Behavioural Finance: its pitfalls for Investors

Behavioural Finance is the study of rational/ irrational behaviour of individuals which influences market prices, returns and allocation of resources. It attempts to understand how people forget fundamentals and make investments based on emotions.
The primary objective of all investments is to maximize returns and create wealth. Observing the behaviour of individuals leads us to believe that people are very often ruled by emotion (greed and fear) rather than by logic. They display imperfect rules of thumb (heuristics) to process the available data, thus bringing in individual biases in their beliefs, leading to commitment of fatal errors of judgement.

The important heuristics driven biases are:

• Representativeness – Forming an opinion of future action based on past performance. Investors may tend to rely on certain patterns in the past data that are random.
• Overconfidence – The human mind is trained to extract the maximum information from the available data, but it may not be adequate to arrive at an accurate forecast in uncertain market conditions. This phenomenon is described as ‘self-attribution bias’, where people tend to attribute their success to their investment skill and their failure to bad luck.
• Anchoring – Conservatism or the inability to change an opinion after subscribing to a fixed idea, often manifests in a failure to react to a new information which is relevant to one’s investment but does not match with his/her subscribed opinion.
• Innumeracy – This results from ‘mathematical illiteracy’ where people tend to misunderstand the statistical data. Generally, people tend to give more importance to big numbers and tend to overlook small figures.

Investors often fall prey to their own and sometimes others’ mistakes due to the use of extreme emotions in ‘Financial decision making’. If you compare the overall profits of traders, you will find that they make similar profits as long term investors. This is because they tend to pay huge fees such as brokerage, transaction charges, short term capital gains. You as a long term investor may be able to earn a higher return, in addition to the peace of mind.

So, the next time if one of your friend suggests a great investment opportunity, naming a ‘ten bagger’ or a ‘multi bagger’, just ignore it. When the market has crashed, the same set of people will create a panic by telling you to sell, just hold your emotions. Do not get carried away by extreme sentiments, because they bias your judgement and can only help you to make blunders. Have firm faith in yourself, and make your investments based on confirmed information and objective analysis of the same.
Remember: Money cannot buy happiness, but the lack of money can buy a lot of misery.

Inflation Effect: Is this the end of the India Growth story?

Week after week the inflation data is causing tremors in the markets. For week ending May 3, 2008, it has risen to 7.83%, a level not seen since 2004. How does it auger for the Indian economy? Inflation indeces comprise of 3 broad catagories: Agricultural output, Metals and Energy (Oil & Gas). Today analysts are pointing towards continuation of higher inflation, due to higher demand from the developing world, including India and China. The way things stand today, inflation is driven by high level of speculation in the 'commodity markets', a bubble which is waiting to burst. In the developed world, commodity prices have hit new highs recently as a lot of hot money has been diverted to the commodity markets, from other markets. Even pension funds have been investing higher proportion of their funds in commodities as a diversification tool. Let us analyse the movement of prices in India in the next 3-6 months:

• Agriculture: Foodgrain prices in India have started to ccol off with the bumper wheat harvest. World over foodgrain prices have softened recently. With the likelihood of normal monsoon prediction for the year in India, foodgrain prices are likely to remain soft over the next 2 quarters. The impact of this will be evident in the inflation indeces within the next 2 weeks.
• Metals: The slowdown in demand is starting to show its impact on prices of select metals. Gold is down almost 15% from its peak, and Nickle prices have cracked almost 50% from their peek. Iron ore prices are also showing signs of weakness. Cement prices in India historically have been low in the monsoon months, the impact of which will be seen after the onset of monsoon by the end of this month. Cement producres have been smart enough to reduce the prices of a bag of cement upto Rs.7 foreseeing a slump in demand.
• Energy: The only cause for concern remains the high crude oil prices. With the energy demand from the western world continiuing unabated, crude prices have continued their upward march. Speculation in the commodity futures is responsible for this trend. Indian economy is facing a double whammy: high crude prices accompanied by the slipping Rupee is causing a huge outflow of funds, putting pressure on the inflation indeces. Oil should peek out somewhere around the 130 $/ barrel mark soon.

