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Nitin Grover ACA

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Behavioural finance is a very interesting stream of economics that studies the irrationalities of human behavior when it comes to financial decision making. It also explains why most investors lose money in the financial markets and / or under-perform the market.

Behavioural Finance: A few basic tenets of irrationalities

Mental Accounting

 If we earn USD100 from gambling or windfall gain, we are more likely to spend it for giving party to our friends. We tend to create different buckets in our mind (Hard earned money / windfall gain / inheritance etc) as to the source of money and it drives our end use. Money however has the same color and carries the same purchasing power irrespective of the source. An electronics store doesn’t question the source of money when the customer approaches to buy goods. 

It also has an implication on our investing behaviour in Behavioural Finance. We are likely to be less conservative in our investments if in our mind the source of money is other than hard earned money. We are more likely to invest the money in risky assets and therefore probably lose it. 

Loss Aversion

Various psychology tests have concluded that the pain from losing USD100 far outweighs the joy of earning the same sum of money. When we are earning a positive return on an investment, there is also a temptation to book profit lest we lose the money that we have earned. It explains why most of the scrips in the portfolio of an investor are loss making scrips (Read – poor investments) and therefore underperform the market.

When we are losing money on an investment, we tend to hold on to the scrip as we are averse to book losses. Scrips which are delivering profit are sold off and we are left with a less than an optimum portfolio.

There is an old saying that amateur investors book profits while professional investors book losses.

Herd behaviour

There is a tendency of retail investor to follow the latest trends and / or fancies of investment ideas. A very good example was during IT bubble of year 2000 when dot com companies were losing money / burning cash but were the darlings of the markets. Portfolios which would stick to time tested principles of picking companies with strong cash flow and low valuations were under-performing the market. Recession is invariably preceded by euphoria in financial markets and not surprisingly the world went into a tail spin with the collapse of IT Bubble in 2000. Similar euphoria in stock markets was visible in 2008 when the world was beginning to see signs of financial crisis 

Parallels today can be drawn in the valuation of E Commerce companies like Amazon, Flipkart which keep burning cash but carry exorbitant valuations. 

Herd behaviour in Behavioural Finance is what Warren Buffet cautions in his famous saying “investors should be greedy when markets are in a state of panic and panicky when markets are greedy”.

Price Anchoring

When we buy a book and find it to be not so interesting, we tend to complete it just because we paid for it. In the process we ignore, the cost of book is a sunk cost and the time could be better utilized in something more productive. When we spend heavily on the maintenance of our vehicle and end up encountering another maintenance issue which requires more expenditure, that we have spent already on the maintenance of our vehicles drives our decision to spend more than replace the vehicle.

Similarly, we get anchored to certain price points which could be the purchase price of our scrip, the high that it made yesterday etc. We end up not buying a scrip as it has moved few rupees where it was trading the day before and lose several times the money.

Investors need to train themselves to ignore the cost of purchase / other price anchors as sunk cost / missed opportunities and be oblivious to them in their investment decisions

High Self rating

A survey concluded that 80% of the drivers rate themselves as above average drivers. Most of the investors rate themselves better than others and their over confidence on their abilities as an investor drives the under-performance of their portfolio.

Our mind tends to process information and give a lot more credibility to data points / news that in sync with our investment philosophy. It strengthens our self-esteem and re-inforces our belief in one self.

We are unwilling to accept and process information that is not in sync with our themes and we discount it as just another view or a stray opinion. It makes us over-look important data points and ignore mistakes which leads to holding of sub-optimal investments. We also end up adding more money to “average cost” in case of price corrections in such scrips to re-inforce our belief in self. It is like putting good money behind bad money. 

If we are over-excited about an investment, we are more likely to lose money as we have over-looked risks associated with the scrip. 

The most difficult thing is to manage our emotions which influence our decision making, move against the herd and carry conviction in our investments with the humility that we are not infallible and prone to mistakes. These are the hallmarks of a great investor. 

Don’t forget to read Real Life Emotional & Cognitive Biases simplified for a Retail Investor

US economy has been the most dominant economy since the end of World war 2. US dollar continues to be the store of value and haven for investors in times of risk aversion. 61% of the Forex reserves of countries are invested in dollar-denominated assets and 40% of world debt is denominated in the US Dollar, as per IMF

US dollar was created by the Act of Federal reserve in 1913. At the time, the US had overtaken Britain as the largest economy though Britain continued to hold its sway in the world economy and most transactions continued to be done in Pounds. US dollar was pegged to Gold as were all the major currencies of the world. The US was the major supplier of military equipment during world war and imported huge quantities of gold creating the largest reservoir on the planet. Bretton wood agreement put the seal on the US dollar as the reserve currency in 1944 when all major countries linked their currency to US Dollar while the Federal reserve re-affirmed its commitment to redeem the dollar for the value of gold.

