Behavioral investing # 1: Overview: Heuristics

Well, ‘Behavioral Investing’ may sound like a fancy term but it is as old as the existence of behavioral aspects influencing investment decision making.Talking about behavioral influences on us, few of my favorites quotes catches the essence like no other;

"If you don't know who you are the stock market is an expensive place to find out."

                                                                                                -George Goodman

"The markets are moved by animal spirits, and not by reason." 

                                                                                                         -John Maynard Keynes

“Markets can stay irrational longer than you can stay solvent.” 

                                                                                                         -John Maynard Keynes

 Behavioral investing is specifically focused on the study of the influence of various behavioral aspects on investment decision making in financial markets. Investment decisions are made by individuals as well as by entities. Knowingly and unknowingly, willingly and unwillingly – we are for most of our investment decisions (also for any other decisions!) under the influence of behavioral aspects. Like it or not, as long as humans are involved in investment decision making – one hundred percent rational unbiased decisions are a myth! Investment decisions such as buy, sell and hold in financial markets are influenced by two categories of biases namely; 1. Cognitive errors (biases) 2. Emotional biases. In many cases, heuristics are considered to be a source of such biases. Hence, let us understand heuristics first.

Heuristics – A mental shortcut / Rule of Thumb:

Origin: from Greek ‘heuriskein’ for ‘to find’.

“When we do not have the ability or willingness to process complex questions or have to choose out of multiple choices many times, we resort to a quick way of decision making based on what we already know”- that is 'heuristics’. It is a quick way or approach that the brain adopts to reach to the solution/conclusion. Many times heuristics are gained by trial and error method. Heuristics give us fast answers in order to make a decision pertaining to complex questions without involving yourself in exhaustive research and analysis. Though in a day to day life routine decisions taken based on heuristics are mostly prudent but It is important to note that not all such decisions taken based on the heuristics may turn out to be the optimal/best choice. Hence, these decisions are prone to error. 

We daily apply heuristics, period. But why? Well, we have increasingly come to know that our brain cannot process way to complex things and also our system 2 (as described in the book: ‘Thinking fast and slow’) is lazy processing complex set-ups as processing complex set-ups consumes a significant amount of energy. Hence, naturally and sometimes after training our brain starts developing a mental short cut to process or perform tasks. 

Example from daily life:

1.  How many times you have bought the product just because it was ‘limited edition’ product or having only a few units left? When our decision to buy a product is majorly driven by scarcity of the product rather than requirement/utility/feature of the product – we are affected by ‘scarcity heuristic’. 

Example from investment world:

1. The rule of 72 is heuristic. All it provides is the quick but not precise answer to the question of how many years it will take to double my money at a given interest rate.

2. Asset managers, investors and financial professionals apply heuristics to speed up the investment decisions based on limited data set. ‘Copycat investing’ can be termed as heuristics, where an investor is trying to follow blinding other famous investors’ strategies.

One of the very famous heuristics which distort investment decision making is ‘representativeness’.

Representativeness Heuristic:

Investors can be under a heavy dose of representative bias when they make long-term investment decisions based on recent (last few quarters or last few years) performance of the mutual funds/stocks etc.This bias also hit us hard when we choose a particular broker or a stock analyst because of his stellar performance in the last few quarters. In this context, when a very small sample time frame is taken for the analysis purpose and labeling (hot or not so hot!) of a particular mutual fund/ stock/broker/ analyst is done based on performance during that time frame -we are likely to make faulty long-term investment decisions.

Applying heuristics have advantages as well as disadvantages.The art is to know where not to apply heuristics!

Cognitive errors (Biases) and emotional biases will be up for a brief discussion in the next blog.

Behavioral Finance: Laying the foundation

Is it true that the pain from losses is more impactful than the happiness from the gain?

Why we keep on riding our loss-making investments?

Why we are more inclined to spend windfall (unexpected) gain for leisure but not so much with our ‘hard-earned’ money?  

Why we are more convinced to invest in the stock whose brand or company name is familiar to us even without having any idea about the financial health of that stock?

We are puzzled by questions like above and many more, which we shall try to elaborate and resolve in upcoming series of blogs on behavioral investing.  

