Investors, Stock Market & Behavioural Finance
By Pramod Pandeya, CFA
Last one year or so has been remarkable for Nepal ’s Stock Market. During the period, we have witnessed many encouraging northward as well as breathtaking southward movements in the index. It is good that, as a result, the NEPSE’s movement has been the subject of corporate as well as tea-shop gossips these days. Regulators, market pundits, bankers, industrialists and even common investors have their own opinions about the future of the market. Since the last six months, We have read many market experts commenting on the fundamentals, pricing as well as future (possibility of crash or new height) of NEPSE based on modern financial theories.
In fact, most of these financial theories are based on the notion that individuals act rationally and consider all available information while taking decisions. It is precisely this theoretical assumption that gets people into trouble. So, it is always better to understand that Stock Market is guided not only by the financial theories but also by the behavioural aspects of the investors. This article tries to figure out why stock market behaves irrationally or to find out rationality behind irrationality.
Investors Follow Herd Mentality
This is the proven fact that the investors are irrational and follow the herd mentality even in the most efficient market. So we Nepalis are no exception. Here are some common examples of how investors take investment decision:
a. Investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. This is because investors tend to experience sorrow and grief after having made an error in judgment.
b. This is a typical example of what is happening in the Nepali stock market at present. During the time when stock markets are going down investors expect the stocks to go down further. It is the opposite in boom time. Even if the stocks reached the new highs, investors would not sell hoping that the stock would continue to rise further. These sentiments tend to blind the rational thought process of that particular investor. While the investors are continuously trying to catch the pulse of the market, they typically put too much weight on recent experience and extrapolate recent trends that are at odds with long-run trends. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down.
c. Investors have the habit of following the crowd and conventional wisdom to avoid the possibility of feeling regret in the event their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalise it even when it is going down. Buying a stock with a bad image is harder to rationalise if it goes down.
d . In addition, investors are generally overconfident. They move from the traditional value investing to growth investing and feel proud of owing the growth stocks. However, overconfidence shows no correlation with greater success. This overconfidence ultimately leads investors to overtrade with the belief that they can beat the market.
e. Investors often see others’ decisions as the result of indiscretion, but they see their own choice as rational. Investors frequently trade on information they believe to be superior and relevant, but in fact it may not be so and that information may be already fully discounted by the market.
f. Investors generally lack the cognitive ability to properly measure risks and rewards. While making an investment, one who has even a slight advantage in recognising risks and rewards will get certain advantage that will be amplified over the period.
Financial Advisors: Word of Caution
With the growth and complexity in the domestic stock market, financial advising (stock advising) business is also booming, specially in the periphery of NEPSE building. Financial advising is a prescriptive activity and the main objective should be to guide investors to make decisions that best serve their interests. In fact, understanding the Behavioural Finance would certainly help local financial consultants to better understand the investors’ perceptions and existing anomalies in the capital markets so that they can guide the investors in more efficient and effective ways.
Basics of Behavioural Finance
If above mentioned consistent human (investors) flaws can be predicted then it can be exploited for profit. This is where the Behavioural Finance comes in, which has evolved as an attempt to better understand and explain how emotions and cognitive errors influence investors and their decision making process. As decision making involves psychology and not many financial models take this into view, many pundits believe that the study of psychology and other social sciences could shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies. Behavioural Finance, with its roots in the psychological study of human decision making, analyse how and why most investors are more confident than they should be in their forecasting ability, why they do not process information efficiently, experience the illusion of control etc.
Stock Market and stock investing is the combination of many inter-related and un-related factors. Picking a stock or advising on various facets of the market considering few inter-related or un-related factors could be fatal. So, it is imperative to understand the nitty-gritty of the market prior to jumping on this bandwagon.
(views expressed are personal)
One Year Genesis of Nepal ’s Share Market
By Atma Ram Ghimire
The shares are becoming precious, good yield items now. Observe, study and go get now because it will be always too late in future.
In the last one year, Nepal ’s share market has gained extra momentum. The growth, in general, is very positive. As development is a process, there is a lot to be done in this phase. But what the market has already achieved is laudable and the main task of the regulatory institutions is to maintain this positive development. The share market is always of hope, dreams and realities. When the market is imperfect, unconfirmed information, rumours and price-pegging ‘play and plug’ by larger stakeholders play dominant role in price determination of stocks. Sometimes news, analysis and individual stock analyst’s news favour and disfavour certain scrip which also affects the market prices. The growth of the share market is as anticipated irrespective of daily changes in indices and share prices.
