Behavioural Finance in Investment Management

The Detached Investor | Introduction

In Verse 7 of Chapter 3 of the Bhagavad Gita, Lord Krishna states:

“However, that person who controls the senses with the mind and engages them in karma-yoga (the path of selfless action) without attachment is superior, O Arjuna.”[1]

One of the ways in which we can relate the teachings of the Gita to wealth management is by visualizing an investor who possesses a dispassionate investment discipline that entails a clear research-driven strategy focused solely on achieving financial goals over a longer period. More importantly, this investor can keep emotional reactions to severe market fluctuations at bay, perhaps by staying invested for the long term.

For example, an investment in NIFTY 50 on June 30, 1999, would have grown to around 23 times its original amount as of September 30, 2023. A simple buy-and-hold strategy on the NIFTY 50 Index would have generated a CAGR of 13.79% (Total Returns before taxation) over more than 24 years, indeed an impressive track record, when looked at in hindsight.

However, these returns would have accrued to only those investors who would have also endured the following episodes in the NIFTY 50 Index in these 24+ years:

• Over 50% wiped out amid the Global Financial Crisis of 2008
• An extended 40% decline following the Dot-Com Bubble of the early 2000s
• A near-30% drop at the onset of the Covid-19 pandemic
• Few periods of 10-20% declines

Thus, the NIFTY 50 Index would have ended up as a 23-bagger investment for investors who would have overcome their emotions of fear and greed, more so in the face of extremely volatile market periods. In yet another reference to the Gita, equanimity on the part of the investor in booms and busts alike would have ensured superior returns over a longer period.

Feelings and Financial Decisions | Limitations of Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) rests on the premise that market prices reflect all available information and, thus, asserts that decision-making by investors is unbiased and rational. However, several episodes in financial markets across asset classes have challenged this assumption, revealing the deep-rooted influence of emotions on investment behavior at a market level. For example:

• Dot-Com Bubble (Late 1990s – Early 2000s): Overconfidence and Euphoria are said to have caused speculation, propelling investors, traders, and venture capitalists to pour money into technology and internet-based startups, many of which lacked a sustainable business model and a track record of profitability. The subsequent crash resulted in a bear market that lasted for two years.[2]
• The Global Financial Crisis (2008-2009): This phase was preceded by Greed and Over-Optimism in the housing market propelled by reckless lending and a perception of low risk of mortgage-backed securities that otherwise bundled high-risk loans. Fear and panic following the bursting of the bubble drove irrational behaviors across markets.[3]
• Cryptocurrency Mania: A CNBC survey conducted back in 2021 revealed that 83% of Millennial millionaires owned cryptocurrency. There was an anticipation that a deep-seated atmosphere of FOMO or Fear of Missing Out would drive the prices as well as the adoption of cryptocurrencies in 2022.[4] Eventually, however, Bitcoin saw its price come crashing down from nearly USD 69000 in November 2021 to below USD 15,500 a year later, wiping out more than 77% value from its all-time high levels.
• GameStop Short Squeeze: Several hedge funds and institutional players had taken substantial short positions on the stock of GameStop, a brick-and-mortar video-game retailer, betting against its financial success. However, in a rather unusual case, collective buying by retail investors pushed up the price of GameStop stock to exorbitantly high levels. This led hedge fund players such as Melvin Capital and Citron to cover their short positions at substantial losses.[5] This event is considered the most notorious short squeeze in the history of financial markets wherein amateur traders are believed to have been driven by the feeling of Revenge against hedge funds.

It is becoming increasingly evident that the Efficient Market Hypothesis has its limitations in explaining the impact of investor behaviors on market dynamics and asset prices. This only underscores the importance of incorporating behavioural finance and emotional considerations in investment decision-making.

Mind’s Financial Map | Behavioural Portfolio Theory (BPT)

Behavioural Finance is a branch of behavioural economics that suggests that people often make financial decisions based on deeply embedded emotions, cognitive biases, and other psychological biases. An offshoot of behavioural finance, Behavioural Portfolio Theory (BPT) recognizes investors as ‘normal’ and not rational, asserting that investment decisions of people are often influenced by traits such as overconfidence, regret, and loss aversion.[6] Some advantages of Behavioural (BPT) Portfolios over Traditional (EMH) Portfolios are as under[7]:

• BPT recognizes how cultural and social considerations in different parts of the world influence respective investors in their investment decisions. EMH largely ignores these considerations.
• BPT takes into account the time, knowledge, as well as physical fitness of investors. EMH on the other hand focuses more on monetary factors.
• In BPT, an investor constructs his or her portfolio with multiple layers in mind, as if representing a pyramid. The objective to is allocate investments with varying levels of risk toward different financial goals ranging from necessary to aspirational. Under EMH, the objective is maximizing overall utility.

Investment professionals, wealth managers, and financial advisors are already harnessing the insights of Behavioural Portfolio Theory in their respective practices. Understanding the cognitive biases and emotions of their clients as well as their own, enables them to craft tailored financial strategies and enhance their value proposition to the investor community. This proactive integration of BPT principles fosters better-informed decisions, nurtures client relationships, and builds greater trust in the advisory process.

Conquering Thy Emotions | Conclusion

One of the most famous quotes by the Roman emperor and Stoic philosopher Marcus Aurelius goes by:

“If you are distressed by anything external, the pain is not due to the thing itself, but to your estimate of it; and this you have the power to revoke at any moment.”

While the importance of thorough due diligence and periodic risk management cannot be disregarded, investors would likely be better off recognizing that staying invested in the long term does come with its share of occasional knee-jerk reactions to exogenous shocks, indeed a challenging pursuit. Changes to the investment strategy should be propelled by a limited range of factors such as a drastic change in financial objectives or a significant challenge to the fundamental assumptions underlying the investment.

It is also worth noting that on one hand, Robo Advisors equipped with Artificial Intelligence and Machine Learning technologies can better enable financial advisors to factor in behavioural considerations by employing features such as sentiment analysis and predictive analysis. On the other hand, the mass adoption of these technologies by institutional players has the potential to eliminate emotions from the picture due to rapid information processing, continuous learning of tactical trends, and a drastic reduction in arbitrage opportunities.

It is worth contemplating if Industry 4.0 considerations will make Efficient Markets an eventual reality.

References

[1] (Swami B. G. Narasingha). Chapter 3: Karma Yoga – The Yoga of Action. Shrimad Bhagavad Gita. Gosai Publishers

[2] Salvucci, Jeremy. (Updated 2023, January 12). What Was the Dot-Com Bubble & Why Did It Burst? The Street. – https://www.thestreet.com/dictionary/d/dot-com-bubble-and-burst

[3] Loo, Andrew. 2008-2009 Global Financial Crisis. Corporate Finance Institute –  https://corporatefinanceinstitute.com/resources/economics/2008-2009-global-financial-crisis/

[4] Hall, Jo. (Updated 2021, December 21). FOMO will drive crypto adoption in 2022, says BlockFi co-founder. Cointelegraph – https://cointelegraph.com/news/fomo-will-drive-crypto-adoption-in-2022-says-blockfi-co-founder

[5] Salvucci, Jeremy. (Updated 2023, September 15). An in-depth timeline of the GameStop short squeeze saga. The Street. – https://www.thestreet.com/investing/stocks/a-timeline-of-the-gamestop-short-squeeze

[6] McClure, Ben. (Updated 2022, January 26). An Introduction to Behavioural Finance. Investopedia. https://www.investopedia.com/articles/02/112502.asp

[7] Behavioural Portfolios. Management Study Guide. https://www.managementstudyguide.com/behavioral-portfolios.htm