, on both stock- and sector-specific exposure.

It will hurt to lose out on gains today, but you’ll come out on top in the long run. Goal-based investing with asset allocation and portfolio rebalancing will help avoid pitfalls.

Confirmation

A lot of the market commentary these days is on why the ongoing bull market is here to stay. This time, it’s really different, they say.

The vaccine is around the corner, India has big growth potential, low interest rates globally and in India will help, the economy will pick up smartly soon, growth could be in double digits in FY22, India Inc’s earnings revival will continue, foreign funds will continue to flow into Indian markets thanks to global easy money policies, et all — many are the reasons for optimism.

But not often spoken about, or drowned out in the chorus, are the many risks lurking that could derail the rally — high valuations; the challenges in vaccine distribution in a vast, complex country such as India; the possible bottoming out of interest rates in the country given the inflation threat; the cost-cutting-led recent revival growth of India Inc that has implications for future demand and growth; the weak state of government finances that could inhibit its spending plans; uncertain export growth prospects due to continuing global economic troubles; India’s tensions with China and other geo-political jostles.

What is it?:People have a tendency to see and hear what they want to see and hear. They focus on information that reinforces their beliefs while disregarding anything that counters their narrative. This confirmation bias can lead to risky choices such as buying more of existing stocks in the portfolio without adequate reasoning, and not paring exposures despite negative news.

Mitigators: Question your assumptions. Seek out opinions that contradict your views on a stock and assess them for validity without bias.

It is essential to incorporate the correct inputs in decision-making — even if it is not to our liking and runs contrary to our assumptions. Be humble enough to acknowledge that you could be wrong and others right.

Anchoring, Loss-aversion

The recent market rally has seen many stocks touching new life-time highs before cooling off.

This could cause behavioural trouble among many investors.

Consider a case where an investor bought a stock at ₹100 and it rallied up to ₹150. But then, the stock began slipping and has now fallen to ₹130.

Even after the fall, the stock’s at a three-digit PE and has delivered gains beyond expectations.

The ideal thing for the investor to do would be to exit at ₹130. But he is fixated with the high of ₹150 and refuses to sell below it.

Now, say the stock price falls from ₹130 to ₹80 — below the purchase price of ₹100. The investor must, in good sense, exit in quick time and cut his losses. But he doesn’t because he thinks the stock can recapture its highs.

What is it? The investor is exhibiting two biases —anchoring and loss-aversion. In anchoring, investors anchor to a number and this influences their subsequent decisions. They are unwilling to change with the circumstances. In loss-aversion, investors tend to avoid recognising losses to the extent possible. This behaviour is understandable because the pain of loss is said to be twice the pleasure of gain.

In the bargain, investors tend to hold on to losers for too long or even buy more of them in the hope of breaking even. Loss-aversion also leads to selling winners too quickly to book gains and, in the process, losing out on more potential upside in the investment.

Mitigators: When the facts change, change your mind and your investment approach. Instead of holding on to past glories, rely on fundamental analysis based on the latest information. Do not fall into the loss-aversion trap. Learn to overcome the mental pain of recognising loss.

In sum, control your emotions and base your investing decisions on rational choices, and you won’t regret it when the tide turns.

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Published on December 12, 2020
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