Falling stock prices and our brain

Dear Readers, Markets are falling continuously these days. Let us try to understand how it affects our thinking so that we can tide over this phase of the market.

Falling Stock or Losing money affects the same part of our brain as that of any other fear which endangers our survivability. During the hunter gatherer days our ancestors used to feel fear on seeing some predator approaching them. The best course of action in that situation was to run as fast as one could to escape from the predator to keep oneself safe. If during that time our ancestors had taken time to analyze the predator. Whether it was harmful or not then there was a maximum possibility that that person would no longer be able to survive.

In the case of investing whenever we see losses in our portfolio, the same fear centers of our brain are activated as those of our ancestors when seeing a predator. But in this case the natural tendency of running from the predator i.e. falling stock prices is counter intuitive to investing success. Instead of running away from the falling stock prices i.e. selling all our holdings and moving to safe avenues like Fixed Deposits we should stay the course of regular investing.

Instead of fearing the paper losses in our portfolio we should try to build the mentality of increasing our allocation to equities when it becomes cheap. Long term success in investing is possible only through behaving in the right way during these down periods. When we see falling prices or discount any of the stores where I can purchase our things we become excited and happy. Then why should we be depressed on seeing cheaper stock prices. Also as long as we do not sell our holdings, all the losses that we see in a downward phase of the market are temporary or paper losses. Instead we should focus on our long term goals and act accordingly. In the short term share prices are determined by the emotions of the participants but in the long term it is determined by the earning power of the business.

Investing is 20% knowledge i.e. selecting the right stock to invest in and 80% behavioral i.e. how we behave during the tough phases of the market. So instead of fearing the falling share prices we should gather courage and invest for the long term when the valuations become cheap.

With a little bit of effort many of us can identify the right companies to invest in. But it is the behavioral aspect which determines the success and failure in equity investing. How we behave during market downturns determines the future outcome from equity investing. Multi bagger returns can be made by only by Investing during the bear phases of the markets and not during bull phases.

Have you ever wondered why we hear about stock market investing only after 1-2 years of good performance in the markets? That is because people become attracted to the markets by seeing the rising share prices or by seeing their friends and relatives making money from the markets. You will not hear anything of that sort from people after 1-2 years of declining markets. This is called recency bias. People extrapolate the recent trends into the future.

When stock prices are rising for the last 1-2 years people extrapolate the same and think that it will continue to rise in the future also and make their return calculations accordingly. And when the stock prices are falling they extrapolate the same and make a very gloomy projection for the future. The trick is to overcome this bias and invest when the present market situation is bad and to book profit when there is euphoria all around.

But these biases are not easy to overcome as these are hardwired into our brain since the time of hunter gatherer days. In those days these biases helped our ancestors to survive. But for investment success these biases stand as obstacles in front of us. I will try to write about different biases that we face in our everyday life in a future articles.

For investment success we will have to strengthen our brain muscle memory to fight against theses biases. Just think about why we fear falling stock prices? Because, we do not like losing money. But as long as you do not sell your shares those are only paper losses and if you can build the confidence about the business by studying about its prospects then you will know that this decline in stock price is temporary and as and when market conditions improve your stock prices will also recover and scale new highs if the business is sound. Sometimes businesses face hard times for a few quarters as there is no business out there who do not face any challenges. That is part and parcel of doing business.

Sometimes margins may shrink due to rise in raw material prices. sometimes some big orders may get cancelled etc. During those times share price drops as market only looks at the near term and does not look beyond a few quarters. That is the opportunity for us retail investors. If we can develop a good understanding about the business by studying it ( topic for another post ). then we will know that this downturn in the business is temporary and the business will come back after sometime. We can invest during that time in the company that we have studied as it will be available at a cheap price and reap the benefits later when the business improves.

Is this doable or is it tough? Do let us know about your thoughts on the subject. Again you will have to be curious to know about the businesses and how it works. You should love to read. You will have to devote your precious weekend time which is mostly devoted to other activities like watching TV or outing etc. to reading and understanding the businesses. That’s all for today.

– Regards
B.K. Sharma

Disclosure : Nothing on this website should be construed as investment advice. Please consult your financial advisor. We are not SEBI registered Analysts/Advisors. We are not accountable for any loss or gains that might occur to you from this or any analysis on the website.