Contributed by: Aneek Saha, CFA & Hareesh Mothi, CFA
The Bangalore Chapter had an enthralling session presided-over by Richard Harris, CEO – Port Shelter Investment Management. Richard apart from is work enjoys playing rugby, radio jockeying and piloting his plane. During the discussion, he shared his personal experiences that made his realize the importance of human behavior in making investment decisions.
Rational Finance tools involve fundamentals, geo-politics, macro trends and economic results and trends. The basic drivers of the markets are fundamentals, valuation and liquidity. In addition to that we have technical analysis as well as asset allocation, asset selection, portfolio construction and risk analytics. Behavioral finance as a discipline has gained prominence with the award of the 2002 Nobel Prize to Daniel Kahnemann and the 2013 Nobel Prize to Fama, Hansen and Schiller. Behavioral finance has its roots in psychology and investment management. Markets reflect emotions, as they over and undershoot the true value of the assets.
Kahnemann propounded that our minds work on two levels: the instinctive mind which is activated when one sees a picture and identifies whether it is male or female, the approximate age of the person in the picture and the expression on his face, and the conscious mind which is used when one needs to calculate a complex equation. On most occasions, markets tend to be more instinctive than cognitive, particularly in the emerging world where most wealth creation has been recent and where most investors tend to be speculators who like to make quick, risky decisions akin to gamblers. Speculators are susceptible to behavioral biases in their decisions.
We process information based on the following paradigms (heuristics): Greed vs Fear, Sentiment vs Reason, Boom vs Bust, Pride vs Regret. The human brain is bad at assessing probabilities. There are biases in mental accounting wherein the mind perceives one dollar from his salary more valuable than a dollar from his bonus. The mind also creates a money illusion. To illustrate, one feels happy if the stock went up from $10 to $30 directly and stays there and feels sad if the stock goes up from $10 to $50 and falls to $30. The net profit made on the stock remains the same. However, the mind perceives the gains in different terms.
News is a fertile area for behavioral biases. For instance, the importance of news and its timing may influence investment decisions. Investors / fund managers may feel that a particular piece of news is important when it in reality may be just noise.
Anchoring too plays an important role in choices made by managers. For instance, whatsapp was valued at $19B because the buyer had this number anchored in his mind. If a number, say for instance, $1.9B had been anchored in the buyer’s mind, the deal could have closed at a far less amount. Harris also elaborated how other biases such as status quo, recency and primacy, overconfidence, representativeness and hindsight influences decisions.
Per Richard, the ways to overcome these biases is to constantly ask questions, do one’s own thinking and be a contrarian. The session ended with an energetic thirty-minute long question & answer session and a networking session over lunch.