The Growth
The growth of the share market is perceived in terms of number of investors, transaction amount and transaction numbers, automation in floor trading and settlement, online trading from broker premises, availability of financial resources, if partial information flow and media coverage and reporting.
l Increasing Number of Investors: This is the most significant improvement in the process of growth of the share market. There has not been primary data available on the number of investors in Nepali share markets but after automation there are at least 100,000 investors’ name entries made by share brokers and there are at least twice as many names pending the entries. This suggests that there are about 200,000 active investors making transactions at least once in a week. This is a big leap from under 10,000 investors when this market first opened for transactions. The number of primary and idle share holders is almost three times that of the active share investors. As such, the best estimate right now is 1 million people engaged in Nepal ’s share market.
l Transaction Amount & Numbers: From annual Rs. 100 million when the stock exchange first opened 15 years ago to daily Rs. 100 million transaction per day now is a big growth. Just to compare, the year ended on July 2006 had daily turnover of Rs. 17.5 million in average and now it is 70 million. The transaction numbers have increased from 150 in average to around 350 in average between these two dates.
l Automation in floor trading & settlement: The automation in share trading floor and partial transparency in transactions have tremendously improved confidence of the investors. In south Asia except Afghanistan , Nepal was the only country not to use ICT in the stock exchange. The software system, support and other related problems are still there but automation has indeed started. Brokers and investors have welcomed the automation and management is appreciated for this noble beginning.
l Online trading from broker premises: After few months of automated floor trading, Nepal Stock Exchange has allowed few brokers to do transaction through the net from their own premises. This step has enabled investors to concentrate on brokers premises rather than in stock exchange building and it has added more transparency in transactions as brokers cannot have intermittent communication for stipulated pre-determined transactions.
l Availability of financial resources: The increasing number of commercial banks and finance companies in the country has made a huge fund available for stock market. Even after Nepal Rastra Bank tightened the margin lending rules making it possible to lend only 50 percent of share’s average market value, investors seeking resources have been increasing. The banks were reluctant to lend even against share certificates, now they lend even against purchase bills from broker office. The interest rate on such lending has decreased to maximum 10 percent from 12 and certain banks charge even less than 7 percent per annum.
l Partial information flow: Recently, due to the pressure from shareholders and increasing share prices, NEPSE has been frequently asking for financial details from listed companies. Especially the financial sectors companies are responding to NEPSE request. As such, NEPSE website and notice board have some information available on financial indicators of listed companies. Though NEPSE has been very weak in terms of getting information from insurance companies and others, we can hope for improvement also in this respect.
l Media Coverage & Reporting: Due to increase in the number of daily newspapers and their coverage of share market news, share transactions have gained public attention. Television broadcasting of share prices, talk programs, interviews and FM radio programmes on stock market have immensely popularised this sector and the general people have noticed the boom effects of share market. The analytical weekly on stock news and analysis “Aajako Abhiyan” has significantly contributed towards the growth of the share market.
Area for Improvement
The share market has grown. It has attracted large number of investors. It has significantly contributed to the revenue of government through capital gain tax and it has started automation. But there is ample room for improvement from basic to professional norms. Central depository system, trading software and settlement system, information flow, internet broadcasting, management of the market operator, implementation of budgetary announcement regarding stock exchange are some areas which need immediate improvement.
The Problem
The main problem in the stock market is the lack of knowledge for its regulatory framework and market operations. Proper attitude and knowledge of decision makers are very much necessary for an effective policy framework. Fundamental requirements go missing when they have little knowledge about the issues. Every share market has its unique characteristics, though they may have certain similarities.
For example, when you say the market is ‘open’ it must be open and the regulators should not try to put their conditions in open market. It is the market which should decide which conditions it should have. At policy level, we say it is free and open market and mentally we are always there to control it.
Conclusion
The share market in last one year has achieved momentum. Despite several hindrances, the market will take its own course and the course will definitely be positive. If we are able to improve in the required area, the good ones will stay in the market and they get good prices, bad ones will automatically go away. The shares are becoming precious, good yield items now. Observe, study and go get now because it will be always too late in future.
