A great piece by my friend Mangesh Ghogre and Vivek Kaul. A must read for stock market investors.
Why you lose money in stock markets
Why you lose money in stock markets
March 24, 2005
(reproduced with permission)
It is the investor's dream come true: the Bombay Stock Exchange's Sensex and the National Stock Exchange's Nifty are scaling all-time highs.
In fact, in the last 6 months, both the indices have risen by 18.74% and 19.79% (considering the period from September 21, 2004 to March 21, 2005), respectively. By any standards, the Indian stock markets are witnessing a bull run.
Economic theory tells us that, ceteris paribus, higher prices dampen demand and lower prices increase demand. But when the stock market witnesses a bull run, investors do not behave like normal consumers.
As the stock prices go up, the more stocks appeal to investors. This leads to investor psychology during a bull run that is detrimental to the investor as well as for the market.
No wonder some investors end up making losses. Let us see how.
The herd mentality
Robert Shiller in his book, Irrational Exuberance, says, 'A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times.'
Marketing research has shown that the typical Indian buyer's decision is heavily influenced by the actions of his acquaintances, neighbours or relatives. Psychologically, the desire to conform to the behaviour and opinions of others, a fundamental human trait, is what drives such buying behaviour.
So if everybody around is investing in the stock market, the tendency for potential investors is to do the same. Like sheep in a herd, investors in a bull run find it cozy to be inside the herd rather than outside it.
The Ant Effect
Another interesting observation during a bull run is the order in which investors take decisions. Ants, when they get separated from their colony, obey a simple rule: follow the ant in front of you. Much like the circular mills of the ants, investor decisions are made in a sequence.
People, who invest in the stock market during a bull run, assume that investing in the stock market is a good bet simply because some of the people they know have already done the same and made profits.
Consequently, during a bull run the stock market has more buyers than sellers. Expectedly, stock prices zoom up. Expecting the bull run to continue, more and more investors enter the market, fuelling an even greater price rise and this cycle gets repeated.
Riding the bull wave, stock prices of fundamentally weak stocks also start to go up. Driven by unrealistic expectations, these unsustainable prices soon start to tumble and the bubble eventually bursts.
At times, investors know that the stock they are investing in is fundamentally weak but they are still willing to invest in the stock, because they feel that some greater fools could be depended on to invest in the stock after they have and this would give them handsome returns on their investments.
Greed
Investors are human, after all. So, the lure of quick wealth is difficult to resist. During a bull run, stock markets offer astonishing returns in a short period of time as compared to other investments. This helps in attracting more money into the stock market.
If we look at the present scenario in India interest rates on a six-month fixed deposit with a bank stands at around 5 per cent per annum.
Other investment opportunities like the Public Provident Fund, Kisan Vikas Patra, etc do offer better interest rates, but the investment is locked up for a significant period of time.
If one compares this with investment in an index fund (let us say an index fund that mirrors the BSE Sensex), the six-month return on it would have been a whopping 18.74% (considering the period from September 21, 2004 to March 21, 2005). Given this it becomes very difficult to stay away from the stock market.
Greed also results when investors see people they know making money through investments in the stock market. As Charles Kindleberger wrote (in his all-time classic Manias, Panics and Crashes), 'There is nothing so disturbing to one's well being and judgement as to see a friend get rich.'
This leads to more people entering the stock market without really understanding the market.
Rear view mirror driving
Investors in general, and especially during a bull run, tend to look at the recent past pattern and assume that the future patterns will be identical to the past ones. This is as good as driving a car looking in to the rear view mirror.
A rear view mirror-driven car will not meet with an accident as long as the road ahead of the car is exactly as it is behind the car. This is rarely the case, both on roads as well as in the stock markets. But, when the stock market is on an upswing, the more investors tend to believe that it will keep going up forever.
They mistake probability for certainty. They pump in more money into the stock market and this always does not go into the right stocks.
Mental accounting
Richard Thaller, a pioneer of Behavioural Economics, coined the term 'mental accounting', defined as 'the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent.'
Research in Behavioural Economics shows that gamblers who lose their winnings typically feel they haven't lost anything. The fact though remains that they would have been richer had they stopped playing while they had won enough.
Investors during a bull run tend to behave similarly. Once they have got a certain return on their investment they tend to plough all their returns back into the market. When such money goes into fundamentally weak stocks, investment essentially boils down to speculation.
In closing
Individual investors, while investing during a bull run, ignore the most fundamental principle of investment: high returns come with high risk.
And in the euphoria to make quick returns, investors forget the risk involved in the stock market investments.
Individuals logically should seek information on where to invest. But most investors do not. Few ask the right questions at the right time and are naïve enough to go with the crowd.
From the point of view of business no one on the Dalal Street has any reason to suggest that the market (or for that matter a particular stock) is overpriced. Investors need to find out.
The greatest damage happens to those investors who buy fundamentally weak stocks when prices have peaked. When the price of such stocks come crashing down the confidence of the investor in the financial system plummets.
Investors become reluctant to part with their money. This in turn hampers the ability of the capitalist system to raise capital for newer ventures. Also the financial market ends up
misallocating resources and it creates unnecessary risk for ordinary citizens.
Investors should remember that bubbles are caused by excess cash coming into a particular investment theme.
Thus, investors during a bull run need to be careful and not put all their eggs in one basket. They need to spread their investment across stocks and if possible stay invested in other assets as well.
Further, an investor should have a good idea of the business of the company he is investing in. Hopefully, this will help him to make an informed decision.
Even as you read this, chances are that you may think: 'This will not happen to me.' And this false notion is at the root of all the problems. So, ensure that your investments are based on strong company and industry fundamentals and not just hearsay.
Happy investing!
Vivek Kaul is Research Scholar, ICFAI University; and Mangesh Sakharam Ghogre is a Mumbai-based freelance writer and a keen observer of the stock markets.
