Understanding Investment Psychology When Investing in Market

What if a stock you invested into is a wrong investment and you know for sure it is a mistake but are not comfortable booking a loss?

To answer this question let us understand the psychology of losses and psychology of averaging down.

1. The Psychology of Losses

Let me share with you a study by Richard Thaler where he provides an interesting experiment to demonstrate concept of perceived loss. In his study he started with 2 groups of people and provided with a problem that had a same outcome but framed differently.

In the first group everybody was given $30 in cash and told they had 2 choices:

1. Walk away with the money
2. Gamble $9 on a coin flip i.e. If they won they will get $9 extra and if they lost they will have $9 deducted.

70% of the people took the gamble.

The second group was offered a different choice.

1. Gamble on a coin toss. If they win they will get $39, if they lost they will get $21.
2. Walk away with $30 on no coin toss.

Only 43% of the people opted for gamble on coin toss.

If you look at the problem presented for both the groups, its identical, they will make $30 and if they opt for a gamble on a coin flip, they will end up either $21 or $39.

Why did the first group opt to gamble more than the second group? They perceived the problem differently though the result of the scenario was exactly the same in both the cases.

The first group of people got the money and then they were told to gamble on it. Brain started to look for spending the found fortune and was ok loosing as well. The second group did not get any money upfront and so they wanted to make most of the opportunity first and so most of the people opted to walk away with $30.

How the above Study Relates to Investment in Market?

You may have this question in your mind about how the above study related to investing in market.

So let us apply similar scenario to market.

You invested in company X at 100 Rs per share. The price of X comes down to Rs 90 per share. As soon as the stock price hit Rs 90, you found second company Y trading at Rs 90. Now out of X and Y, you know for sure that chances of Y hitting to 100 is far more than X going back to 100 because Y is in a uptrend where as X coming from 100 to 90 suggests its in downtrend.

You have couple of options to choose from

1. Book a loss in X and invest the same amount in Y to recover the losses.
2. Remain invested in X till it reaches price level of 100.

Most of the time people will opt to go with second option.

Do you know why?

People view the above scenario – As long as they remain invested in Stock X, they are not at loss. As soon as they opt for first choice, they feel uncomfortable because they think they are making losses. Loss is not a loss till it is acted on.

In the last couple of articles about emotions of market: fear and greed, I mentioned one common point of being able to book loses and be prepared for the worst. If you cannot book losses, you should not be in the market.

2. The Psychology of Averaging Down

We saw that when it comes to investments, we should not be driven by emotion but be rational but most of the time we tend to be driven by emotions. In the above scenario I showed how psychology of investment get people to be doing things that is not right investments and still people sit on wrong investments for years.

It looks like it cannot get any worst than that but averaging down is even more worst. It’s like compounding the problems without actually realizing it.

Let me share yet again the same hypothetical example of company X at price 100. As soon as we invested in the stock, it starts sliding and soon in a month or so, it is at Rs 70.

It is a great company to be investing into and soon it can turn things around and so you decided to average down the stock. You buy more shares of company X at 70 Rs to average down your price to 85 Rs per share and double the number of units you had.

If at first you invested 100,000 Rs and purchased 1000 share and now you invested 70,000 more to purchase yet another 1000 shares. Your total investment is 170,000 and total number of shares that you have is 2000 units assuming your stock can go back to 85 Rs very soon where you will be at no profit no loss scenario and that is correct but…

Fall from 100 to 70 is 30% fall in stock and to gain from 70 to 85 is still a gain of 20+% rise.

So should you invest in Stock X more and wait for gain of 20% or you can invest in some other stock and start making profit?

Conclusion

What if your stock X is a wrong investment and you know for sure it is a mistake but are not comfortable booking a 30% loss?

It looks like we have only 3 choices.

1. Hold the investment (Psychology of booking losses)
2. Average Down the bad investment (Psychology of averaging down)
3. Quit the market.

Do you see any other choice?

The answer is YES. There is one more choice which I have shared with many of my readers and it has helped them weed out many of their bad investments like Reliance Power investment in IPO or State Bank of India purchased at 3000+ price in 2011.

Booking losses can be nightmares and so I advise a method of booking losses where you don’t feel guilty about booking losses. The amount of investment planned to average down in X can be used to Invest in some other company Y and as you profit in Y, book the same amount of loss in X as well to even out profit and losses. It is nothing more than just to feel not too bad about the losses.