Thursday Thud“- screamed the ET’s edition of 17th August, 2007.. “Sensex tumbles 643, Nifty 192… ” !! I have been dabbling with financial economics & the stock market of late & this was food for thought & a blog action! A bit of R&D and I came up with a couple of observations offered by the “dismal science” (read Economics)!

       Classical Economics has relied on the assumptions of a ‘homo economicus’ motivated by self-interest & capable of rational decision-making. But history has a different story to tell with stock market anomalies, market bubbles & crashes across the world. So, the question is-if man is rational & the market is efficient, why did all this take place? The answer lies in the vagaries of the human mind such as greed, fear & hubris. This has been the focus area for a growing body of of work called “Behavioural Economics” which explains the impact of human emotions & cognitive errors on the investment process. While classical economics is concerned with how people should behave, behavioural economics focuses on how people actually behaved in the real world.

    One rupee is not the same as another. Richard Thaler coined the term ‘mental accounting’ which refers to the inclination to categorise & treat money differently. To cite an instance, people may go out of their way to save Rs. 5 on purchase of goods worth Rs. 25, but won’t do the same to save Rs. 5 on purchase of their favourite CDs worth Rs. 500! Change in wealth appears to be more important than the ultimate value. It is a proven fact that people are willing to take more risks to avoid losses than to realise gains. People tend to ignore ‘sunk costs’ & dislike accepting losses. A familiar problem with investments  is the sunk cost effect-the tendency to ‘throw good money after bad’. The human mind has such a dislike for incurring losses that many are willing to accept gambles in the hope of avoiding them. 

   Success in the investment world depends on the decisions one makes. Due to ‘irrational exuberance’ investors invest large sums of money in select sectors/stocks without paying heed to one’s asset allocation & risk tolerance. This leads to buying of securities at near-peak prices & selling of securities in a downturn. To cut a long story(research) short keep emotions out of investing!!