My keen interest in behavioral finance (in general) and in behavioral investing (in specific) is instrumental in jotting down what comes next as a series of blogs in ‘behavioral investing’. But, before we jump to behavioral investing it is crucial to lay the foundation of behavioral finance and how it is positioned against standard (modern) finance. Hence, we go for a brief overview in this blog.

_______________________________________________________________

Standard (Modern) Finance: Rational ‘economic man’ (Homo economicus) and Rational markets: Homo economicus is rooted in neoclassical economics exemplifying ideal human economic behavior grounded on principles of 1) perfect information 2) perfect self-interest and 3) perfect rationality. Modern finance is built on the tenet of prefect rational behavior of agents and markets. Below Figure-1 establishes the fundamental idea and key contributors in standard Finance and behavioral finance.

Figure-1: Standard Finance V/S Behavioral Finance

Behavioral Finance: Since the 1950s, the confluence of experimental economics, cognitive psychology and decision theory started laying the foundation for the genesis of a discipline called ‘Behavioral Finance’. At the core of behavioral finance is the premise that agents (humans) do not behave completely rationally all of the time while making financial decisions. Behavioral finance believes that financial decision making is influenced by the behavior of decision-maker which in turn is influenced by biases and heuristics. Here, the focus is on how individuals and markets behave in reality rather than in theory. Behavioral finance branches out into two categories;

1.Behavioral Finance –Micro aspects (Individuals/Investors):

Theory of Moral Sentiments (1759) by Adam Smith was perhaps the first account that focused on the emotional and mental underpinning of human interaction in economic activity. Likewise, Jeremy Bentham also elaborated on the psychological aspects of economic utility. These early thinkers recognized the role of psychological idiosyncrasies in economic behavior. But the voice of these early thinkers lost amid the rise of revolutionary neoclassical framework around 1870. At the heart was ‘Rational Economic Man’. Rational economic man epitomizes the idea of maximizing economic well being and expected utility, utility-optimizing goals and using all the information available to take the most rational decision. The famous economist John Maynard Keynes was never a proponent of ‘Homo economicus’. He believed in animal spirit – human emotions that played a role in many actions. A much better version of this philosophy was bounded rationality of Hebert Simon.  Bounded rationality assumes the choices of individuals may reflect rationality but there is a limit to the knowledge and cognitive capacity. Behavioral finance disputes the idea of rational economic man which is a key tenet of standard finance.

2.Behavioral Finance –Macro aspects (Corporates, markets and economies):

Behavioral corporate finance: It is a study of financial decisions by principals (Promoters) and agents (CEO,CFO, managers etc.) in a corporate setting with the understanding that decision-makers are less than fully rational and influenced by biases and heuristics.

Financial Markets & anomalies: As opposed to the ideology of standard finance/economics that markets are rational and efficient, behavioral finance argues (based on evidence) that markets have a tendency of over-reacting and under-reacting and markets are prone to behavioral effects. Thousands of studies have emerged out of never ending ‘market efficiency’ debate. Many studies have focused on existence and persistence of anomalies which are broadly categorized into three types as under;

 

Economics/ public policy-making: The policy-making is possibly least influenced but the most promising domain by behavioral economics. Here, the idea is to use behavioral insights to design and implement policy decisions with the aim of maximum reach and impact. Insightful paper by Raj Chetty, deliberates on how new policy tools can be created and how effect of existing policies can be improved with a behavioral economics approach. The idea of ‘Nudge’ by appropriate use of choice architecture as proposed in the book Nudge has gathered enough steam. Likewise, The Behavioral Insight Team which now has developed into the advisory unit assisting across policies, countries, NGOs on incorporating behavioral science insights for better outcomes.

Behavioral finance is an endeavor to understand and correct if possible (especially when we are biased/blinded) the very behavior of humans while making financial decisions. 

Debacle of DHFL : Story so far & some staggering questions

How is it possible that the company which hit a high of Rs. 691.50 on 3^rd/ Sep/18, is trading at paltry Rs.17 in just one year and three months?

How is it possible that the company which was once a darling of foreign portfolio investors, mutual funds, Rakesh Jhunjhunwala (RJ) etc. has seen many of these investors vanishing?

How is it possible the company which was supposedly in pink of health and had clean chit from various credit rating agencies (CRAs) having AAA or equivalent of ratings for debt instruments has now ‘default’ rating and heading for insolvency proceeding?