Our stock markets have shown tremendous resilience, despite the negative inflation data, and flagging IIP numbers. In the short to medium term the markets have the potential to move upto 10 % from these levels, which will be an opportune time to book partial profits. The first quarter results for India Inc. may provide a slight negative bias, forcing the markets to react negatively. But a normal monsoon will help in easing the inflationary pressures by the second quarter of this fiscal.

Market Direction: Important triggers

Efficient Market theory advocates that human beings behave rationally and the markets always behave efficiently. But this is not true most of the times. Human beings rarely behave rationally as a group. The markets always look for market triggers: positive or negative to find their direction, in the short term. Let us find out what are the triggers for the market at this juncture:

• Results for FY 07-08: Currently the results are playing a major role in deciding the immediate course of the markets. As the results of majority of the companies have been better than expectations, markets have moved up about 20% from their March lows. This also is the time for portfolio churning based on the annual returns of the companies.
• Progress of Monsoon: Indian economy is very much dependent upon the monsoon. The markets will start discounting the progress of monsoon from the end of May. The predictions by the IMD are for a normal monsoon this year, if it holds good than the stock market will have a sustained rally in the months to come.
• Inflation: The government is doing everything to contain inflation, but the results have not been reflected in the inflation data so far, which continues to be a source of worry for the markets. Although the foodgrain prices have started to soften, the prices of crude oil and basic commodities like steel and cement continue to rise globally and the govt. can do very little in this regard. The artificial reduction in prices through force will only worsen the situation, unless supply concerns are met.
• Exchange Rate: The Rupee have depreciated against most currencies in the recent past and has recently breached the Rs41/ dollar mark recently. With crude oil ruling at all time highs of over 120$/ barrel mark, it does not auger well for the Indian economy as we are a large net importer of petroleum products. This will put a lot of pressure on our budgetary deficit and fuel inflation. But it augers well for certain sectors like oil exploration and refineries as their margins would improve. But public sector companies will continue to bleed because of faulty pricing mechanism followed by the govt.

Overall the markets have been resilient despite the negatives, and are currently consolidating above the 17000 level on BSE and 5000 on the NIFTY. In the absence of any major negative news, the medium term trend for the markets is up. But partial profit booking is advisable in the range 18200-18500 on the sensex and 5400-5450 on the NIFTY.

It is back to Fundamentals

The Indian Stock market is now reacting to fundamentals, therefore, money making is going to be selective. The Year 2008 will see to it that money is not made on tips or hearsay. This is not the year of 'Momentum Stocks', so one should focus on 'Value stocks'. The current uptrend/relief rally or whatever you may like to call it, is based on the fundamentals of the companies on the basis of quarterly/ annual results for FY 07-08. The market will reward those who do their homework well. There are three levels of analysis to take stock of the market moves. It is known as EIC analysis (Economy, Industry and Company).

• Let us first analyse the Economic situation. The ngative factors are a high inflation rate and high commodity prices. Although, with the prospects of a good crop foodgrain prices are likely to cool off soon, but high crude prices are here to stay, and this may hurt the Indian economy very badly in the long run. But the positiove side is, that Indian economy is still growing, and even a slower growth rate of 7.5-8% will not hurt the sentiment badly. The CRR hike is already behind us. The credit policy on 29th may announce a Repo rate hike of 25 basis points, which has been factored by the markets. If the hike is higher it might effect the sentiment negatively. It is unlikely that the RBI Governor will resort to a steep hike, which might kill the India growth story. If no surprises are there in the credit policy the markets are likely to maintain their uptrend in the near future. Valuations of the overall markets at 17000 level BSE/ 5100 on Nifty are in line with the historical trends (PE of 20 trailing basis, and 17 for one year forward basis). The markets are not likely to move past the earlier tops in the next 6-9 months, because of the uncertain economic/ political environment. The range for the markets could be 15% on either side of the fair market value i.e. 14500-19500 for the sensex. Broadly this range may be utilised by long term investors: Buying at the levels of 14500-15500 and booking partial profits above 18500 levels.

