January 7, 2015

Emotions and investing

We are all supposed to be perfectly rational, supercomputers that can do a discounted cash flow analysis on every investment idea we come across. If this is not enough, we are also supposed to be able to compare all investment options at the same time, before making a decision.
This is what most ivory tower professors would have us believe (except one ). Ofcourse this does a lot of disservice to a budding investor, who feels stupid when he or she lets emotions creep into the decision process.

I have invested for around 15 years now and in the countless investors I have followed, I have yet to come across anyone who comes close to this mythical investor. For the ordinary investor like me, I find it far more useful to acknowledge my irrationality and learn to work with it. Although there are no universal rules to managing emotions when investing, let me share my experiences as some would definitely be instructive.

Let’s start with a list of some commonly felt emotions and their impact –

Think back to August – Oct 2013. Rupee dropped close to 71 to a dollar. Current account deficit was around 5% and at the risk of expanding further. The Indian government led by congress was in a state of paralysis. The net effect – The stock market dropped close to 10%. The same story had occurred in 2003, 2008-09 and 2011.

Inspite of the economy and market coming back after a few years in the past, a majority of the commentators and investors decided to stay away from the market. This is even more surprising considering the fact that Mid caps and small caps were selling at 5-6 year lows and some highly profitable and growing companies were available at decent valuations.

My thinking: It is not that I am immune to fear and pessimism. I felt equal depressed about the state of affairs and angry with the government. However, during such times I go by my sense of history (past record of the stock market) and valuations. If the company is doing well and available at decent valuations, I will buy the stock without worrying about when I will be proven right. How does it matter if the stock doubles in one year or the end of year three?

I don’t have to go far on this one. Look around now – after almost five years, the small investor is now coming back. We have mutual funds advertising the last one year results and people are now getting excited about equity after a 55% rise from the bottom.
This is a very predictable pattern. Gold increased by 19% CAGR from 2001-2011 and everyone was bullish about gold.

Indians, with a perennial love for gold, found one more reason to buy it and anything associated with gold such as jewelry companies got swept up in the same euphoria.
Gold is down 25% now and so are gold related companies. As far as I know, I am not seeing analysts recommending gold or gold related companies now.

So the emotion of greed is obvious – once we see others make money, it is easy to be envious and follow the crowd. The result is predictable too – The last people to join the herd also lose the most money.

My thinking: I have a standard thumb rule. Do not buy something which almost everyone is recommending. If I do buy into something which is the current flavor of the market, I try to move slowly into it so that I don’t lose much if the tide turns. In addition to that, I won’t buy something I don’t understand. For example – I was never able to understand what the true free cash flow for most gold companies is (except titan industries), considering all their profits are generally eaten up by inventory. As a result, I just stayed away from them.

Love and security
Now this is not an emotion, one associates with money and investing. I did not consider it relevant for a long time, but as I think about gold and real estate, I can see the role of these two key emotions

I first realized the importance of love and security as an investment criteria when my mother tried to convince me to buy gold to secure the future of the family. I tried to explain that equities give a better return, but soon realized that there was no way I could convince her.  Of course, she decided to take matters in her own hands – she went and bought some gold for the family and said that that was her way of providing security to the family :)

The effect of emotional attachment is very high with gold – When it goes up, people justify its purchase based on the price rise. If it goes down, the justification changes to it being undervalued or being a hedge against catastrophe or any other reason you can think of.
If you still don’t agree with me – go to your spouse or any other member of you family and suggest the following: Please hand me your gold, I will sell it and invest it in a higher return instrument. In X number of years from now, you can buy more gold than what you have now. I have tried it and I am scared to use the two words ‘gold and sell’ again in the same sentence :)
If you think, love and security alone explains the fascination for gold – think again. I always found it irrational to buy gold or even real estate (beyond your housing need) if all that you are looking for is high returns.

This thinking changed when my family and in-laws felt that I had finally arrived in life when I bought my own flat with a big loan and essentially signed my life to the housing finance company (read EMI!). I never got any praise for buying an asian paints or any other long term compounder , whereas the flat was a concrete evidence (no pun intended) that I was doing something right in life

There is a tangible quality to both gold and real estate. You can see it, feel it and even flaunt it . In the past one could look and touch the stock certificates, but now with demat accounts what are you going to show others?

Imagine this fictious dialogue

Mom to her friend: My son has finally arrived in life! he bought a 1000 sqft flat in XYZ location. We are going to grah pravesh (house warming). Why don’t you join us? <so that she can show the house and feel proud>


Mom to friend: My son bought 1000 shares of asian paints. Let me show you his demat account! you know this company has a sustainable ……… will this dialogue ever happen!!

It’s the same with gold. Your wife or mother can wear the gold and in a lot of cases this serves to signal that the family or husband/ son is wealthy.  So gold and real estate actually help in feeling secure or in displaying wealth. It is incidental that they earn some return too.

These emotions sometimes creep into stocks too. At the height of a bubble, investors want to invest in the hottest companies so that they can show their friends and colleagues how smart they are.

My thinking: In my own case, I have usually not felt the need to flaunt (or so I believe).  At the same time, I try hard to avoid envy, which causes one to do stupid things such as chase the latest investment fad or buy stuff to show off.

There are only a two exceptions to the above rule in my case – The first one is that the emotional value of your own home is high, so it don’t look at it as a financial decision, but something which makes my family feel secure. The second one is that when my wife wants to buy jewelry I look at it as an expense to keep her happy

The driver
Volatility in prices is not an emotion in itself, but a driver of a lot of emotions we have been talking about. When stock prices crash, we can see that investors are overcome by fear, despair and in some cases complete disgust to the point of avoiding equities forever.