What has happened?

The ominous day of 21^st/ Sep/18 when DHFL (Dewan Housing Finance Corporation) crashed by 42%, has changed permanently the fate of DHFL (and its’ investors & lenders) for the worst. The crash which never recovered was in a response to the rumors generating from the bigger crisis of IL&FS.In the last 15 months, DHFL the NBFC- has degenerated from ‘safe bet’ and ‘sound NBFC’ to a candidate for insolvency proceedings. Fast-forwarding to the recent development, DHFL has stopped making any payments to secured/unsecured creditors as well as fixed deposit holders as per the order of Bombay High Court in a case filed by Reliance Nippon Life Insurance. However, the court has amended the order and allowed DHFL to make payments to the banks and NBFCs with which it has existing securitization and loan assignment agreements. Looking at the grim situation, with this circular the Board of Directors of DHFL has been superseded by the RBI. Also, RBI has appointed the resolution professional to take charge of insolvency proceedings.

How it has happened?

1. Snowball effect from IL&FS trouble: First and unrecoverable dent came from IL&FS crisis and related rumors. I could not find any warning bells on DHFL before the ominous day. In fact in the same month last year, DHFL clocked all time high of Rs. 691, with the promise of further upside from so called analysts & talking heads. Default by IL&FS on various obligations certainly choked the credit market and liquidity crunch was felt across the financial system for a sometime. This undermined DHFL’s capability to arrange much needed capital for meeting the upcoming debt obligations.

2. Cobra bite - Fraud and fund diversion: Lethal salvo was fired by a post (Thank God at least few are doing their job seriously!) from cobrapost.com alleging the promoters of DHFL for siphoning off Rs. 31,000 crore worth of public money to shell companies. Well, recently submitted forensic report by KPMG confirmed that the funds were siphoning from DHFL to other promoter backed entities. Consequently, Ministry of Corporate Affairs has ordered investigation by SFIO (Serious fraud investigation office). Only time will tell what SFIO is going to unearth but this has led to a huge trust deficit from investors and lenders in the DHFL. The share holding pattern -shown as below - at the end of Sep-19 quarter vis-à-vis Sep-18 quarter is reflective of vanishing investors’ trust and interest in DHFL.

            Share holding pattern of select public shareholders of DHFL

Public shareholders	Sep-19	Sep-18
Foreign Portfolio Investors	9.48%	19.43%
LIC	3.44%	3.44%
Mutual funds	0.01%	2.94%
Body corporate	6.20%	12.76%
Mr. Rakesh Jhunjhunwala	2.46%	3.19%

          

            Source: As per filings by DHFL 2018&2019

3. Faulted business model & Asset- liability mismanagement: It is an open secret that how NBFCs run their shop. Majority of NBFCs reside to the strategy of borrowing for short term tenure and lending for long term tenure. Lure of borrowing short term and lending long term to safeguard better interest margin/profitability is overpowering among many financial institutions. But time and now, it has been evident that the exploitation of borrowing short term & lending long term- strategy has transmitted into asset –liability mismanagement. Improper asset-liability management is harbinger of liquidity risk which if remains unattended can lead to solvency risk. Seemingly, DHFL also travelled the same path. Due to market conditions, downgrade in credit ratings and unearthing of the fraud, ‘money’ pipe-line for DHFL was choked and it was put into such a dire state that it could not arrange capital to meet various redemptions of debt obligations leading to a default and cascading effect.

Bigger questions:

No matter whatever bitter remedies are going to get suggested, be it- securitization (selling loans to banks), liquidation, equity conversion to lenders etc. following staggering questions remain unanswered!

1.     Why do we remarkably fail to see the ‘Black Swan’ events and system at large remains stubbornly reactive?

2.    Is the process and basis upon which deposit-taking NBFCs are granted the permit to take a deposit from public robust? Does RBI on regular intervals appraise such permits? Should it cancel the permit after regular audit if it finds the NBFC is not fit to take deposits from the public?

3.    What will happen to the ‘hanging fate’ of fixed depositors(unsecured creditors) consisting of retirees, salaried, senior citizens and of course there are Mutual funds & banks?

