The Psychology of Investing

In the beginning of the chapter, the author recalls the concept of “Mr. Market” given by Ben Graham in his book The Intelligent Investor. Consider the stock market as a person named, Mr. Market. He is a very emotional person. He will get excited on good news and will give you higher quotes on such dates. Similarly, he gets sad very easily and will give you lower quotes of the same script in case a bad day arrives. There is one more important characteristic of Mr. Market, he does not mind getting snubbed. If Mr. Market’s quotes are ignored, he will still come back the next day in another mood. Now, it is up to you, whether you get influenced by Mr. Market, or take advantage of him.

Now the chapter shifts toward some of the behavioral finance concepts.

Overconfidence

Investors are generally overconfident that they are smarter than others. This is the major reason for the underperformance of active fund managers. This should be avoided.

Overreaction Bias

With the advancement of information technology people are overloaded with information and have the ability to check stock prices every minute. This leads to overreaction over a certain news or event which otherwise was not that important. The only fixation to this bias is to invest and don’t check your phone continuously. 

Loss Aversion

Warren Buffett advises us to be greedy when others are fearful and fearful when others are greedy. But is it that easy to do? Imagine the fall seen during the corona virus outbreak. There was blood on the wall street and hence difficult to resist fear. However, if we could understand how greed and fear affect our financial decisions, we might be able to react in a better way. 

The fear of making a loss is called Loss Aversion. 

Let's dig deeper into the concept of loss aversion. Say you are given ₹1000  and two options

1. Fixed gain of 500
2. Flip a coin, If heads – get 1000, if tails – get nothing

In a survey, most of the people chose option A. Let’s take another example,

1. Fixed loss of 500
2. Flip a coin, heads you lose 1000, tails nothing

Here, in the survey, the majority chose option B.

If you have studied probability, in both the examples, the expected cash flow was the same, 500 so you should have been indifferent ideally.

But choosing option B in the second example and option A in the first suggests loss aversion. Since a fixed loss of 500 is unbearable, we would take the risky option B, wherein the chance of losing nothing was also there. Whereas in the first example, the sure gain is preferred over bumper gain involving luck/chance. 

Loss aversion is there in our mind subconsciously and has the following effects on us.

• Preference for fixed income over equities
• Booking profits early on fear of losing the gain
• Taking more risk than warranted due to instability of mind. Remember in the stock market people are loss averse (loss fearing) not risk averse.
• Hold on to losers and sell the winners
• Tax aversion is the resistance to pay taxes. Subconsciously we want to pay less tax which leads us to generate lower income. The trick is to always count your income net of tax.

Mental Accounting

Mental accounting is when we consider money used for different purposes as different instead of both being earned in the same checking account. For example, suppose you had to pay the barber $10 but didn’t find the $10 note in your pocket. Therefore, you went to the ATM, encashed another $10 and gave it to the barber. However, later you found the same $10 note in your pocket and henceforth felt it as free money. This is a wrong notion, since both the $10 belonged to you and hence should not be considered as different.

The same happens in the world of finance, wherein you invest in bonds for your daughter's marriage and stocks for retirement income. Whereas, the correct methodology should be to estimate the future cash requirements, the risk that you can take and then design a portfolio that suits the cash flows and risk profile the best.

The Lemming Factor

This is the behavioral trait that explains the investor’s choice to follow what the majority of others are doing. Buffett wants us to consider professional money managers, who are all too frequently paid by a system that equates safe with average and favors obedience to traditional methods over independent thought, in order to help investors avoid this trap.

Managing Emotional Traps

Recovering from a loss is the most difficult task for investors and hence is an important concern for people to be able to follow the Warren Buffett Way. Warren Buffett has been able to tackle the myopic loss aversion bias and hence is very successful. He was able to do this because of the structure of Berkshire Hathaway. Berkshire owns both common stocks and wholly owned businesses. This makes him understand the value of businesses rather than concentrating just on the stock prices. 

Investors must be prepared for stock market volatility. Hence, they should only buy stocks that they may own for at least 5-10 years. Buffett says that once he buys any stock, he would be happy if the stock market closes for the next 10-years, so that he doesn’t need to think about selling.

 
Investors must be prepared for the stock market volatility. Hence, they should only buy stocks that they may own for at least 5-10 years. Buffett says that once he buys any stock, he would be happy if the stock market closes for the next 10-years, so that he doesn’t need to think about selling.

Academicians over the years have come up with a few important concepts that reduce the risks in the portfolio. The most important ones are: -

Harry Markowitz – Covariance

Markowitz proved through mathematical calculations that no investor could earn above average return (returns more than the index) without assuming above average risk. He devised that diversification of the portfolio should be done by looking at the covariance of the stocks with respect to the index. The more related a stock is to the index, the higher the risk that both will move down simultaneously.  Hence a risky stock may be a conservative investment if its covariance with the market is negative or if it moves in the opposite direction to the market. Hence you will outperform when the market underperforms. 

Eugene Fama – The Efficient Market

Market is efficient and information is available to everyone. Hence it is almost impossible to outperform the market.

Bill Sharpe – Capital Asset Pricing Model

There are two types of risks, systematic and unsystematic risk. 

Systematic risk is the risk of the market and can not be diversified away. Unsystematic risk is the risk of an individual stock and can be diversified by holding a large number of stocks in the portfolio. For example, the GDP growth decelerating is a systematic risk and hence all the stock operating in India will go down if the GDP falls. On the other hand, Satyam filing for bankruptcy post the fraud disclosure was an unsystematic risk and hence can be diversified by simply holding a large number of stocks in the portfolio or keeping a cap of individual holdings as a % of the total portfolio, say any stock cannot be more than 5% of the total portfolio.

As we have already read, Buffett and Munger disagreed with all these theories of diversification. Their understanding was that if you know the business well and you buy it at a reasonable price, the risk is diversified away.