Technical Analysis

Sold for a penny?

KARTHIK RANGAPPA | Updated on January 23, 2018 Published on May 17, 2015

If you are an active market participant, chances are that at some point in your investing/trading career, you would have convinced yourself to buy stocks that trade at really low prices of, say, ₹5 or lower. Generally, the decision to buy these stocks does not emerge from a rational research framework, but from an emotional one. The typical thought process before buying such low-priced stocks, often called penny stocks, would be something like this: “The stock is anyway trading low; so, how much further can it fall? There is no harm buying a few thousand stocks that trade in this range. In fact, if the trade works in my favour, there is a good chance of doubling or even tripling my money.”

To be honest, I have also fallen prey to the above buying psychology 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 penny stocks? Most often than not, we are cognizant of that fact that there is a more-than-fair chance to lose money on such trades. Despite this awareness, we still end up buying penny stocks. Why? Well, there is a behavioural angle to this.

Quick gains

As human beings, we are guided by expectations. Hence, looking forward to seeing our money double and booking profits in quick time 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 the manner in which our brain functions, you would probably know about the ‘reflective brain’ and the ‘reflexive brain’. The reflective brain is more analytical and responsive to rational decisions. This part of the brain helps you think and analyse. On the other hand, the reflexive brain is more impulsive. It makes you to take decisions based on intuition and emotion. So, when you have the urge to buy a penny stock, it is actually the reflexive brain at work, which prompts you to take irrational decisions. To overcome taking such irrational decisions, shift to ‘cognitive investing’.

Focus on behaviour

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 we make. A typical cognitive investor pays attention to the stock’s valuation, business model, valuation, and asset allocation, among others. He should typically isolate these variables from the current market conditions. Besides, cognitive investors can very efficiently stay clear of opinions and predications by market gurus, attention-grabbing headlines, and so on. Cognitive investing is therefore, all about tuning yourself to use the reflective brain and not get swayed by irrational thoughts.

The writer is Vice-President, Zerodha

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