With markets on an upswing, it’s important to make the most of the opportunity. But there are pitfalls too
The stock market is currently in a prolonged phase of bull run. A bull market is often defined as a period during which share prices rise 20% or more without a drop of 20% in between. A price decline of 20% is called a bear market. The terms ‘bull’ and ‘bear’ are commonly used to describe the positive or negative outlook of individual investors.
Some investors who are bearish in nature believe that it’s the Reserve Bank of India (RBI) policies that have helped sustain the bull market. Moreover, price increases have outpaced earnings growth, making stocks more expensive relative to corporate profits. The BSE Sensex is trading at about 16 times the earnings over the past year, roughly about twice the level five years ago.
On the positive side, bulls point out that the stock market has been rising from generational lows and could climb further if economic growth picks up speed. Stock prices generally reflect economic conditions and the financial performance of individual companies. Stock market indices are generally considered as the barometer of the country’s economy.
Investors, who sold shares during the downturn may not have participated fully in some of the subsequent bull market gains. A recent Morningstar study found that emotional trading practices had a negative effect on investment returns over the last decade.
For the 10-year period ended December 31, 2013, investors’ per annum returns were, on an average, 2.5% less than that of the average mutual fund’s performance. This is primarily owing to the tendency to buy high and sell low.
Avoid emotional responses
Constant portfolio monitoring and emotional response to gains and losses in the market may drive excessive trading behaviour. Despite transaction costs, individual investors find it difficult to refrain from making frequent trades. In an interesting study of individual accounts from a large brokerage firm, it was found that excessive trading has significant adverse effects on mean returns of investors. Men, in particular, seem to suffer from investment restlessness, which may be why their investments underperform women’s.
A portfolio that provides the highest expected return for a given level of risk consists of a diversified mix of assets. A mutual fund, for instance, provides an easy way for an individual investor to create greater diversification at a lower initial investment. Individual investors, however, exhibit a surprising lack of wealth diversification. This may be partially a function of the complexity of selecting an efficient portfolio, which requires an awareness of the covariance among investment assets.
Many investors simply allocate their portfolio evenly and equally among all available mutual funds rather than simply choosing a single diversified fund — leading to an aggregate portfolio that lacks diversification despite splitting money among a number of funds.
Prior return fallacy
The use of prior return information holds tremendous intuitive appeal to investors. When choosing for a share, investors look to investment guides, advertising, or even Sebi-mandated disclosure to identify companies that have stronger recent or long-run returns. The intuition is that some companies are better managed than others, and that prior returns help investors identify the best shares.
Investors are willing to shift their money to recent winners in terms of returns and move away from last year’s low-return firms though the low returns could be temporary in nature. There is nothing wrong in extrapolating past trends, but, often, investors tend to forget to incorporate the appropriate changes into their projections. While making the projections one needs to keep in mind the prevailing momentum. Investors place too great a weight on recent stock performance as representative of future returns. This ‘hot hand’ phenomenon has been observed in basketball, where it appears that a player who just sunk consecutive shots is more likely to score on his next shot when, in fact, he is not.
Many investors exhibit a ‘bias’ in which either they prefer investing in geographically proximate stocks, or those of company products which they use. For instance, if an investor uses brand ‘X’ toothpaste for a long period, he tends to think that the particular company is good. Even employees who invest in their employer’s stock are subject to extreme idiosyncratic risk as both their investment portfolio and human capital are weighted toward the fortunes of one firm.
When investors make mistakes, it is assumed that more rational or informed investors will intervene in financial markets to force asset prices back to their fundamental value.
Since asset prices are at their fundamental value and share prices may be efficient, the inefficient choice could leads to significant wealth losses as investors deviate from an efficient portfolio. Investment is like a game that requires certain special qualities on the part of the investors to be successful in the long run. These special qualities and characteristics can be developed over a period of time. While these qualities don’t assure you superior returns, they do improve your chances of doing well.
The writer is associate professor of finance and accounting, IIM-Shillong