The paralysis of a market crash

I couldnt help read and re-read Rob Arnott's excellent assessment of human behaviour : When there happens a crash, you have enough uncertainty .. that it paralyses the people who might otherwise take the other side of your trade.

When the Indian stock markets came down from 21,000 to 18,000 levels (Fall 1), a number of individual investors couldnt pass for the wonderful opportunity to purchase their favourite stocks at a bargain. It's probable that you too were able to spot a stock available at much cheaper levels and would have invested a significant amount of cash. The valuations did seem very good then.

However, when the markets go down even further (from 18,000 to 15,000 (Fall 2)) - the same investors who invested in Fall 1, almost refused to invest further. A paralysis of sorts struck these investors ! They hibernate and only show some activity when the market approaches the Fall 1 levels. By this time, they lose a fantastic opportunity to buy ridiculously inexpensive value stocks.

When asked a reason for not investing at these levels, investors oft say : "I'm waiting for the market to settle down". Experts blame this behaviour on the "recency bias". The recency bias means that investors will put too much weight on recent experiences and trends to determine the future. This is what happened during Fall 2. When the stock market tanked the second time, the recency bias set with most investors and fear set in. During a period of fear, taking actions is very difficult and hence the paralysis.

Ofcourse, the lag between the great crash (Fall 2) and restoration of investor confidence (Fall 1) is often the little window of opportunity that value investors tend to capitalise on. The last three months have provided a value investing opportunity for the Indian stock market.