Greed, Fear & Funds

Behavioral biases while taking investment decision makes an investor take irrational decision, who otherwise make rational decision. DSIJ explains how two of the most dominant emotion impacts your overall investment returns.

Every attempt by the bulls to take control of the market is being butchered by the bears. The equity market that was bi-polar for some time has become unipolar in the last few trading sessions. Few stocks that were taking the market up till recently are also witnessing selling pressure now. Although the bellwether equity indices have gained 12% since January 2018, and till recently, these indices were soaring to new highs. But it was only a handful of stocks that were driving the indices higher. Hence, this masked the turbulence in the broader market. The fact remains that Indian stock market is going through one of the worst phases in recent years reflected in the graph below.

Now, even the sacred names have started falling and are showing signs of fatigue after their recent results or management commentary. Therefore, in the last few trading sessions, we saw that the market was falling continuously.



The graph clearly shows the movement of the Indian equity market since the start of FY17. After the initial soaring of the key indices, there has been a free fall of the Nifty Midcap and Smallcap indices after they reached their highs at the start of January 2018. The frontline index Nifty managed to stay afloat, thanks to those few names. The broader indices Nifty Smallcap and Midcap are already in the grip of the bears and have fallen by more than 20% from the peak attained at the start of the year 2018.



The impact on MF investor
All the naïve investors who invested in the mutual funds following the all-pervasive advertisement by industry body AMFI, ‘Mutual fund Sahi Hai’ must be wondering how investment in mutual fund is ‘sahi hai’. Most of them might have been witnessing a negative return on their investments, especially if they have invested in small-cap and mid-cap dedicated funds. If we take the total loss to equity investors (including equity MF investors) from the peak attained at the end of January 2018, it is more than Rs. 13 lakh crore. To give you a perspective, it is more than half of the total AUM of domestic mutual fund industry (including debt funds).

At the end of July 25, almost 60 per cent of the equity-dedicated open-ended funds yielded negative return in the last one year period. The average of funds that have managed to give positive returns comes to around 3.18 per cent and most of these are either large-cap dedicated funds or sectoral funds such as IT and banking.



Compare this with the year 2017 when the average return generated by the mutual fund schemes were in excess of 34 per cent, while there were also funds that generated returns in excess of 70 per cent. There were only four funds that generated negative returns.

What has changed fundamentally in the last one year that has led to such a drastic change in the performance of the funds? Pessimists will always argue that a lot has changed in the last one-and-half year in the mutual fund industry. First, the fund houses have rationalised and categorised their funds as per the SEBI directive that has led to churn in the portfolios, which might have resulted in such performance. Second, the reintroduction of long term capital gains (LTCG) tax in the last budget resulted in lower appetite for equity investment and impacted the equity returns overall.

Besides, there were some company-specific issues that have cropped up in some of the mid-cap and small-cap companies, which further dragged them down. The stocks of companies such as DHFL and Manpasand Beverages are a couple of examples. Therefore, investors have become more risk-averse. And not to forget the sagging economic growth.

Greed, Fear and Fund’s Performance

Nonetheless, seasoned investors know that the market many times is influenced more by the investors' behaviour. Fundamentals do play important role, however, behavioural biases of the investors too plays a vital role in determining the equity investment performance. This is more so in the case of mutual fund investment. It is well-known that fund performance is determined by various factors such as its size, flows, turnover, management fee and the expense ratio, but behavioural biases of investors play an important role too. There are studies that show that an investor gets different returns and many times lower than what the fund has generated. For example, a fund might have generated 15 per cent annualised return in the last five years; however, its investors may have not generated similar returns during the same period. The reason being the timing at which they enter and exit a fund. It has been seen that investors purchase funds with a better performance history and redeem those with a poor performance history. Therefore, they end up investing in funds that are near their peak and exiting them once they are near their bottom. This is just the opposite of what one should be doing to earn better returns.

Morningstar, which has calculated investor returns for openend mutual funds to capture how the average investor fared in a fund over a period of time, shows that investor’s returns are often lower than the fund returns. This is because many investors chase past performance and end up buying funds too late or selling too soon. As a result, they suffer from poor timing and poor planning.

Greed and Fear

So, what explains such behaviour of the investors? The two strongest emotions that move investors are greed and fear. The emotional fluctuations of investors, especially changes between greed and fear, may lead to larger price changes of both equity and equity-related mutual funds.

