Understanding human behaviour and stock market gyrations

"I try to get rid of people who always try to confidently answer questions about which they don't have any real knowledge"- Charlie Munger (Buffet's Devil Advocate)

Today's post is a bit different. It is not related to any particular sector or macroeconomic headwinds. We would try to identify the role of human behavior in investing/trading and how efficient market hypothesis does not hold true as long as humans are the participants in trading or investing. This post would cover the following subjects:

• Explanation of most common Human Biases
• How stick market experience bull and bear phase
• Efficient market theory (EMT) and how human behavior negates EMT
• Examples of assets (majorly equities) exhibiting glaring human biases

A short story to start with: Shortly after 1550, the growing affluent class of Holland was introduced to Tulips. Due to their aesthetics, they were well sought by these classes. However demand soon overtook supply and the prices of Tulips started rising. At one point in this frenzy, tulips were accepted as a dowry from bride. Furthermore, witnessing the price increase, middle class population mortgaged their real estate to buy the tulips and resold it at higher price. In 1637, this frenzy came to an end when people started doubting whether the price would continue to increase. As a result, the price of tulips crashed leaving behind a financial mess for middle class in Holland.

This episode, know better as Tulipmania, is always quoted as a lesson of consequences of human greed in case the asset price goes way higher on account  of excess optimism. In this version, we will take a look at the 5 most important cognitive biases which affect decision making while evaluating different options to invest:

1. Loss Aversion: This principle states that the humans are more likely to avoid losses than acquiring equivalent gains. In other words, the loss of Rs 100 is much more painful than the joy of gaining Rs 100. This loss is twice as powerful as joy which is incurred by gaining. To avoid experiencing the pain of loss, an investor would continue to hold the bad investment even after the losses continue mounting. This is because he/she does not want to experience the realized loss by selling the asset
   
2. Hindsight Bias: Hindsight bias is the tendency to see an event as predictable after it has occurred although there is no objective basis of predicting it. As an illustration, people generally say that 2008 sub prime crisis had been avoided. All the indications were present for the impending crisis. However had it been so simple, the crisis would have never occurred at the first place. On the contrary, people who objected to the practices at that time were laughed at and rejected
3. Anchoring Bias: This is the tendency to rely on the first information received while making decisions. If two companies A & B of the same sector and exactly the same business with the same EPS, free cashflows, EBITDA are valued at 100 and 1000 respectively and if the investor is shown A and then B, he/she would find B expensive and A as normal. On the other hand if he/she is shown B first and then A, the investor would perceived A as super cheap
4. Recency Bias: Tendency to believe that what occurred in recent past would continue to happen in future. In India, the consumer goods trading at expensive valuation is case in point. People become overly optimistic on observing the continued good performance by FMCG majors and hence command them expensive valuation
5. Confirmation Bias: This is the tendency of people to pay close attention to details which confirm their belief and ignore the information that contradicts it. As an illustration, an investor holds Indiabulls housing in his/her portfolio. As an early warning of corporate misgovernance,  the investor tends to ignore the signal confirming to his/her belief of positive outlook. As a result, the investor ends up loosing ~70% of the value

For detailed understanding of biases, there is always a better source which I always refer to: (https://fs.blog/blog/). These are the reasons why stock markets gyrate. As an illustration:

 I recently saw amazing results reported by Yesbank. I buy the stock as an affliction to recency bias hoping that the same performance would continue. I continue to hold the stock due to confirmation bias I possess for the belief of the positive outlook. As signs of corporate misgovernance seeps in, I tend to not sell the stock due to my loss aversion and ultimately I realize a huge loss.

This is the precise reason why the market gyrates. Common wisdom flock on the stock and shoot the prices at insane level. Once the company announces "not so good" results, the investors drive down the prices as a result of fear. A shrewd investor spots the opportunity precisely at this time and hence able to multiply his/her wealth manifold.

Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) states that the share price in the markets reflect all underlying information and consistently beating the market is impossible. The proponents of this theory do not take into account the human behavior and consistently underpin humans as a rational entity. The fact of the matter is humans are always irrational and due to this behavior, the markets experience bull and bear phase

The most famous rebuttal to this theory was given by Warren Buffet in his famous speech "The superinvestors of graham-and-doddsville" (Link).

I will consider only one example in this post:Selan Exploration Technology Ltd. According to current market price, the M-Cap of the company is ~Rs 210 Cr with no debt. Let's have a look at its annual report

 A company with (132+14 = 146) crores in investments and having MCap of ~210 crores deserves another detailed look. Another look at its investment annexure:

The company has parked all its money in Mutual funds. Also the Free cash flow for the company is ~60 crores. Now a company having a net value of 64 crore (210-146) is generating an FCF of ~60 crores. That is a pretty interesting proposition for an investor. Also the company is having reserves of 88 MMBOE (Million Barrels of Oil Equivalent). Even if I consider 10% to be extracted in Phase 1, I am looking at the oil reserve of Rs 3200 crores to be extracted over the period of ~10 years considering their current extraction capacity.

So much so for the Efficient Market Hypothesis (EMH). One of my best post for understanding EMH rebuttal would be Prof Sanjay Bakshi's post : Link

As long as humans are the participants of markets, a rational investor would find the ways to multiply his/her wealth in a long term. The way out is to stay patient and become aware of human biases afflicting the decision making.

~Disclaimer: I do not endorse any opinion on investing or on any stock. These are my personal views. An investor making the investment based on this article, is liable to his/her losses without my involvement.

Special mention:

• Hersh Tolani (Linkedin)
• Parth Joshi (Linkedin)
• Dhiraj Bedi (Linkedin)
• Vinit Rane (Linkedin)