If you are caught in a dilemma whether to further invest in a weak stock in which you have lost, say, more than Rs 1 lakh, so that you can average out your investments or put your money in a promising company that could reap you rich dividends, which would you choose? It’s a dilemma that faces many of us and often comes in the way of making a rational investment decision. Very often, investors choose the former to cover up losses in their portfolio or just hold on to the stock in the hope that it will bounce back soon. Behavioural finance experts say investors tend to behave in this way because the pain of loss far exceeds the pleasure from gains. It’s this emotion of “loss aversion” that many investors unwittingly succumb to when making investment decisions. Often, not understanding one’s emotions when investing in the stock market leads to big financial losses for investors.
Investors get easily swayed by another similar emotion: the “sunkcost fallacy”. This means that investors are throwing in good money after bad. On the other hand, if your investment is in a weak stock, then no matter how much you invest in it, chances are that you will still lose money. But sometimes you can use this psychological effect to your advantage. Let’s say you buy a gym membership for a year rather than for a month. Here you sink the money for a year, but it psychologically forces you to go to the gym rather than forego a huge sum. In investing, it works when an individual investor rupee costaverages on a good stock.
A common trap investors fall into when they are driven by emotions is when they try to recover a loss. At such times, an investor has to commit a bigger sum of money to recover his loss in the market. In doing so, he fails to recognise that his risk capital and exposure to the market has increased.
The first step to clearing the mental cobwebs is to make a note of why you are taking the decision in the first place. There are some key questions you should ask yourself before taking a decision to invest. Do you want to recover your losses? Do you find the investment worthy at the current market prices? Are you keeping away from the stock market for fear of losing money? Or are you investing right now because you find stocks very attractive? Are you afraid of losing money or are you afraid of taking risks?
It’s not difficult to understand your emotions over time. Question every investment decision you make with your own experience. Ask hard questions about the prospects of the company and whether the price you are paying for it is right. Circumstances can change for a company (as the Satyam episode has shown), so not every investment might turn out to be right. Shrug off your losses and move on to the next story.
On the other hand, don’t latch on to every new idea that comes your way at the cost of your old ones that might still have potential, but rather weigh your investment decisions before you take a call. The key to wealth building is to balance your investment decisions with your objectives and the circumstances of the market. Exploit the emotions of the market when there’s an opportunity. Chances are that it will leave you better placed than the rest of the market—and well-prepared for further opportunities or downturns.