In 1971, stagflation in the US economy prompted a run on the US dollar when the demand for redemption of the dollar against gold created the risk of the US losing out on precious gold reserves. After a round of devaluation of the US dollar against gold, President Richard Nixon delinked the US dollar to gold standard. This effectively removed any limit on the supply of dollars by the Federal Reserve. The devaluation of the dollar also made US exports more competitive giving a boost to domestic manufacturing. 

Petrodollar 

OPEC imposed an oil embargo on the US in 1973 as a protest to its support to Israel in the Yom Kippur war. This created long ques at the fuel stations and effectively brought the oil guzzler economy to a grinding halt. In 1979, US entered into an agreement with Saudi Arabia and oil-exporting countries wherein they agreed to sell oil only against dollars. It created an unending appetite for US Dollar by oil-importing countries like India, China

In return, US agreed to protect the House of Sauds against all acts of internal and external aggression. OPEC countries also pegged their currencies to Dollar or a basket of currencies dominated by the dollar. It helped in insulating the economies of OPEC countries from wide swings of inflation as they were importing most of the goods also in US dollar.

Current status of US Dollar and Covid 19

  1. US dollar continues to be the preferred currency of exchange and US continues to be the largest economy. It is noteworthy that personal consumption as a share of US GDP has risen from less than 58% in 1967 to over 70% today. Unlike other countries, US borrows its way to consumption by issuing US treasury bills which are lapped up by Central banks, Hedge Funds, etc around the world. US redeems Treasury Bills by printing currency since there is no limit on the supply of dollars after the abandonment of the gold standard. Ironically, the holder of reserve currency runs the largest trade deficit in the world at USD 616.8 Bn in 2019. US today has become akin to a consumer that maintains its momentum of consumption by increasing its debt and meeting it by printing currency. Rest of the world is also playing the game as it keeps its factories up and running, needs dollars to buy oil, and gives it the fallacy of increasing foreign exchange reserves denominated in a currency issued by a country that has an unending supply of notes. The question that we need to ask is that is it sustainable?
  2. Total debt carried by US has risen from USD 10 Tn in 2008 to a staggering USD 24 Tn as per Congressional Budget Office. Daily interest cost of the debt is a staggering 1 Bn USD and the debt per person in US is USD73K. As a percent to GDP, it stands at 106.9% up from 68% in 2008 when financial markets were on the brink of collapse. Further, it is 106.9.% of GDP of a country where consumption contributes 70% of the GDP funded by the largest trade deficit in the world. Debt is invariably a pre cursor to a financial crisis and the world is not a pretty place today. 
  3. US has been at the fag end of the curve in the manner in which it is responding to the pandemic. As of the date of writing, US has 7.2 Mn cases of infections with more than 200K deaths. Different countries have followed different approaches in responding to the pandemic. While we are yet to see any meaningful analysis in terms of what would be the most optimum approach in dealing with the pandemic, US has been the worst hit. It may not be an understatement to say that the US is heading into a catastrophe that is both human and economical. 
  4. This crisis is inherently different from the housing crisis of 2008. In 2008, the cash flows of Subprime bonds rated AAA by rating agencies around the world trickled down to zero with the collapse of the housing market. AIG which sold insurance against the default of Subprime bonds through Credit Default Swap (CDS) was staring at losses running into billions of dollars. It was bailed out by US govt which invested a staggering USD 180 Bn to prevent the collapse of the systemically important institution along with investments in major US banks to prevent their collapse. Companies today have created global supply chains to optimize on the sourcing, manufacturing and logistics costs. Covid 19 has disrupted the global supply chain in a manner that was not hitherto imagined. US has reacted to the existing crisis like how it was able to successfully manage the housing crisis of 2008. It has unleashed a Quantitative easing program for a staggering USD 2 Tn. Economists have been pleasantly surprised with the return of demand at Pre-Covid levels in some sectors but the distribution of demand is far from uniform. Companies have been responding to the loss of demand with automation and digitization initiatives which would not help in restoring employment to Pre-Covid levels for quite some time. Supply chain disruptions due to Covid-19 will not help the matters either. The huge influx of liquidity in the world economy may keep financial markets afloat for some time but will lead to inflation and devaluation of US Dollar which has been in an era of unlimited supply. 

The world order is changing in ways that have not been seen earlier. It will be too early to hazard a guess on the world order post the pandemic but will essentially depend on how various countries around the world respond to it. If US fails to respond in time before it’s too late, it may impact the world order and the greenback leading to a crisis of confidence in currencies. Gold may come back in limelight and so may the cryptocurrencies. Time is yet to cast its dice!

2020 has been an extraordinary year. The onset of COVID-19, consequent lockdown, payroll cuts, retrenchments, and bankruptcy of companies like JC Penney, Hertz etc has been the new normal and guess what, the year is not over yet!

