Instinct, the best investment gauge

Interactions with investors in these heady days of the bull market are turning out to be an alarmingly predictable exercise for me.

With growing willingness to hear positive stories, social interactions are skewed towards markets and their moves. But it is the simplistic translation of hearsay into belief that is baffling. The eagerness to participate has left the conservative investor feeling like an outcast. Then, conjectures pass off as proven theories.

One such piece of thinking that keeps coming back to me is that if markets move too high, informed and smart investors, say, the FIIs (foreign institutional investors) and mutual funds, would begin to book their profits. Therefore, as long as they are buying, markets should be fine.

That there are more buyers is indeed pushing prices up, but there is little evidence that a select group of investors would have and implement an insight very different from the rest in the market. Economic sociologists who have studied the markets clearly do not think so.

Seminal research work in cognitive sciences has established that even the most experienced traders suffer emotional bias when they operate in the markets. The large sophisticated traders could then actually be real people like all of us, and could actually be more inclined to use the social transmission framework of the markets to create following for their thinking.

Which is also why buy recommendations always outnumber sells, and the reporting of markets is highest in a bull run. There is a large body of work on the economic sociology of markets that says there is little evidence that a group of investors, however informed and smart they are, can take contrary positions in the market.

There are constructs of the social structure of the market which challenge the notion that the sophisticated level of social learning that is required to correct discrepancies in valuation actually exist in markets. Therefore, there is still the large possibility that everyone out there could be wrong.

So there is the need to understand our limitations when we operate in the social structure that is the market. When we buy the story that India Inc has learnt to compete with the world, we must also ask what our learning as investors has been.

Evidence that Indian business has begun to adapt to the demands of a global market for goods and services is there in their numbers. But there is limited evidence that investors have adapted to the changes in the equity markets, and are therefore exposed to the danger that they may be using tools and techniques imported from an earlier experience.

Andrew Lo, Professor at MIT, has published an interesting and widely appreciated work called 'adaptive market hypothesis' where he argues that player behaviour in the markets is influenced by the ability to adapt and evolve to changing situations. Market behaviour could draw more from Darwin than from Adam Smith.

Investors tend to use tried and tested rules of thumb in markets until they understand the difference in the situation, and then they learn ways to work the markets. What they do is more about survival instincts, and constant innovation and evolution, than about cold-blooded mathematics and analytics.

In this game, therefore, the mindset of the player is pitted against the social structure of the market, and the learning and evolution can never be uniformly distributed. Also there is no conclusive evidence that one set of players evolves faster than the others in the market ecosystem.

Others who have actually taken the logic of evolutionary learning to the labs have found that large mammalian brains like ours are perhaps incapable of winning in the markets, as our innate survival instincts are pitted against skill sets needed to win. Barry Ritholtz presents interesting work that argues that we may simply not be capable of investing rationally, given our genetic make-up and our learning process.

What does this interesting body of work tell us? We are perhaps better off remaining closer to our innate preferences and choices until we learn to adapt. Making investment choices that are ill suited to our basic levels of cognition and understanding, and more importantly, our ability to cope, can be risky.

We also cannot lean on the collective capability of the market to correct our limitations, because such a premise may not be possible. If we disapprove of dramatic life style changes that seek to live up to the Joneses, we should also disapprove of investing and trading stances that are not suited to our levels of risk and return preferences.

We could be left like a flapping fish that mistakenly uses its swimming skills on land.