The ticker symbol that fluctuates between red and green is the image that probably comes first to your mind when you think about the stock market in Nepal. It is also true that while thinking about the stock market often, people think about day trading and people running around in brokers’ offices screaming and shouting. But in reality, people who trade daily only represent about 2% of the total investors in the country at a given time. Yes, 2 % of the total investors are the ones who define the price of the stock you and I want to buy. But there is nothing to worry about as those investors can determine the price of shares only in the short run. In the long run, however, most companies reflect the market price of their stocks equivalent to the progress they make financially and socially.
From this article, you will learn the following :
- Heard mentality and what it is?
- What does it mean to invest based on emotions?
- Why will you lose by trading on emotions?
Herd mentality and what it is?
No matter how many times we like to think that we are above irrational human instincts and behavior, we can’t seem to get rid of them. This is because those instincts are built deep in our psyche. E.g., let’s say you are walking down a street and you see about five people staring into the sky. They seem to be watching something very keenly. What would you do? It would definitely intrigue your curiosity and would probably make you look at the sky as well. And, what if I change that number to a hundred or a thousand people. I will bet you one thing; you will check to see what they are looking at.
Let’s try another thought experiment. What if you are in a group of people and someone makes a lame joke. Will you laugh? Of course not if the joke is lame, why should you laugh, right. Then, what if you are in a group of 5 people and four people start laughing. Will you not laugh? Difficult isn’t it. Because not laughing would be socially awkward in that situation. So my best bet is that you will laugh with them, albeit reluctantly.
Let’s look at another example. Suppose you are walking down the street and you see a large group of people (20-50 or more) running towards you and then past you. Will you wait around and see what they are running from? Or will you run with them without asking a single question? I can easily bet that you will choose the second option. Why? Because there is fear involved in that particular situation, and fear is a compelling motivator. Maybe they are all running from a tiger that just got out of a zoo? Or a serial killer with a chain saw? Or they may be running towards a free for all sale at the supermarket? Who knows? You don’t want to wait and find out because you don’t want to take a chance and be killed by a tiger or a serial killer. I know its a bit of an over-exaggeration but you get the point.
What does it mean to invest based on emotions?
All of the examples that I gave above are an example of the herd mentality. Herd mentality, mob mentality, and pack mentality, also lesser known as gang mentality, describes how people can be influenced by their peers to adopt certain behaviors on a mostly emotional, rather than rational basis.
This mentality is most prevalent in the stock market. The reason why I gave all those examples was to demonstrate how this idea of following the masses is entirely reasonable but not avoiding that normal human tendency while investing in the stock market can be detrimental. There is a reason why most people are interested in the stock market when the market itself is booming rather than when it is crashing (Most people follow market sentiments while making investment decisions). In contrast, the opposite should be the case—being a long term investor, I am often glad when the stock market crashes because it allows me to buy stocks at a bargain price.
This particular bias, which we talked about, is something that we cannot get rid of completely, but we can be aware of it. And I think it will allow us to make better judgments.
Most of us invest based on emotions because we don’t want to lose all the profit that everyone else is making in the stock market when the market is booming. Below I will demonstrate how investing with your emotions can prove to be fatal in the long run and also show how value investors invest compared to people who trade based on emotions.
Why will you lose by trading on emotions?
“Be fearful when others are greedy and greedy when others are fearful.”Warren Buffet
Disclaimer: This is just an assumption and a stereotypical retelling of how people behave in the stock market. This is not to say that everybody behaves the same way. The company I am about to use in this example is a generic hypothetical company called Eternals which sells energy drinks. I will be dividing this idea into 3 stages so that it would be easier for everyone to understand.
I like this company, and as I look at its financials, I see that it has an EPS of 23 Rs and a book value of 145 Rs. I also understand that its P/E ratio is 10 with a P/BV ratio of 2, it gives me a reasonable margin of safety. Also, it helps that the company, on average, has been providing a dividend of 10% annually for the last ten years. Overall, I think the intrinsic value of the stock is close to 300 Rs.
I like this company because I like its energy drinks. They have it in every store in every mall. I see a lot of people drinking it. I recently heard that they are coming up with a new product line and everyone is talking about it. I think I should buy the stocks in this company.
Note: Let us assume that they both bought 100 stocks each of the company trading at 240 Rs. And let’s say after 3 months the market price of the company drops to 200.
Stage 2 ( Value Investing vs Emotion-based trading)
The earnings that the company brought in the last quarter were less ( Eps = 20 Rs), but I still think its stock price is worth 270 Rs. So at 230 Rs., I would buy more.
What have I done I just lost 4000 Rs? I may have to sell the stocks before I lose more money.
Note: The first investor buys 150 more shares at 200 Rs. while the second investor will hold the stocks because he is scared. Let’s say after a year the market price of the stock jumps to 350 Rs.
Stage 3 ( Value Investing vs Emotion-based trading)
I think it is trading for more than it is worth and it has brought in very bad earning in the last few quarters. All in all, I am not satisfied with the performance of this company. It is taking on more debt and not utilizing its cash properly. I would rather sell it and take the profit to invest somewhere else where I can get a better value.
Yes! I just made a profit of 9000 Rs on my investments. I knew I made the right decision when I decided to invest in this company. I want to buy more.
Note: The first investor sells and makes a realized total profit of 33,500 Rs. while the 2nd investor buys 100 more stocks at 350 Rs. and makes an unrealized total profit of 11,000 Rs. As you can see the 1st investor was always buying low while the 2nd investor was always buying high. This is, of course, a hypothetical scenario and things in the real world may not play out as neatly. This example clearly shows why people who trade on emotions buy high and sell low.
Note: Just because a stock is trading above its intrinsic value does not mean you should sell the stock outright. Value investors only sell when the company’s financial performance is not satisfactory. Again note, that social performance (media) is sometimes a bad indicator of how the company is doing. Hence, it is always better to look at financial statements before making a decision to sell.
- Following the crowd is built into human nature.
- Do not invest based on emotions.
- Instead, Invest based on the financial results of a company.
Last articles on Value Investing
For more research: you should check out https://www.theinvestorspodcast.com/ as I am sharing the ideas I learned from his videos