If you are an active market participant, chances are at some point you would have convinced yourself to buy a stock which is trading at a really low price say Rs.5 or Rs.4.
The decision to buy these stocks most likely wouldn't be a rational one, but rather an emotional one. The typical thought process would be something like – ‘The stock is trading so low, how much lower can it go from here?
There is no harm buying few thousand shares at this level. In fact, if the trade works in my favor, there is a good chance of doubling or even tripling my investment’.
Let me be honest, I’ve myself fallen prey to such thoughts couple of times only to see my money disappear in due course. Why do we convince ourselves into such irrational investment ideas? What compels us to buy these such stocks?
More often than not, we are aware of that fact that there is a more than a fair chance to lose money on such trades, despite the awareness, we still end up buying penny stock, why?
Well, it so happens that there is a behavioral angle to this. As human beings, we are guided by expectations. Hence, looking forward to seeing our money double (quickly) and also realizing that expectation (in terms of booking profit) is exciting.
Like they say, ‘The chase is better than the catch’, research in neurosciences proves that the anticipation to see our money double is more exciting than the actual act of profit booking.
If you are familiar with how our brain functions, you would probably know about the ‘Reflective brain’ and the ‘Reflexive brain’. The reflective brain is more analytical and is responsible to take rational decisions. This part of the brain helps you think and analyze.
On the other hand, the reflexive brain is more impulsive. It leads you to make decisions based on intuitions and emotions. So, when you have the urge to buy a penny stock, it is actually the reflexive brain at work, which is promoting you to take that irrational decision.
So, how one does over comes falling prey to such irrational biases? Well, say hello to ‘Cognitive Investing’.
Cognitive Investing is an investment philosophy which requires one to isolate the current market condition from the investor’s time tested investment thesis.
Clearly, the idea behind cognitive investing is to be completely aware of the fact that humans suffer from many psychological biases which can negatively affect the investments that we make.
A typical cognitive investor pays attention stock’s valuation, business model, valuation, asset allocation, etc. He would typically view these variables in isolation of the current market conditions.
Besides, cognitive investors can very efficiently steer themselves clear of other external noise such as the opinions in media, predictions by market gurus, attention-grabbing headlines etc.
Cognitive Investing is therefore all about tuning yourself to use the reflective brain and not really get swayed by noiseDisclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.