4.   Are the employees of UP Power Corporation Limited whose money through state power employees' provident fund was fraudulently invested Rs. 2600 crore in DHFL going to get their money back?

Round-Trip Fallacy: The reasoning error to avoid

The human brain is wired to interpret similar sounding sentences/scenarios/situations in the same way however the reasoning behind it may not be similar at all leading to the generation of reasoning errors and faulty decisions.

The classic similar sounding situations;

"No evidence of cancer" 

                   &

“Evidence of no cancer”

The above situation looks similar hence our brain interprets it as the same. But the below explanation reveals that these are completely different. 

1). "No evidence of cancer" = The test/expert/instrument was unable to detect evidence of cancer.  

    "No evidence of cancer" ≠ There is no existence of cancer. 

It simply means we are so far unable to detect the cancerous cell in the body however this does not lend itself to the premise that there is no cancerous cell in the body.

2). “Evidence of no cancer” = simply there is no cancer.

 But this is not possible as no amount of tests/experts/instruments can confirm with a hundred percent surety that there is no cancerous cell in the body. 

Technically speaking:

The technical term for the above confusion (absence of evidence of such events-cancer for evidence of absence of such events-cancer) is ‘Round-Trip fallacy’ which was coined and elaborated by NassimTaleb in his book The Black Swan. 

 An analogy from the world of finance:

“There is no evidence of fraud/ wrong-doing/ cooking the books in this company” = The so-called auditors/experts/regulators could not find (didn’t want to find!) so far any evidence of fraud. OR They did not know where to look to find evidence. 

“There is no evidence of fraud/ wrong-doing/ cooking the books in this company” ≠ The company is clean.

“There is no evidence of financial trouble/ crisis in the economy” = So far no evidence found to say that there is trouble or crisis.

“There is no evidence of financial trouble/ crisis in the economy” ≠ The economy is booming & everything is rosy! 

In a nutshell:  

When we try to interpret these kinds of similar sounding situations/events, our brain tricks us into believing that no evidence of any such events means no existence of such events. But understanding the ‘Round-Trip fallacy’ and learning to go a little slow while processing such information may help us avoiding faulty decisions. It is high time that regulators/ fraud detection experts/ auditors etc. start understanding this reasoning error in order to perform their duties in a better way. Being more skeptical than usual while analyzing companies/situations/events/economies for financial or any other decision making may be more advisable especially in the world with tariff wars, grappling with negative interest rates, frauds, defaults….!    

Linking bank loans to external benchmark rate : the good, the bad and the ugly

In an effort to uplift the falling economic growth rate and consumer sentiment, RBI made an announcement regarding external benchmark based lending on 4^th/Sep/19. Though the final guidelines are awaited yet, the details can be read in this circular. However RBI may deny that this announcement has nothing to do with the current state of the economy, but the timing of this announcement and its’ direct influence on reviving the consumer and business sentiment by lowering the cost of borrowing tells the opposite of it.

I attempt to do a quick analysis of this announcement in the Good, the Bad and the Ugly style…!

The Good:

1. Better and faster policy transmission:

Undoubtedly, linking loans to an external benchmark rate seems more effective and faster policy transmission tool. We have come across as a borrower, the propensity of bank to quickly raise the lending rates when there is a rate hike cycle but being laggard when there is rate cut cycle. RBI has been suffering a severe headache due to this reluctance of banks to reflect a rate changes disproportionately and with longer lag. This year so far 110 bps (Basis point) rate cut is made in repo rate by RBI of which very little has been passed on by banks to the customers. For varied reasons, banks were less willing to pass on these cuts.

The Bad: 

1. Time period mismatch:

The external benchmark rates provided by RBI are 1. Repo rate of RBI 2. Three-month T-bill yield 3. Six-month T-bill yield or any other market interest rate as published by Financial Benchmarks India Private Limited (FBIL). As it can be observed, these benchmark rates are there for very short time period instruments. The lending rate for long term business loans to MSEs and home loans to retail borrowers if linked to one of these external benchmark rates, it may lead to interest rate risk as well as asset-liability mismatch due to time period mismatch. (When long term loans are linked to short term rates and not long term rates)

