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Value Investing And Behavioral Finance

Lessons From The Chapter Understanding Behavioural Traits

What Makes Investing Risky?

According to the previous study, corporate earnings have steadily increased over the 16 years under consideration, resulting in a compounded rate of return of around 16 per cent, as reflected in earnings per share. Earnings fell only during the three years from 1998 to 2000, which is explained by the fact that many good profitable companies comprised the Sensex were replaced by low profit-making information technology companies simply because the IT sector happened to be a "fancy" sector. Investors were willing to pay exorbitant multiples for such stocks in the hope of making large profits in the future.


Even this drop in earnings can be viewed as an outlier. As a result, earnings, in general, have been consistent, reliable, and sound over the last 16 years. This is reflected in Sensex's compounded return of 18 per cent over the same period.


Sensex's yearly return, on the other hand, was far from consistent due to irrational investor behaviour. This highlights an essential aspect of equity investing. The returns are determined by the companies' earnings that comprise the Sensex and changes in the PE ratios.


Acquisition Price Determines Stock Returns

The change of PE ratios over time reflects changes in investor sentiment. These changes could be caused by various factors, including:

  • Changes in the business environment 
  • Changes in a company's fortunes, 
  • Changes in sectoral performance 
  • Macroeconomic factors 
  • Government deregulation
  • Overall optimism or pessimism.

These factors can provide excellent opportunities for investors who are on the lookout for such behavioural mispricing. This is abundantly clear when we consider the stellar performance of companies from 1995 to 1997 and the returns on the Sensex—these three years presented enormous opportunities despite a tremendous amount of pessimism in the markets. The negative speculative element almost threw up great deals.


During this time, corporate earnings increased from ₹113.8 at the end of 1994 to ₹270.8 at the end of 1997, representing a 33.6 per cent CAGR in earnings. The Sensex, on the other hand, fell from 3,927 at the end of 1994 to 3,659 at the end of 1997, for a negative –6.8 per cent return. When we add the 4.1 per cent dividends received during this period, we get a negative 0–2.7 return from the Sensex. What accounts for the anomaly of a 33.6 per cent CAGR in earnings resulting in a –2.7 per cent return for shareholders? Excessive optimism prevailed in 1994, and investors were willing to pay high valuations, as reflected in the high PE of 34.5.


However, due to the high PE, the fundamental performance could not be translated into commensurate returns for the shareholders.


During the years 1995/6/7, investors profited greatly because the prices they paid were significantly lower than the fundamental values due to excessive pessimism.


Stock returns are determined by the purchase price.


Mr. Market Oscillates between Greed and Fear

The anomaly mentioned above was not a one-time occurrence. It happens again and again as the markets swing between optimism and pessimism.


Markets are made up of emotional people who make decisions based on the current mood of the environment. At times, they exhibit greed, but this greed is displaced by fear at other times. Stock prices become volatile due to bouts of greed and fear, trapping investors and causing them to lose fortunes.


Corporate earnings increased at an 8.8 per cent CAGR (Compound Annual Growth Rate) from ₹195.6 at the end of 2000 to ₹231.1 at the end of 2002, but the Sensex delivered a negative –14.9 per cent return to investors. The figure fell from 3,972 at the end of 2000 to 3,377 in 2002. When we add the 3.9 per cent dividends received during this period, we get a negative –11 per cent return from Sensex.


Corporate and shareholder performance can be opposed. Equity investing appears to be a risky proposition due to the investor's behavioural traits and the market's crowd behaviour in general.


A wise investor can identify bargains by being aware of and controlling one's emotions, as well as understanding the behavioural anomalies of others. Your Self-Control


Returns are determined by fundamental performance and the price paid for that set of fundamentals. Paying 25 times recent earnings for a company and then expecting it to grow at a rate of 25% over the next few years can lead to disappointment on two fronts. First, if and when earnings fall short of expectations, say by 25%, and second, losing on the speculative return front, i.e., a change in the PEs.


It is critical to be disciplined in your investment approach.

Opportunities do not come along every day, and one must be prepared and ready with money when they do. Unfortunately, investors tend to chase stocks when they receive tips, and they become such engrossed inexpensive stocks that they lack the funds when the markets tank and opportunities arise.

Proper discipline and courage are demonstrated when you buy when you do not feel emotionally inclined to buy and sell when your heart says no, but your mind and logic say yes.


Key Takeaways

One may be a winner or a loser in any given year due to changes in speculative interest driving the markets. Still, the long run distinguishes a true investor from a speculator. Just as an investor would try to be subdued during periods of optimism because his fixation is not only on the recent twelve months' profit and next year's expectation but on the long-term trend of the enterprises' earnings and profitability, a speculator will be fixated on the recent earnings and growth projections and be willing to pay a high premium for the current set of earnings, leaving him in a position where he may not be able to reap the profits of a bull market.


On the other hand, a true investor would wait for the period of optimism to pass before selecting opportunities in which the future is not favourably discounted into the price, allowing the stock price to catch up with the business fundamentals through PE expansion. All the while, he would look for companies where the fundamentals could continue to thrive, giving him a double whammy. For one, an increase in earnings will contribute to fundamental returns. For two, positive speculative interest in the stock or sectors will result in earnings expanding from low PE to moderate or high PE ratios and superior returns over time.


Equity as an asset class has provided attractive returns while investors have fared poorly, demonstrating erratic behaviour. We must recognise that we are human beings with hearts and minds. We must make decisions with our minds. We can use our minds to determine whether a stock is expensive or not, whether we are paying for its fundamental value or not, the amount of speculative interest and its reflection in the price, the value you are receiving concerning the price you are paying, and the general market sentiment, whether bullish or bearish.

However, when you use your heart, you tend to follow the herd and do what they are doing. If everyone else is buying, you'll start buying, and you'll end up spending a lot of money. Similarly, if everyone else is selling, you will sell and thus sell cheaply. As you become a part of the crowd, you are moved by market emotions and do foolish things that harm your financial interests.


You chase stocks because you get greedy when others get greedy, and you end up buying stocks at high prices. But, in reality, you must be greedy when others fear buying stocks at reasonable prices.


Because we are emotional beings, we tend to make decisions based on our emotions, which may not be in our best financial interests.


This emotional behaviour is evident in the stock market, where we oscillate between our basic emotions of greed and fear. Our emotions become eruptive because stock markets are volatile, and the results are all about making or losing money. Greed and fear are fueled by money. The challenge for a successful investor is to control one's emotions and not be swayed by emotional outbursts. Being calm in the face of market turbulence will aid one's ability to be a successful investor.

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