By Somnath Banerjee
Today, I am going to talk about behavioural finance and its impact on investing.
There are various styles/strategies of investing i.e. fundamental, technical, momentum, value etc. Various investors deploy these strategies in isolation or in a mix. One must find what works and then stick to it.
Whatever style or strategy one uses, investing is all about controlling emotions i.e. greed, fear and hope. There may be more (anger and ego comes to my mind) but that’s secondary or at least should be kept on the top shelf where it’s difficult to reach whilst investing. A lot of commentators say emotions are best kept away from investing but my humble opinion is that it’s impossible.
We are creatures of habits and emotions. It’s unnatural to not feel emotion in something as important as investing unless one is just doing it only for fun without any reasonable stakes involved. So, the best we can do is control these emotions and I would argue having controlled/measured emotions may even help in investing (at least it does to me).
Get the balance of emotions right and you will be like Hemmingway’s Old Man in the Sea when it comes to measuring your performance. Get the balance even slightly wrong and it will turn into a Shakespearean tragedy. Don’t get me wrong, I love Romeo but does he have to die? I would rather win over my Juliet (ok, ok, there is no Juliet in my life, its symbolism for successful investments).
In this piece, I will only be talking about hope. Allow me some latitude to build my case. I will be using some specifics to drive my point home. Why don’t I start with Cryptos that caught the market's imagination in the past decade or so.
Arguably, bitcoin won’t be bought anymore once its price volatility stabilises. Huh! Some of you might be thinking that’s totally counter intuitive as volatility of bitcoin is one thing that goes against buying it. Please humour me for a moment. Most speculators who are buying it are doing so because they ‘hope’ their ‘gamble’ will come good and it will return a massive return quickly (or they will lose all). So, this volatility is giving them ‘hope’.
Broadly speaking that’s why one would bet on red (nothing against black but just that I like red more, still as of yet that colour doesn’t show me much affection) on a roulette table despite knowing math (risk-reward) is against taking that bet.
The same principle could be applied for the frenzy that saw retail investors buying meme stocks (Gamestop et al.). I can even decide to buy a company that has filed for bankruptcy in the hope that central bankers/treasury may start dropping money from a helicopter and the bankrupt company may become solvent again and my investment will be the lottery ticket that I never won. Wait a minute, that story is of Hertz in 2020. So, it does work!
The same applies to Special Purpose Acquisition Companies (SPAC), Non-Fungible Tokens (NFT) etc. I can go on and on and on. But you get the idea.
The driving emotion here is hope and gamification of investing. But is there no scientific basis justifying this hope? I reckon, if there is a crash course on ‘Investing in 2020’s – 101’ taught in business schools, this is how it would go about it.
If there are hundreds of investment opportunities with each one having a 1% probability of returning a hundred thousand percentage and 99% probability of going to zero, math (risk reward) says I should invest 1% in all one hundred investment opportunities equally as it is expected to make ten times my initial investment. In essence, that’s how you find your Amazons by investing in 99 others.
But here is the problem with the rationale outlined above. No one is going to get the chance to invest in so many investable opportunities with such characteristics, realistically speaking. Imagine investing in all but just that one investment which will win the lottery for you. What a disaster it would be, right!
Essentially speaking, anyone following the logic above would be increasingly frustrated (when not able to find enough investment opportunities) and will start overestimating upside returns and its probabilities. And that would up the risk and lower the reward.
Hope is not a bad emotion but having it in proportion in line with realistic estimation of risk reward is extremely important.
Disclaimer
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.