2. Challenges of linking deposits rates to external benchmark:

To take the pressure off from volatile profit margin, banks may eventually introduce linking of deposits (savings account, term deposits etc.) to the external benchmark rate. As per this article, SBI being one of the first movers, has announced the linking of savings deposits to the external benchmark rate. For CASA (current account-savings account) deposits, floating saving rates may not be much of a deterrent but knowing Indian depositors for term deposits, they may show strong reluctance in adoption of floating rate term deposits as they generally crave for stable/fixed rate of interest on such deposits. Banks with higher CASA portion in their total deposits may have a less bumpy ride to migrate to external benchmark linked deposit system but for others (having a higher contribution from term deposits) they can be placed between the devil(keeping the fixed rate on deposits & hurting the profit margin) and the deep blue sea. (Moving to floating deposits rate - facing depositors’ wrath & losing the business) One remedy to this challenge can be if all banks migrate to floating deposit rate system it may mitigate the competition of fixed-rate v/s floating rate deposits but still there will be competition.

3.  Not market –driven rate but RBI governed rate:

It may not be well advised to link commercial rate directly to the monetary policy rate (repo rate) as both rates are set and revised based on different factors.RBI manages the repo rate keeping in mind several factors and repo rate management has multiple objectives to achieve. A floating interest rate of loan benchmarked against repo rate may not be a correct reflection of the market forces.

The Ugly:

1. Volatile profit margin of banks:

The announcement of linking loans to an external benchmark from 1^st/Oct/19 may set the cat among pigeons (banks). For banks maintaining net interest margin may turn out to be a walk on a thin line, especially when lending rates (rates on various loans) are pegged to external benchmark rate which will be reset at least every 3 months while borrowing rates (rates on various deposits) which are mostly fixed/constant for the tenure. If a bank chooses to keep borrowing rates fixed/constant while on other hand lending rates are going to be flexible/volatile then this may exacerbate the interest rate risk problem and reduce the predictability of bank’s profit margin. So, an act of boosting the customer sentiment (by lowering the borrowing cost) may lead to the creation of hindrance for NPA-stricken and already struggling banking sector. 

2. Faster revisions of EMIs or interest payable:

Mandatory linking of floating loans to an external benchmark rate and resetting the rate at least once in three months is going to result into faster revisions of EMI amount or effective interest payable amount. Changing EMI amount which I hope banks will not resort to, can lead to gruesome experience for individual and MSEs borrowers. But borrower’s effective interest payable amount is certainly going to be more fluctuating in nature. A very fine analysis of pros and cons of this announcement is done in this article.

3. For long term borrowers - short term bliss and long term pain:

After a cut of total 110 bps and expecting a few more rate cuts, we may reach at the end of the rate cycle. Cost of borrowing will be fairly lower than the prevailing borrowing cost for various loans from 1^st/Oct/19 for new borrowers and this may lure more and more people to borrow. Fruits of lower borrowing cost will be sustained for short term may be around for next 18 months (as per my expectations) after that interest rate cycle may bottom out and if the economy is reviving the gradual rate hike cycle may commence. Once the hike cycle starts, the long term borrowers be it individuals or MSEs are going to face higher interest cost leading to increased interest payout or larger EMIs. In a nutshell, looking at the interest rate cycle for short term there will be lower cost but in longer term as reversal in cycle kicks in increased cost will be inescapable.

I believe (I can be wrong here) there is a possibility of identifying better external benchmark rate as the currently announced benchmark rates are either not market-driven (repo rate) or having a mismatched time period(T-bill yield) with underlying loan products.

Why RBI should immediately join NGFS?

Recently, an article by Wharton titled as ‘Why central banks are talking on climate change’ , caught my attention. It nicely summed up the reasons for central banks to sit up and notice the imminent impact of climate change for the finance industry.

Network for greening the financial system (NGFS), which is relatively new but supposedly very powerful and crucial organization is going to play increasing pivotal role for the finance industry and climate change. NGFS is a forum created for central banks and financial supervisors to understand and assess the financial risk and also the opportunities emerging from climate change.  NGFS consists of 36 members as of now including central banks and financial supervisors. Unsurprisingly, Reserve bank of India is not part of NGFS (however IDBI bank & Yes bank are mentioned as a part of supporting institutions), while People's Bank of China is part of the steering committee. One of the primary goals of NGFS is carbon risk management. My concept paper(published in 2017)  titled as 'Carbon Risk and Impact Assessment from the Perspective of an Institutional Investor'  which deliberates on the identification of key non-physical carbon risk factors and impact assessment on financial performance drivers of the firm, fits right away into the goal of NGFS.

