Almost 40 years ago, two Israeli psychologists pioneered what we now call behavioural finance. Their theories have gained credence in a variety of ways over the past decade and some of the brightest minds in finance have taken the discipline to a new level of sophistication. Yet, most finance professionals continue to function with little or no regard for the seminal insights, generated by behavioural finance.
Stockbrokers and corporate financers, for example, operate today with the same mindset and business model that they did 30 years ago. They just conduct a bit of research, call up a potential investor, convince him to place a trade and thereby, generate a commission or fee. In this column, I will delve into this disconnect between finance theory and day-to-day practice, and the implications it has for finance professionals.
Amos Tversky and Daniel Kahneman, the Israelis mentioned in the previous paragraph, have pointed out that our mind systematically plays tricks on us and thereby, pushes us towards incorrect investment decisions. For example, most of us suffer from ‘overconfidence bias’ – i.e., we are convinced that we know more than we actually do. This results in making investments based on hypothesis, which we have no way of confirming with any reasonable degree of certainty (such as I will buy XYZ stock at 20x earnings because I believe it can grow earnings at 30 per cent per annum over the next five years).
Behavioural finance remained a relatively low-profile subject until 2001 when Nassim Nicholas Taleb, a Lebanese options trader with a mathematical bent, published a path-breaking book called Fooled by Randomness. In this book and in the follow-up 2007 bestseller (Black Swan), Taleb has pointed out that we are constantly trying to fit random events around us into a compelling narrative (known as narrative fallacy). By deluding ourselves with such make-believe theories, we are leaving ourselves utterly exposed to ‘Black Swans’ – unpredictable events like 9/11 or earthquakes. And I would say that the most extreme manifestations of such make-believe theories are financial models like CAPM (Capital Asset Pricing Model) and VaR (Value at Risk), both of which are unfortunately used far more widely than they should be.
A related strand of thought, developed over the past decade by journalists like Malcolm Gladwell (Tipping Point – 2000; Blink – 2005; Outliers – 2008) and British economists like John Kay (The Truth About Markets – 2003; Obliquity – 2010) and Tim Harford (Adapt – 2011) may help us as it:
Accepts that the world around us is too complex to allow it to be framed by theories and formulae.
Says that we need to be sceptical of experts (be they economists, stockbrokers, politicians or astrologers) who claim to have a handle on the future and on the world around us.
Emphasises the need for practice and trial and error as the best route to finding out what will make us successful (as individuals and as companies).
Unfortunately, the wisdom of these intellectual powerhouses seems to have gone unnoticed by my profession which wakes up every morning to flog predictions based on theories which do not capture the complexity of our world (and which are, in turn, are fed by inaccurate and out-of-date data). This problem is even more extreme for the Indian market, given the complexity of the country, the pace of change in the economy and the relatively low quality of data. However, that does not stop hundreds of brokers, bankers and corporate houses from evincing faith in something called the ‘India story.’
So, what can we do as individuals to respond to the developments in finance outlined above? Put differently, what can we do to save our clients and our portfolios from the limitations of our own minds?
The first step, I believe, is to cut the information overload. Thanks to the Press and the Internet, we are bombarded with so much information that we get a false sense of empowerment in spite of the knowledge or the insight that the content/data being fired at us is relatively low. The remedies I use to deal with this are: I don’t have a Bloomberg terminal at my desk and don’t watch TV for more than 10 minutes a day.
One of my clients has gone even further. He does not even read the daily newspaper but relies on his weekly read of a good news magazine to stay abreast of events.
Secondly, the fewer predictions or investment decisions we take, the more likely it is that we will be in control of our faculties while making these calls. I have never seen Warren Buffett make any more than two or three big investment decisions in a year. One of my biggest clients – a giant FII – makes no more than one big investment decision per month.
Finally, 80 years ago, Benjamin Graham gave us a concept which has stood the test of time – the margin of safety. Graham has suggested that we look at unpopular or neglected companies with low P/E and P/B ratios and which ideally have hidden assets (for example, investments in other companies) which are potentially unnoticed by the market. Because fair value is difficult to compute accurately and because investors’ decision-making processes are fallible, the margin of safety gives investors and their advisors room for error.
The views expressed here are author's own and not Ambit Capital’s.