The Hindu Business Line : Know-it-alls, warts and all

STRANGELY, individual investors are not the only ones who fall prey to overconfidence and violate the rational model of the stock market. Human emotion overriding commercial logic is a character flaw that tends to betray even institutional investors, such as investment analysts or fund managers, in mutual funds as well as the top executives or senior management teams of leading companies.

There is no doubt that individual investors have to guard against their own irrational human emotions (see Business Line, June 22, 2003).

But for individuals investing in mutual funds or stocks, it may be equally important to be conscious of the fallible behaviour of the institutional participants.

Irrational investment decisions

Fund managers: Individuals investing in mutual funds may need to factor in the possibility of:

Overconfidence: It is generally believed that fund managers have greater access to management of companies and better information or resources at their command. This leads to the inference that superior information or experience will help them outperform the major market indices on a consistent basis.

Mutual funds the world over trumpet their superior performance as a virtue favouring active management. And this has encouraged the tendency of excessive portfolio churn among mutual funds. But so far there has been no conclusive evidence that this overconfidence has helped mutual funds (as an investment class) to beat the market in the long run.

Events of chance: Individual investors are inevitably drawn by advertisements of mutual funds with consistent performance, say, over a three- or five-year period.

But, as Mr Nassim Nicholas Taleb writes in his celebrated book, Fooled by Randomness, how many of us are conscious that the advertisements that we see are only of "successful or so-called consistent performing" funds among a multitude of mutual funds choices available to investors.

On top of that, how many of us tend to extrapolate the past success as an index of the future? Rarely does it pass our mind that the past success may only be a random event.

Herd mentality: Most individual investors have observed the madness of crowds — chasing a stock or few stocks or a certain investing theme or sector — at some time or the other in their investing careers.

They have admitted it as a human failing or folly after the event. But how is it that when it comes to mutual funds we ignore or fail to recognise the "herd mentality" at play in stock picking.

How is it that we attribute superior stock picking skills to mutual funds, even though most of them hold the same few stocks (in probably different proportions) or chase the same "hot" stocks in order to avoid being penalised or fired by the trustees of the fund.

Investment analysts: While the role of investment analysts in rational decision-making is significant, individual investors need not always swear by their recommendations.

It is observed that analysts are slow to revise their previous assessment of a company's financial projections, even when the fundamentals of the industry show signs of a change.

The software sector in India, especially frontline stocks may be a good example of this trend. This slow impounding of negative information is greater for stocks which are past winners for the analyst community. Mind you, this is not true for the analyst community as a whole, but a good proportion of them may be at fault.

Management team of companies: Individual investors overrate the management abilities of a company with a good track record. A healthy scepticism is in order in areas such as:

Overconfidence in acquisitions: Despite overwhelming evidence that a buyer generally overpays in an acquisition and the losers are shareholders of the acquiring company (called famously as the "winner's curse"), the CEOs and senior management team are overconfident in their ability to make the acquisition a success. They believe that they can spot the right target, have superior wisdom in integrating and managing them and ensure that they are EPS-accretive in the medium term.

Probably on an average, for every successful acquisition, there is an incidence of failure. However, selective amnesia comes into play with only successful acquisitions being cited as examples, while the less successful ones are allowed to recede from public memory.

Loss aversion: Just as a good proportion of investors holding a losing position find it difficult to sell out and cut losses, a number of managements hold on to loss-making projects without taking the bold decision of terminating them.

Though this means throwing good money after bad, managements continue to favour that course as terminating such projects actually mean loss of face and acceptance of the grim reality that they made a professional error of judgment.

Consistent undervaluation: Most management of Indian companies believe that their stock is undervalued in the market. This is obvious from the number of companies putting through buybacks compared to companies returning excess cash to shareholders.

The former is aimed as an attempt to correct undervaluation of the stock. But the latter is considered an admission that it does not have projects on hand which will yield returns in excess of its cost of capital. The latter course of returning cash is viewed positively by the stockmarkets in only select cases.

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