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Primer | How not to be swayed by greed and fear while investing in stock markets

Traditional finance theory – the Capital Asset Pricing Model (CAPM) in particular –  makes many assumptions. The rationality of investors is arguably the most important of them. It assumes that all investors arrive at the same opinion about each stock in the market, and that opinion is based on their analysis of company fundamentals.

However, as the working of the real market suggests, this is rarely the case. In fact, one may go so far as to say that investors’ rational decisions are often vetoed by irrational behavioral biases, be it fear or greed.

Why does an overpriced stock keep going higher? The answer is greed, or ‘FOMO’ – fear of missing out.

When an investor sees a stock clocking 10 percent return every day, greed takes over, and she has this urge to jump on to the bandwagon. Too many investors jump in, and that drives the stock up even higher. This starts a vicious cycle – the more people that buy in, the higher the price goes, thus attracting even more investors and driving the price further up. This vicious cycle keeps driving the price to unrealistically higher and higher levels.

Until when?

Until fear kicks in. Someday, during the stock’s happy ride up, an investor starts to have doubts: Is the stock really worth this much? Weren’t there rumors of corporate governance issues in the company?

She decides to stay safe, and books her profits. And word spreads. Then panic sets in. Eventually, each of those happy investors, who were part of the bandwagon, is in a rush to get out, driving the stock price lower and lower.

What’s interesting is that all this chaos in the stock’s price may happen even without any significant change in the company’s fundamentals!

The alert reader might ask who starts the rally or the selloff in the first place. Who is the driver of this bandwagon that people jump into and out of in a blink of an eye? Often, the answer is “pump-and-dumpers”.

Perpetrators of this illegal stock manipulation scheme first pump up the stock price by spreading positive rumors about the company, and then, dump their own lot when the price is high enough. They make a killing by exploiting the greed of the gullible (usually retail) investors. A reverse Robin Hood effect ensues – retail investors use their hard-earned money to bulk up the wallets of the rich pump-and-dumpers.

But what is the solution? How should a retail investor protect her investments? The short answer is to go strictly by fundamentals and stay invested for the long-term.

Market-manipulators can maintain a propped-up price for only so long. If you buy into a quality company with great future prospects, and ride it out through the market-manipulation driven gyrations and economic cycles, long-term wealth creation is a near certainty. Howsoever simple this answer might seem, it is not easy to implement. It is but natural to experience FOMO when a stock you are not confident on keeps scaling new heights, or to panic when your holding plummets. So, we need a solution that is not just simple, but also effective.

The answer lies is investing through quantitative portfolio managers (not to be confused with portfolio managers who use technical analysis). This admittedly obscure species of fund managers make no bones about basing their investment decisions on numbers and numbers alone. With the help of statistical techniques and exponentially rising computational power, they look at all companies in their universe; screen out the ones with poor fundamentals or low liquidity, and cherry-pick from what’s left. Again, this cherry-picking is based on hard facts, and not gut feelings. In other words, they follow rules-based strategies, and stick to the rules unless of course, there is sufficient evidence to the contrary.

So, if quantitative investment is the savior that I am claiming it to be, why isn’t it more popular?

It is actually quite popular, just not in India. In fact, 90 percent of the trading volume in US is quantitatively invested. Quantitative finance is a $1 trillion market according to Global Algorithmic Trading Market 2016-2020, and is growing at more than 10 percent a year. In India, however, the concept is not formalized yet; Indian investors might have heard of factor investing or systematic investment, which are nothing but flavors of quantitative investing. In the end, it is just a matter of time before quantitative investing picks up pace in India and becomes a way of life.

In subsequent articles of this series, we will look at the investing world through the lens of quantitative investing after going through the pitfalls of some of the most prevalent behavioral biases.

(The author is an associate portfolio manager with Reliance Capital. Views are personal).

This is the first of a series of articles that will be published every Monday on how to avoid irrational behaviour while investing.

[“source=moneycontrol”]

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