Introduction

Infosys, the bell weather of Indian Technology stocks fell 40% in two trading sessions after its guidance of a flat revenue growth. Then there was a Bank stock rally - many now term it as Bank Bubble. Agreed that there were reasons behind the events, it's the extent of movements that seems like "Over-reaction" or "un-justifiable".

Similar instances can be found at frequent intervals in all the indices. For e.g. in October 1987, US shares fell over 30 per cent in a two-month period. Ironically, there was negligible new information to justify such a move. Take the Technology Bubble - Tech heavy Nasdaq, which peaked on 10 March 2000 at 5132, now, trades at around 1700.

These are serious challenges to the Efficient Market Hypothesis (EMH), which says that all the relevant information are reflected in share prices and so in a rational manner. Does that mean investors are not rational and fail to react appropriately to any new information?

Individual Psychology

Although, no unified theory of behavioural finance exists at this time. The fact remains that human mind is susceptible to emotional & psychological biases. Studies by psychologists have identified that:

• Investors tend to assume that recent events will continue into the future (for ex. to assume that recent share price gains will continue). This can manifests itself when investors seek to buy 'hot' stocks & to avoid stocks, which have performed poorly in recent past.

• Availability bias emerges when people place undue weight on easily available information in making decision. Investors may act overly conservative in adjusting their expectations to new information and/ or tend to ignore information that conflicts with past decisions (helping bubble to grow). Also, investors need less information to predict a desirable event than an undesirable one ("wishful thinking").

• Overconfidence leads investors tend to overestimate their 'predictive' skills & believe they can 'time' the market. This may lead to excessive trading.

• Investors get emotionally involved with an investment strategy - For ex. if a strategy has been winning of late, an investor is more likely to expect it will continue.

Crowd Psychology

The various individual judgement aggregates to form "Crowd psychology". "Crowd psychology" tends to magnify and reinforce individual judgements.

Investment markets have long been thought of as providing examples of crowd psychology. General media play a major role in creating the "crowd psychology" by highlighting stories of sharp rises/falls in asset prices, etc that grab investor attention and provide a positive feedback loop to prevailing trends. This becomes a phenomenon as the pressure for conformity binds the investors not to deviate from the crowd via diverse mechanisms as industry standards, interaction with friends and benchmarking.

Points to note

It must be noted here that investor psychology & confidence does not act in a vacuum. Favourable fundamental developments, e.g. strong economic growth, better corporate results, easy monetary conditions etc. drive up positive feelings and vice-versa.

What is important here is that investors must read any market extreme with a contrarian view. Please think - major bull markets do not start when investors are feeling ecstatic and major bear markets do not start when they are feeling depressed. The reason is that by the time investor confidence has reached these extremes all those who wish to buy/sell have done so, meaning that it only requires a small amount of bad/good news to tip investors back the other way.

In particular it usually pays to be contrarian. Extremes of bullishness often signals market tops, whereas extremes of bearishness often signals market bottoms. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital. Likewise an investments in Infosys on 11-12 April 03 (The day panic selling bought it down to 2300) would have given a 45% absolute return by 27 Jun 03 i.e., within 3 months.

Contrary strategy therefore calls for intellectual independence with a healthy dash of skepticism about consensus views. If and when a consensus grows to be a 'herd' or 'crowd', the contrarian will flee. The winning approach in contrary investing is that of a rigorous independent thinking with an inclination to be attracted to a point of view that has not yet been thought of than one that has been considered and rejected.

Unfortunately, contratrian investing isn't always easy. As John Maynard Keynes once remarked, "The market can often stay irrational longer than you can stay solvent".

* Contributed by -
Harit Shroff, PGPM (2002-2004), MDI, Gurgaon.
and
Bratin Biswas, IFCI Ltd.