• The next level of analysis is the Industry Analysis: Although the benchmark indeces give us a direction, all stocks within the index do not move in the same direction. The sunrise sectors of last year which have given super normal returns will no longer lead the uptrend. We need to divide sectors into three catagories: First the ones which have long term value at current levels and are less likely to be affected by an economic slowdown: Pharma & Healthcare, FMCG, Retail, Media & Entertainment. These sectors are more or less insulated from the economic slowdown. Selective purchases can be considered in stocks from these sectors. The next are the sectors that get negatively impacted by the slowdown: Capital goods, Auto, Banking & Finance, Realty & construction. Auto & Banking (especially PSU banks) are still quoting at reasonable PE multiples and can be bought on declines. But refrain from investments in Capital goods and Realty as most of the stocks from this sectors are quoting at ridiculously high PE's. Case in point are the stocks like ABB and Siemens. I would consider even L&T and BHEL expensive at current levels. The sectors falling in the third catagory are those which get affected by Govt. policies. These sectors are Oil & Gas, Telecom, Basic Metals. PSU Oil/Gas companies like ONGC, Gail, IGL, IOC, HPCL, BPCL are all quoting at reasonable PE multiples, but the Govt. policy is responsible for keeping them at subdued performance levels. Telecom sector is highly dependent on spectrum allocation. Diversified companies like Bharti still hold good value from this sector. Basic metals like Steel and Aluminium, and even commodities like Cement are currently under the scanner of the Govt. in its bid to control inflation. So, a prudent investor should stick to the first catagory of stocks for buying. Partial profit booking is advisable in the second catagory, whereas a wait and watch approach is advisable for third catagory of stocks.

• The last level of analysis is the Company Analysis: Generally the markets tends to give a thumbs down to certain sectors, and even individual 'Gems' from the sector get punished alongwith the market sentiment. Intelligent investors are those who are able to identify these gems from the beaten down sectors, these stocks ultimately turn out to be multi-baggers. One such beaten down sector in the current scenario is the IT sector, where lot of good growth stocks are languishing at ridiculuosly low valuations.

Year 2008 will prove that there are no short cuts to make money on the stock markets. Do your EIC analysis properly before taking an investment decision. Otherwise it will be better to park a large chunk of your money in fixed income instruments for atleast one year.

Markets poised for a turnaround: RIL is the key

Indian markets last week gave a thumbs up to the results announced by the corporate sector, with Infosys providing the initial fillip. All the indeces including midcap and small cap indeces ended with gains of 3-5%, with strong advance decline ratios. There is an aura of cautious optimism amongst the market players. The negatives have been overplayed in the marketplace, but the results announced by the companies may dispel some of the negative feelings. Some events of the next week are being looked upon by the bears to make a killing: continued high inflation, hike in repo rate by 50 BPS by RBI on Thursday, introduction of short selling from Monday 21st, and the F&O expiry on Thursday 24th. Most of these factors will be taken by the markets in their stride.

The earnings announced by the various companies will decide the future course of the markets. Reliance Industries will announce the results on monday which will decide the direction of the markets for good part of the week. The global indeces have performed well on Friday, both DJIA and NASDAQ putting up strong gains during the week. The Indian markets are likely to cross their 200 day moving averages shortly. We can look forward to a period of optimism with the sensex attempting to cross a major resistence at around the 17200 level. Long term investors may hold on to their stocks, and profit booking, if any, may be considered only close to sensex level of 18000, once the earning season is over.

