It doesn’t pay to be an emotional investor

NEW DELHI: A week, it is often said, is a long time in politics. On that count, the past three tumultuous weeks mark an eternity for the Indian stock market. Between the market as it was on October 5 - when the Sensex touched an all-time of 8821 - and today -when the bellwether index has slipped below 8000 - there’s a world of difference.

There’s been a dramatic turnaround in sentiment: the same investors who were wildly exuberant when the Sensex was on a roll are now distinctly downbeat. Where once it seemed that a bull was on the rampage, today the animal species more closely associated with the market is the dreaded bear.

How did the mood of the market swing so palpably - and so violently? The answer may have less to do with the market itself than with investors. In both cases - when the Sensex was at 8800 and when it’s below 8000 - investors’ judgments have been perceptibly clouded over by irrationality and by extremes of emotion. The market, it is said, swings between Greed and Fear: the happenings of the past three weeks have only validated that maxim.

How do emotions influence our investment decisions? That question is the subject of some fascinating researches by behavioral economists, some of whom have gone on to win the Nobel prize for economics.

One school of thought has persuasively argued that emotions interfere with the capacity to make prudent financial decisions.

The other believes that it is possible to exploit emotions and profit in the capital markets.

One of the most recent studies on this subject, conducted by a team of researchers from the Stanford Graduate School of Business, Carnegie Mellon University and the University of Iowa, established that emotions negatively impact investment decisions.

The findings of the study were published in the June 2005 issue of Psychological Science. The study analysed the investment decisions made by, among others, people who were unable to feel any emotions due to lesions in their brain; these subjects otherwise had normal intelligent quotients, and the parts of their brains that were responsible for logic and cognitive reasoning were not affected.

A test-a 20-round gambling game - was conducted on three kinds of subjects: normal people; participants with brain lesions that impaired their emotional responses; and ‘control’ participants who too had brain lesions, but not in areas associated with emotion processing. Each participant was given $20 as play money, and at the start of each round, he had to decide between two options: invest $1 or not to invest.

If the decision was not to invest, the participant could keep his money and go to the next round. If they decided to invest, they would hand over a dollar bill to the experimenter, who would toss a coin. If the participant won the toss, he would win $2.50; if he lost the toss, he would lose the $1 he wagered.

Participants could theoretically decline to participate in any of the 20 rounds, and still walk away with $20. However, it made sense to play all 20 rounds because the potential rewards from each round ($1.25, with a 50-50 chance of winning) were higher than the potential loss ($1).

The people who took the most profitable approach to the game were those whose emotional responses were impaired. They invested in 84% of the rounds, and earned on average $25.70. In contrast, “normal” participants invested in only 63% of the rounds, and earned on average only $22.80.

As the greed of recent months gives way to Fear of a bear hold on the market, there’s a thought for the rational investor - if there is such a beast at all.