Overcoming a hard-wired bias for loss aversion4 min read . Updated: 26 Oct 2017, 01:47 AM IST
Trends suggest that the traditional Indian 'saver' is embracing equities as an asset class for wealth creation
With Richard Thaler recently winning the Nobel prize for economics, discussions on behavioural economics are back in focus. I first started reading about behavioural sciences about a decade ago. Research done by Israeli-born psychologists Daniel Kahneman and Amos Tversky on cognitive biases and bounded rationality was unique and pathbreaking. Kahneman had won the Nobel prize in 2002 for their seminal work on Prospect Theory (Tversky had died in 1996 and the Nobel prize is not awarded posthumously).
As an investor in the stock markets, behavioural economics helped in providing a theoretical framework to some of the intuitive concepts I had learnt, often the hard way by losing money! Kahneman and Tversky provided an empirically tested body of research to understand human shortcomings while making choices. Investing by its very nature involves taking decisions with incomplete information and making assumptions about the future. Naturally, my motive was to improve the strike rate of making better decisions while investing.
To further overcome any scepticism I might have had on some of the biases that hinder rational decisions, I even decided to teach a course of behavioural finance at a business school in Mumbai for five years. I meticulously conducted these experiments in the classroom to see if they produced similar results as those conducted by these psychologists. To my surprise, the outcomes were strikingly similar (hopefully no confirmation bias here!). And this was despite the fact that the students were primed, i.e. they were answering these questions while attending a class on behavioural finance where the objective was to prove that the choices they make were not completely rational.
So it came as a surprise to me when in an interview last year with Barry Ritholtz for Bloomberg Radio, Daniel Kahneman made what I thought was a startling confession. He said he never invested in stocks because he felt that he was genetically wired to be pessimistic. He even said that this trait was inherited from his mother who had a predisposition for pessimism. One would have assumed that the guru of behavioural sciences who has researched and written so extensively on the subject would have at least attempted to overcome those very biases. But rather, he chose to go with his genetic predisposition for pessimism leading to the age-old question of nature versus nurture.
In his book, The Undoing Project: A Friendship That Changed Our Minds, the author Michael Lewis contrasts the personalities of Kahneman and Tversky. He writes that Kahneman was a pessimist. But Tversky was not merely an optimist; he willed himself to be optimistic, because he had decided pessimism was stupid. Tversky used to say—when you are a pessimist and the bad thing happens, you live it twice. Once when you worry about it and the second time when it happens. So, here we have two brilliant psychologists who have done path-breaking work on the subject of behavioural sciences. One seems to accept that he is hard-wired to be pessimistic. The other makes an active choice to be optimistic.
Again in the context of stock market investing, I often notice this trait among individuals. There are some who brand the markets as a casino for gamblers. They justify why they prefer the safety of bank deposits and government-sponsored guaranteed return products such as post-office deposits and public provident fund. Clearly, the aversion to loss , i.e., the fear of losing your principal, is a factor that keeps individuals away from investing in equities. The pain from a loss, according to behavioural economists, is almost two times the pleasure derived from a similar gain. And many people suffer in varying degrees from this bias of loss aversion. Loss aversion drives people to take suboptimal investing decisions, i.e. settle for lower assured returns rather than choosing a more optimum asset allocation that offers an opportunity to earn better risk-adjusted returns, albeit with some volatility.
When I interact with some of the best investors in the Indian equity markets, who manage their own wealth, what comes across as striking is not their intellect, but rather their emotional quotient. Their ability to take losses in their stride and continue to take new bets distinguishes them from the crowd. And of course, knowing when to scale up the bet on a winning horse is what makes all the difference. Conviction wins over self-doubt. Emotional quotient over intelligence quotient.
With rising income levels, the psyche of the middle-class Indian is shifting from a saver to an investor. The need to make a decent inflation-adjusted return on one’s savings is pushing individuals to invest in equity markets, either directly or through mutual funds and insurance products. Net inflows into equity funds (including the equity portion of balanced funds) in the first nine months of this year is at Rs1.42 trillion, which is two times the inflows that we witnessed in the entire year 2016. Every metric, from new folios at mutual fund houses to new dematerialized accounts opened with depositories (National Securities Depository Ltd and Central Depository Services Ltd), seems to suggest that the participation levels of new investors in the markets is rising at an encouraging pace.
To conclude, while behavioural economists exhort us to understand bounded rationality, it is up to each individual to manage his/her loss-aversion bias. The recent surge in participation in equity markets is encouraging, but there continue to be many fence-sitters. Will the fence-sitters take a plunge into equities if markets continue to provide attractive returns or will some of the existing participants, lulled into complacency in rising markets, hurry for cover at the first signs of volatility are questions that will be answered over time. However, it may not be wrong to assume that there is a bigger structural trend at play in India as many traditional savers overcome their loss-aversion mindset and embrace equities as an asset class for wealth creation.
Amay Hattangadi is with Morgan Stanley Investment Management. These are his personal views.