The greed of an investor always leads him to high spirits and makes him feel bullish for the future market. This leads to an increase in the stock prices, which translates into higher NAV of equity-dedicated MFs. Meanwhile, fear always has the opposite reaction, which means that investors are in a gloomy mood that causes them to feel bearish, resulting in a decrease in stock prices and thereby impacting equity MFs.

When investors are under the influences of behavioural biases, it impacts their decision-making ability, which results in irrational behaviour. So, when investors become greedy, they will show over-optimism and overconfidence caused by an under-estimation of risks and excessive levels of longing for higher returns. Investors have a high desire for wealth, and to satisfy the desire, they take aggressive action. This might lead them to invest even in a bubble. The history of stock market is full of such incidences, starting from the Dutch tulip mania to recent sub-prime crisis, where excessive greed has led to forming of the bubble in the stock market, which is mostly followed by bust and excessive fear.

When the investor is faced with fear, he may show a complete disregard for the fundamentals. They just forget their plans and join the selling spree because they are scared of amplifying their losses. They have uncertain feeling towards emerging situation and make pessimistic judgements on future events.



How to define greed and fear

These two emotions deal with human psychology and hence these are very difficult to define and quantify. In the words of famous economist John Maynard Keynes, ‘The market can remain SDirrational longer than you can remain solvent.’ This was after he entered into a series of highly leveraged trades that went against him.

Nonetheless, there are certain anecdotal evidences that say that a combination of some of the best valuation ratios can be used to check the ‘greed’ and ‘fear’ in the market. We combined three ratios, namely, price-to-earnings, price-to-book value and dividend yield of Nifty 50 equally to arrive at a composite greed and fear index.

We assumed that once this index crosses one standard deviation from its last three-year mean, the market is in ‘greed’ zone and is ignoring the high valuation. Investors are optimistic and ignoring the warning signal. Similarly, if the index is going one standard deviation below its three-year average, they are fearful and not willing to take any risk.

Going one step ahead, we also defined ‘extreme greed’ and ‘extreme fear’. Extreme greed is a situation where the index is two standard deviation above the mean, whereas extreme fear is a situation where it is two standard deviation below its mean.

The below graph shows that at the start of financial year 2017, there was great scepticism in the market that reflected in the index, which was two standard deviation below its long term average. The situation started changing from the start of year 2017 and reached the level of greed in mid-2017 and remained there (except for fall in the month of October 2017) till the start of year 2018, when there was extreme greed.





The Impact on Mutual Fund Investor

There are only two things that impact any investment performance. The first is its entry point and the second is its exit. Although no one can master this, however, one can use the ‘greed’ and ‘fear’ index to time the entry and exit, at least for the next one year.

The above graph shows the average performance of ‘large-cap’ , ‘mid-cap’ and ‘small-cap’ funds when they invested in different phases of the market, that is, ‘greed’ and ‘fear’. If you had invested during the fear phase of the market, that is, at the start of year 2016 and end of year 2016, in the next one year, you would have earned on an average 30 per cent. The highest returns would have been earned in the small-cap funds that generated return of 36.3 per cent, while large-cap and mid-cap dedicated funds would have earned return of 22.7% and 32%, respectively.

In case you had invested during the ‘greed phase’ of the market, that is, after August 2017 or during the start of the year 2018, your returns would have been significantly different from what you have earned having invested in the fear phase. For example, in the small-cap dedicated funds, you would have earned average return of -5.8% if you had invested during this greed phase. 

We tried to test this even with three-year and five-year periods, however, the results were not consistent because the number of periods were very small in case of three years and there was no period in the case of five years as we started our study from year April 2016 and the first five-year period will only begin in 2021.

Moreover, it has been observed emphatically that if you have investment horizon of five-year and more, the timing may have lesser impact on your overall returns as it will follow the long term return pattern.

It is well-known that fund performance is determined by various factors such as its size, flows, turnover, management fee and the expense ratio, but behavioural biases of investors play an important role too.



Conclusion

The above explanation may be oversimplification, but it can often be true. Giving away to these emotions may have a damaging impact on your portfolio. We saw in the above illustration that if you are overwhelmed by one or both of these emotions, your portfolio will always generate sub-optimal returns. Avoiding these two emotions will help you to focus on factors that are important for fundamentals of investing, such as maintaining a long-term horizon, rupee-cost averaging and avoiding getting trapped up in the latest craze.

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