Fear of Losses

Fear of Losses

The latest issue of The Economist has an article about an experiment in behavioural economics. The management of a factory in China asked consultants to design a better incentive bonus system. Most of the consultants suggested fine-tuning the amount of bonus, but two behavioural economics researchers worked purely on the language of the letters through which workers were informed about their bonus.

As an experiment, one group was told that if they met certain targets, they would get a certain amount of money as a bonus. Another group was told that they had provisionally been awarded a certain amount of bonus based on their capabilities. However, if their work fell below certain targets, then they would lose the bonus. In reality, the two schemes were identical.

As researchers had suspected, workers who had been given the provisional bonus were much better at meeting the targets. The fear of losing something you already have is much stronger than the motivation to gain something new. This loss-avoidance urge is well-known to behavioural researchers in other areas like investments.

The loss-avoidance urge is not a fringe phenomenon. It is absolutely central to what makes a good equity investor. The idea that some of the money you have earned may go away at any point is difficult to accept. There's a friend of mine who has been a steadily successful equity investor over many years now. He has this mental concept of 'market ka paisa' and 'mera paisa'. He divides the total worth of his equity investments at any point into these two categories, and generally considers about a fifth of the value to belong to 'the market', which the market can take back whenever it wants to.

This has always enabled him to think clear-headedly about what he should be doing at any given time and has prevented knee-jerk reactions every time there's some volatility. In my experience, investors either have this kind of a mental framework or they tend to take wrong decisions under pressure. This is the kind of instinct that makes people sell off their investments after they have dropped and then not invest again till the climate has changed, thus making their losses permanent. As an investor, either one should have the self-awareness and the self-control to modify one's loss-aversion instinct, or one should go for investment products that are not prone to volatility. These can span conventional fixed deposit, or post office, type of products, or they could be products that have some type of equity elements. For example, there are some capital-protection oriented funds as well as funds that invest only gains from fixed income into equity.

Such schemes offer only a fraction of the gains that real equity products do, but they do earn more than pure fixed income while offering peace of mind, thereby catering to the loss-aversion instinct.

Predicting Markets

Cocktail Theory : Peter Lynch

Peter Lynch has been one of the most successful investors and fund managers of all times and his book: ONE UP ON WALL STREET is a terrific and delightful book. Not only is the book a fine example of the wit, experience and knowledge; it is an easy read, and you can breeze through it.
Anyone who is serious about investing and can spare the cash must read it. This post discusses one delightful theory that Peter Lynch discusses, and I am sure if we look hard enough we can find similar examples from our daily life and relate to what he is saying.
Lynch calls it “The Cocktail Theory”. This theory is developed by Lynch for forecasting markets and has done so by standing in the middle of living rooms listening to what people have to say.
In the first stage of an upward market where the market has been down for some time and no one expects it to rise again people are generally not talking about the markets. When someone asks Lynch what he does for a living and he tells them that he manages a fund they nod politely and move away to talk to the dentist about plaque.
Lynch says that if people would much rather talk to the dentist about plaque than to a fund manager about stock it is likely that the market is going to go up.
In stage two, when the market has risen about 15 - 25 %, but still only a very few people have noticed it, the new acquaintances linger a bit longer with Lynch telling him how risky the market is before moving away to the dentist to discuss plaque.
In stage three with the market up 40-50%, Lynch says that he is surrounded by enthusiastic investors asking for tips, and even the dentist is looking for some tips from him, and everyone has their money invested at one place or the other.
In stage four Lynch is surrounded again, but this time people are not asking him what to buy, they are telling him what to buy ! The dentist has a tip or two of his own too, and in the next few days it’s likely that the dentist’s recommendation goes up.
This Lynch says is a sure sign that the market has reached the top, and is due for a tumble.
Lynch issues a caveat at the end of the theory saying that the key to investing is to buy great companies and not predicting markets.
In fact he categorically states that he does not believe in predicting the markets. Each one of us who has stayed in the market to witness at least one cycle would find a similar example to what Lynch gives and would easily relate to what he says.
I am sure you can use this simple, yet effective technique to find out what are the sentiments in the stock markets.
You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets
- Peter Lynch