Financial markets have been on a roller coaster ride. A steep slide in March followed by fiscal stimulus / liquidity measures and the strong pull back in financial markets. Among all this mayhem, gold has become the new darling of investors outperforming all asset classes over the last three years delivering compounded return of over 16%.

Other than doomsayers, it has taken all the analysts by surprise.

So, what is fueling the rally in gold? I have tried to enumerate some of the key drivers of the rally which should provide some color to the future outlook of the asset class as an investment proposition –     

  • Gold is traditionally considered as a hedge against inflation and a safe haven for investors in times of uncertainty. Gold has a negative correlation with REAL interest rates in US. REAL Interest rate refers to the difference between US Treasury yields and inflation. Gold as an asset class gains when interest income does not compensate for the loss of purchasing power due to inflation. When the REAL interest rates fall, gold goes up in value and vice versa. Below is a chart of REAL interest rates and gold prices over the last 40 years.
Gowth Graph of Gold Price Rate
Graph showing inverse relationship between Real interest rates (red line) and Gold prices (yellow line)

Central banks have been on a spree of money printing in the aftermath of COVID-19 to provide liquidity to businesses to survive the downturn. Fed Bank alone has printed 3 trillion US Dollars in the aftermath of Corona. Interest rates have been maintained near zero to provide relief to businesses to enable them to raise money to tide over shrinking cash flows / service existing loans. Low interest rates also provide relief to Central banks to service sovereign debt which has ballooned due to fiscal stimulus.

Injection of money in the economy coupled with supply chain disruptions due to lockdown have raised inflationary expectations. US Treasury yields are at historic lows pushing REAL Interest rates below zero sparking a rally in gold.

  • Goldman Sachs in its report released in July ‘20 has warned that the U.S. dollar may lose its status as the world’s reserve currency. To quote from the report of Goldman Sachs “The resulting expanded balance sheets and vast money creation spurs debasement fears. a greater likelihood that at some time in the future, after economic activity has normalized, there will be incentives for central banks and governments to allow inflation to drift higher to reduce the accumulated debt burden.”  With US Treasury yields falling to all-time lows, fear of loss of faith in Greenback, Central banks may look at gold as the favoured asset class to diversify their holdings.
  • Monetary and fiscal stimulus by Central banks helped in avoiding another Lehman brothers and a repeat of 2008. It implies that there is more money chasing financial assets than ever before. With world economy shrinking in the aftermath of lockdown, debt yields falling to all-time lows, there exists incentive to shift allocation in favour of gold. Geo-political challenges, pandemic and intensifying trade war strengthens the choice of gold as an asset class.

Future outlook in the rally in gold

While the above arguments sound convincing than ever before, we need to closely look at some more data points to see whether rally in gold is sustainable.

Gold does not generate cash flows and has minimal utility as an asset class except towards jewellery. Therefore, traditional models of estimating the fair value of the asset by estimating / discounting cash flows do not work in case of gold.

There is a traditional belief that gold does not fall in value. If we go back into history, gold made a high of $1800 in 2011 only to fall below $1100 levels in 2015. So, gold DOES fall in value and the fall could be steeper than we might think.

Gold Pieces
Investing in gold without understanding other economic indicators could be gamble

There does exist a distinct risk that dollar may lose its status as the world’s reserve currency. Money printing by US Fed, debt at 107% of GDP and the world’s largest trade deficit at USD 616 billion, could be the harbinger of a fresh world order. While the collapse of US dollar and the rise of alternative currencies may be inevitable, there is nothing to indicate that we are about to breach the tipping point for it to be imminent. There goes a saying that markets may remain irrational much longer than we can remain solvent. For all we know, US dollar may continue to hold fort as the reserve currency in the absence of alternatives for few more cycles of rise and fall in gold prices. 

Let us look at some data points on the real demand for gold in Q2, 2020. Consumer demand for gold jewellery fell by 53% in Q2, 2020 due to lockdown and buying by Central banks fell by 50%. So, what is driving the spike in gold prices? Investment demand for gold increased by 98%. Rally in gold prices is therefore due to Investment demand which is feeding upon itself and is reminiscent of the tech bubble of 2000 before its collapse. 

Most investment houses & analysts are bullish on gold today. But were they bullish on the yellow metal when it began its upward trajectory in the last quarter of 2015? Unfortunately, the answer to this question is NO. These voices tend to follow not predate the rally in an asset class and become louder when the asset class gets nearer to peak ( highest point in prices) than trough (lowest point). And then they pick another asset class citing it to be the next wealth creator and then another.

Today skepticism runs high over investment in equities while there is herd buying happening for gold. It normally pays to play contrarian in markets and resisting doing what is common sense.