Why RBI should join NGFS?

Sooner the RBI joins the NGFS, better it is for the Indian financial ecosystem.

Joining NGFS reaps following benefits to us;

1. Not being part of such initiative especially when India is a signatory to Paris agreement only shows lack of focus from financial initiative perspective. 

2. Whatever contribution from Indian finance sector will be by joining NGFS will go long way in building the 'Finance India' image especially when China is being so proactive. (as being part of the steering committee of NGFS) 

3. Joining NGFS may also give us a chance to look into where the world finance think tank is leading in terms of financial regulations & disclosures, upcoming trends in interaction of financial sector and climate change and so on. This shall certainly give chance to smooth transition for Indian financial sector to future changes otherwise, it will be very chaotic to all the stakeholders to make a sudden shift to new regulatory or other changes. Carbon tax, carbon emission disclosure in annual report, carbon footprint exposure by various institutional investors like; mutual funds, insurance companies, banks, AMCs, etc. may become part of regulatory changes as many countries have started implementing these norms.

Indian financial regulatory bodies can afford to be laggards at their own peril and the cost will be paid by all the stakeholders of Indian financial ecosystem!

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Is RBI playing with fire by contemplating to open up exotic currency derivatives to Indian firms?

A few days back a news article on RBI's proposal (in the discussion stage) of uplifting the ban on exotic currency derivatives caught my attention. Since then various opinions on this have cropped up.

I believe the proposal of allowing firms to trade exotic derivatives may create more problems than solutions for the broader financial ecosystem in India due to followings factors;

1. Poor understanding of the majority of Indian corporates regarding usages of exotic derivatives (exotic currency derivatives gets more complicated)

Note: I believe plain-vanilla derivatives are good enough in normal-case scenarios for the purpose of hedging the financial risk, the creation of exotic derivatives is done to cater the complex and customized transaction requirement which may be needed by a small fraction of Indian corporates. And of course, the creation of exotic derivatives is to earn big fat commission!   

2. Mis-selling & burning figures: 2008 financial crisis and post-crisis time period has witnessed many entities burning figures (also by foreign currency convertible bond issuance) with the initial intention of making some cool profit out of currency swings. When the product is exotic mis-selling is rampant. Opening up of exotic currency derivatives to firms will lead to heighten mis-selling from many broking/consultancy/advisory companies. Amidst this hyped mis-selling, hardly corproates realize that they may not need such ‘exotic’ derivatives at all!

3. The greed rules: moving from hedging to speculation: By my own trading experience and losses, I reckon that there is a very thin line between hedging (primarily done to protect the downside risk or loss) and speculation (done with the intention of making a profit by undertaking risk )! It is extremely difficult for the company (decision makers/treasury department) to control the urge to move from hedging to speculation. Companies don’t know when they silently get tilted from hedging to speculation and get addicted to speculation after the initial taste of profit! Many cases such as Barings bank , Metallgesellschaft AG derivative debacle, Sumitomo Corporation more are examples of mismanaged hedging or firm’s entry into speculation without much realization.  

Standard derivatives are forward, futures, options, swaps and so on. Exotic derivatives can be any combination or hybrid of any standard derivatives, differently designed/structured derivatives to meet customized requirements and so on.

My advisory:

1. Strictly NO–NO for MSME & mid-sized cooperates:  Runway ASAP if you hear exotic currency derivatives words uttered by some super formally dressed smart looking executive, trying to convince you how cool it is! Profit-creator! & it has no big risk! Plain-vanilla currency derivatives are suitable enough for the varied requirement, provided cost-benefit analysis is in your favor.

2. Big corporates but not truly MNCs: As you have war chest you may try these exotic currency derivatives (many times pushed by overconfident treasury department and of course ego- boosted by consultants/banks/advisory firms etc.) only to realize later on that this misadventure has burnt the hole in the pocket. Plain-vanilla currency derivatives are suitable enough for the varied requirement.

3. MNC giants: Exotic currency derivatives are more suitable if they have complicated and customized transactions requirements and may have better resources to play in the currency market.