Earning season kicks off on a Positive note

The earning season has kicked off on a positive note. IT major 'Infosys' has provided the long awaited booster doze to a rudderless market. For the next one month or so the focus will be on the FY '08 numbers, and global signals will take a back seat. The earnings of majority of the companies are expected to be robust, dispelling fears of an immediate slowdown. Other factors of significance for the markets will be:

• Inflation Data: Friday's inflation numbers will provide an indication of the steps taken by the Govt. to curb inflation. The regulators as well as the Govt. must learn to live with a slightly higher rate of inflation between 6-7%, as this rise is due to global factors. As far as the WPI figures are concerned it is shocking to learn that the figures are not being updated regularly, and provisional data is being used to dish out inlation data which is far off from the ground situation. For example, index of iron & steel having a weightage of 3.7% in thr WPI, was first revised in 2008 only on 8th march 08, leading to a sudden spurt in figures. The boom in commodity prices continues unabated, and surprised everyone in the midst of news of a global slowdown. The commodity cycle may be nearing its peak. In India food prices are likely to soften as the Govt is hopeful of meeting its procurement targets for the Rabi season.
• Short selling: From 21st April '08 the six year ban on short selling is being lifted. How is it likely to impact the markets? In the long run it will lead to efficient price discovery and will improve liquidity in the markets. To begin with short selling is being introduced in stocks that are already being traded in the Futures market. It will help in curbing extreme volatilty. Mutual Funds are likely to be the biggest beneficiaries of the new order. mutual funds may be able to earn more than 5% higher returns by churning their idle portfolio through stock lending. This augers well for Mutual Fund investors. It is also likely to bring back arbitrageurs to the market, leading to higher volumes. Some people fear a 'Bear Raid' by taking short positions and spreading rumours to benefit from the measure. However, this view is unsustainable, on the cotrary short selling may avoid excessive price rigging, which augers well for the markets.
• RBI Credit Policy: 29th April will see the unveiling of the RBI's quarterly credit policy. A 50 basis point hike in CRR to contain liquidity is already factored in by the markets. There is a wide expectation that the RBI will not tinker with the interest rates. The CRR hike may lead to raisng of interest rates by the banks, marginally.

Overall market sentiment is likely to be positive for the next one month.

How to identify Stocks?

Stock selection is a very tricky job. The euphoric rise of the markets for the past 2 years till January 2008, gave an opportunity to make easy money on the markets. The steep fall of the past 2 months has again brought to fore the importance of proper stock selection for steady long term gains. In the past one week we have seen a sharp decline in the price of some blue chip stocks like BHEL and L&T. Does it mean that these stocks do not merit investment? There is no doubt that these stocks are excellent stocks with huge growth potential, but their prices had run-up too far as compared to their fundamental strength, hence the steep correction in their prices. Let us examine a few parameters of selecting value stocks for ones portfolio:

• HISTORIC DATA: Book Value represents the net worth of the company, comprising its paid up capital plus free reserves and surpluses. Companies with a high book value instill confidence among the investors, and are viewed as potential bonus candidates. Although declaration of bonus does not materially effect the balance sheet of the company, it often gives a fillip to the stock price as the liquidity improves. Another way to look at the strength of a company is the Replacement Cost of its assets and liabilities. To establish a new manufacturing plant is a capital intensive proposition, so it gives advantage to the existing established players over new players. However, one must take into account the 'technology obsolence' factor while evaluating companies on the replacement value parameter. Another related benchmark is the Price to Book Value ratio (PBV). A higher earning capabilty in terms of return to equity (ROE) tends to increase PBV. Let us take an example: L&T for most part of 2007 was quoting at a PBV ratio of over 25, and a company like HPCL was quoting at a PBV of around 1. But in the long run a very high PBV is not sustainable unless the growth is spectacular. So the moment maket got the signal that L&T's growth is slackening its stock started declining, giving it a discounting of a more reasonable PBV of around 20. On the other hand HPCL merits investment both on the low PBV ratio and a strong replacement cost scenario, but the stock remains subdued because of the govt. policy on pricing of petroleum products.