Professor Sanjay Bakshi is one of India's foremost experts on behavioural finance, the field that deals with emotional biases that creep into humans' financial decision making.
Part 2 of the interview with Sanjay Bakshi, adjunct professor at Management Development Institute, Gurgaon, and Managing Partner at ValueQuest Capital.
Professor Bakshi is one of India's foremost experts on behavioural finance, the field that deals with emotional biases that creep into humans' financial decision making.
Listen to Part 1 here.
Q: How does one become good at investing? What are the basic traits that are required to become a good investor?
A: Well, the most important thing that you need, honestly speaking, is luck. You may be a great investor, but if you have terrible luck for a long period of time, you are not going to make it. So, assuming that you have a long enough career and you end up not being very unlucky, you need three ingredients - three big ingredients.
One is that you need a good understanding of accounting. Accounting is the language of business. If you don’t understand accounting, you can’t do financial analysis, you can’t understand businesses, at least in my view.
The second ingredient that you need is a good understanding of very basic economics – microeconomics. Concepts like pricing power, elasticity of demand, competitive advantage. They are all standard concepts taught in economics, you need to understand these and how they feed through accounting numbers, which creates value on the long run.
But the third ingredient that you need is the toughest one, which is a good understanding of human nature, about psychology, about the flaws of human nature.
Out of these three ingredients, in my view, the first two are skills that can be acquired, nobody is a born great accountant, nobody is a born great business economist, these are subjects that can be learnt by studying them.
The third one is a tough one. If you don’t understand human nature, you are going to make standard mistake that everybody makes in decision making. And in that field, psychology, it’s partly genetic and partly learnable. I mean it’s not completely learnable. Some people are constructed such to be a good investor.
I will give you an example: we all know that in order to do well in stocks, you should buy when things are cheap and you should sell when they are expensive. The formula is very well known, but when things are cheap, there is a lot of pessimism. So you need to have that contrarian bent of mind, which means that you need that independent mindset. You don’t want to participate in the folly of the crowd when they are getting exuberant and therefore the reverse is also true--that when everybody is very excited and making a lot of money then you have to have a detached view of the whole thing.
Now, this independent mind is not an easy thing to develop because you are really fighting evolution. Robert Cialdini called this social proof or what we in Hindi called ‘bhed chaal’ -- the tendency to follow everybody else is a good idea most of the time.
Most of the time it makes sense to follow what everybody else is doing. You know it’s a stupid idea to cross the road by looking at the wrong side, it is a stupid idea to drive on the wrong side of the road. So, usually it’s a good idea to follow what everybody else is doing.
In the financial market it is not and therefore it doesn’t come naturally to us. The reason why we have these tendencies and in fact I am using social proof as just an illustration of all the biases -- we call them biases, but they are really tendencies that have been given to us by biological evolution over millions of years -- and social proof is there in us for a reason. It gives us better chance of survival, it protects us from harm if you know that somebody else who sees harm is behaving in a certain manner, just copy that person and harm will not come your way. So there, are very strong reasons why we have got this.
So, biologically we are constructed to do what everybody else is doing and therefore if you want to be a good investor, you are really fighting biology. You are really fighting millions of years of evolution.
It can be taught and I teach it in my course. But I also tell my students it is going to be very hard to overcome millions of years of evolution and there have been a lot of experiments done in evolutionary psychology discipline. People are put in an FMRI (functional magnetic resonance imaging) scanner, exposed to physical pain, their response recorded and then they are exposed to social pain.
For example, you are playing a game between three people -- you, I and another person are playing a game -- and I throw a ball at you and you throw a ball at her, she throws the ball at me and we are playing a game of a ball, but after a point we stop, we exclude her. We just throw a ball at each other and they monitor what’s happening in her brain. She experiences the same pain in the same region where she would experience pain if you would have pricked her finger with a pin or something.
So in a sense, the reason why we can’t behave independently is because it’s very painful. It’s very painful to buy stocks when everybody else is despondent and negative. Some people, it turns out in those experiments, don’t feel that pain and that’s biology; that is the way they are constructed.So, I tell my students that some people - the people who are loners, people who are not social animals, people who want to spent time alone or they don’t get affected by the opinions of others and some people we know are inherent contrarians, those are the people who have inherent, maybe biological traits of being good investors.