On the contrary if prices rise rapidly the reverse happens – we see greed and euphoria. These feelings are common to all investments, but as the volatility is high in stocks compared to other options, these emotions are amplified in the stock market.

I personally think that one of the reasons investors make higher returns in stocks compared to other options on average, is due to the higher volatility which tends to put off a lot of people. Investing in stocks is tough emotionally, no matter how long one does it. You go through periods of sickening drops and exhilarating spikes and it never gets easier, emotionally.

Take your pick
So it comes down to what one is looking for in their investments. If you want to flaunt your wealth or to feel warm and fuzzy, then go for real estate and gold. The returns could be good, if you have specialized skills in these asset classes, but then that is a different ball game.

If you want complete peace of mind – invest in Fixed deposits and sleep well. There is no harm in that!

If you are ready for a few sleepless nights, stomach churning drops in your networth (even if temporary) or sudden euphoric rise, and have nerves of steel to handle all of these emotions, then you will be rewarded with higher returns over the long term. That is equity investing

This brings me to a final anecdote –
I was discussing about expected returns of various types of assets such as real estate and stocks with a friend. I mentioned that one should expect anywhere between 15-18% from the stock market in the long run. To this, my friend replied that he ‘wanted’ nothing less than 20% per annum.

I asked my friend on why he ‘wanted’  these returns? Ofcourse he had no reason for it. It was just something he thought should be the case!

My reply was that like my kids, if you are wishing for something as they wish during Christmas from santaclaus, you should not hold yourself back. Why stop at 20%, why not ask for 100% - maybe your wish will come true!

We are still good friends, but don’t talk about investments any longer :). This is the final emotion a lot of uninformed investors suffer from – Hope

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.


Bunny said...

very good article, agree with you completely

evolutionary-mutant said...

Wonderful thoughts Rohit. These reminders are necessary for keeping ourselves grounded.

You mentioned -

*I have a standard thumb rule. Do not buy something which almost everyone is recommending*

But as they say, birds of feather flock together. Now I flock with/interact with people who themselves are small time value investors (or so they think). And if everybody in that circle is talking about Page industries, I have doubts - Am I off the frying pan (ET, CNBC) and into the fire (so called value investor crowd) now.

So, according to you who is "everybody" ?

Anonymous said...

Hi Rohit,

as usual excellent....few months back your writeup 'psychological warfare' should be clubbed with this one.

Currently index is showing good divergence one set of index stocks is stll available at nifty 6000 levels.do not know if they will play catch up or the rest will come down.

Buying them is like buying a home ....you do not intend to make money out of it.


Anonymous said...

kahani harek value investor ke ghar ghar ki :)

Lucky said...

Which tablets do you take for sensibility?

Making money in the market is all about emotional balance. Need not control or suppress all the emotions, just tempering the same with "facts" should suffice. WEB also suggests just to be greedy when others are fearful and vice-versa.

Anonymous said...

Loved it..awesome start for 2015.

Believe it or not..when Gold touched all time high of around 32-33K in India..I was able to convince my wife but only for the gold given by my side of the family..:-) hahaha. She's not too crazy about that part. Didn't sell..felt lazy going to a jeweler. But next time surely will do...am somewhat lucky in that aspect.:-)

Matter of fact I hate gold (holding more than one's needs) and anything to do with inheritance. I see it being passed onto generation after generation..being used rarely.

Yesterday I was on my way from Mumbai to Pune and saw this big hoarding "Shaadi ke baad bhi..Kiraye ka ghar? " I thought that was really creative on part of the developer..:-)

SaiSundar R said...

Good post, Rohit.

Also I feel on the same lines about diversification. Most often, since one is not knowledgeable enough about any asset class, they tend to spread it across asset class with hope that atleast something will perform but could end up loosing more compared to a single asset class strategy.

While I don't deny the benefit of diversification, its better to limit to asset classes that are understandable, even if it boils down to one (read equities)

Amit said...

Hi Rohit,

Excellent article as always! It's always so enriching going through your well articulated wisdom :)

In current market, do you still see a value anywhere or just relaxing and waiting for the next value to pick up ?


Rohit Chauhan said...

hi brijwath
thanks for the comment

Rohit Chauhan said...

hi evolutionary-mutant
interesting handle for your name :)

everybody is everyone else ..if everyone else is taking about page or any other company do you rush into it or take your time to think and understand. it is foolish to follow the crowd blindly, but then it is also foolish to oppose it without reason.

i want to reason it out in my mind before taking a decision. if it makes sense, then no harm in following others.

Rohit Chauhan said...

hi anurag
i really dont follow too many index stocks and in the end the index level does not matter. question would be is the company undervalued or not ?


Rohit Chauhan said...

hi anon
it is a universal kahani :)

hi lucky
if there was a tablet, everyone would be rich isnt it ?

easy to read buffett, but difficult to follow him. the few who can are the ones who are successful

Rohit Chauhan said...

hi vikas
you are smart ! you managed to convince your wife :) i wont try ..i dont buy jewelry often for my wife. if suggest that we should sell, she will kill me :)


Rohit Chauhan said...

hi saisundar
if you understand a specific asset class and are smart about it, then is a different ball game

most people just invest blinding, chasing the latest fad.


Rohit Chauhan said...

hi amit
there is a little bit here and there, but not much. but one can always keep studying and be prepared. so bull or bear market, one can always keep preparing

Anonymous said...


Do you have a day job, or are you a full-time investor?

If you are on your own, you can post your thoughts on your experiences, merits and demerits.

Anonymous said...

Do we need to consider the NPA of the public sector bank when we take a long term FD on our entire life savings ? Or can we assume they will always be protecte by the govt. ? Question is because the best rates are being offered by the high NPA banks (obviously).