Did the fall after budget day has scared you? Did the market movements since Budget Day is making you rethink Equity Investments? Well… it’s not normal because if that so, you were not ready for equity yet. You were suffering the Peltzman Effect or the Risk Compensation Theory in finance. You think, everything was going so good, why the hell budget became a roadblock?
I was thinking of writing this Peltzman Effect Risk Compensation Theory for quite some time, but budget volatility gave me the chance.
Actually budget or events like these are normal. The abnormality is to think Equity Investments are one-way in returns & have no risk. This is due to a classic psychological disorder, called by the name of it originator – The Peltzman Effect. Let’s see what goes wrong in the brain when markets do what you have not imagined.
The two days have made many investors ask questions about equity.
Take a look at the falls in the market on the budget day & a day after that:
Such a fall, so much bloodbath and I am saying its normal?
Then one of the newspaper scared the morning hell by this headline:
Each ZERO looks like a black hole…
Well, markets effect because we lack understanding of equities. And for many investors, this lack of understanding to comprehend the true character of equity comes from the Peltzman Effect.
Peltzman Effect Risk Compensation Theory
In the USA, in early 1970s seat-belts were made compulsory by law.
Something strange happened. The seat belts were supposed to decrease the accidents, but the accident numbers WENT UP!
Why?
An economist by the name Sam Peltzman studied and came up with a very unconventional explanation.
The study showed that now drivers had a mental security in form of seat belts. They perceived that road risk has gone down, so powered with the wrong notion of more security they drove recklessly.
Hence accident incidents increased.
They forgot seat belts were to reduce injury, not the accidents.
Another example?
In the Olympics of 1984, it was decided that boxers can fight without the headgear.
There was a huge outcry by media and public that- this is risking boxers with head injuries and might put them to death risk.
But you know, the incidents of head injuries went down. This means the boxers with headgear due to perception of safety took more risk. The boxer knows that his opponent is safe so he took more risk in hurting head region.
But when both players knew that the perceived risk (the headgear) is no more available, both were careful not to hit each other badly.
How Peltzman Effect impact equity investments?
We all know the figures. A large number of investors have entered mutual funds and direct equity in last 2 years.
After Demonetization, the physical assets (gold & property) are less favored. Financial Assets (Equity) are a new flavor.
- No of folios increase is 100% plus burst.
- Demat opened 100% plus at growth rate.
- SIP amount increased from 1800 Cr in 2012 to 6200 Cr in Dec 2017.
And guess what they faced… (happy things of course)
30% return on XYZ fund or 50% rise in ABC share in 2 months.
Hmmm, that looks yummy and PERMANENT. (That’s the starting of Peltzman Effect)
The year 2016 & special mention to the year 2017, has been insane as far as value investors are concerned. We are happy with returns which are normal.
30%- or 70% returns are abnormal. They do not exist for long. They are bubbles.
But the irony is when a person is born (financial journey) in this industry at these insane levels, he thinks its normal. He missed some good years.
SO HE RISKS MORE…
Yes, many people have started taken risk due to 2017 returns or by looking at past performance. They are eating more than they can chew.
I know many investors who had balanced expectations like 12% from equity. But their parameters changed just by looking at there equity portfolios in 2017:
- Few “smart” investors took money out of DEBT and invested in equity.
- Balanced funds have become 5 times of what they use be. FD money is going into this category.
- They refuse to re-balance.
- They no more follow asset allocation.
- Many investors have started taking heavy bets in equity.
- They have increased allocation to mid & small caps as they have yielded more.
- They constantly follow returns.
Clear indications that they have perceived RISK LOW due to SHORT TERM EUPHORIC PERFORMANCE.
The Peltzman Effect Risk Compensation Theory in action…
What this volatility teaches us?
The extraordinary returns have created a false image of equity being RISK-FREE.
Equity is what it is and use to be.
Don’t be surprised. Friday 02 Feb 2018 fall was the 9th of the highest one-day falls.
Don’t be so surprised… its normal for equity markets to move any side based on the information it receives.
The biggest fall ever was in 2015. Equity markets and investors made returns after that too.
Markets are electric shocks to
- Who believe equity will be linear earning investments. It never goes down.
- Ones who do not diversify – asset wise.
- Investors who do not take stock of their holdings.
- Who do not have patience or time to spend with a volatile friend.
“I’m accustomed to hanging around with a stock when the price is going nowhere. Most of the money I make is in the third or fourth year that I’ve owned something.” – Peter Lynch
Finally,
Are you suffering from Petzman Effect… these last 2 days and coming few weeks will tell.
Important is not to lose sight of your goals.
Understand risk and appreciate the risk mitigation process.
One who talks about risk is not always a passive, docile or conservative advisor.
Whats your view and experience in this market volatility? Do you think you agree with me?
Share your experiences with me in the below comments section on Peltzman Effect Risk Compensation Theory .
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