In 1973, the Kreditbanken (bank) at Norrmalmstorg in Stockholm was attacked by robbers, who held bank employees hostage for five days. After the drama, it was evident that the hostages sympathized with their captors, even though they were held against their will. The situation is now considered an academic study — the Stockholm Syndrome — where people get emotionally attached to people who obviously try to do them harm.
More apparent, perhaps was the case of Jaycee Lee Dugard, who was held for 18 long years — from 1991 to 2009 — but got so emotionally attached to her abductor that she even helped him in his business and met customers. Being an unwilling hostage, or in other cases, just being in an unwelcome situation with no way out, makes us rationalize in favour of our position.
Less dramatically, we become hostage to our own opinion. We simply can't let go of what we believe is "normal", even in the face of facts. If your blood tests show you have a high cholesterol level, your immediate reaction is to hope the problem will go away on its own, or imagine that the tests were incorrect. A person abused at work — sometimes with lewd suggestions — will initially justify it as harmless workplace banter. The victims of a drunken driving accident will side with the driver saying how good a driver he "usually" is. We simply don't want to see it, even if we know it.
In the financial world, our beliefs are tested often. In 2011, the markets fell over 24%, with the situation in December as dire as it could be; the government was running out of money, industry was slowing down, inflation was high and everything looked bleak. In January 2012, we saw the Nifty and Sensex rise 12%, with no apparent improvement in any of the other pieces of data. This rise has bewildered most analysts, who continue to believe, at every stage, that the market will reverse back down. Consistently, nearly every day, the market sees a rise, but the sage opinion is that this is a fake rally, and that this will come down like a ton of bricks.
It might. The analysis may be spot on, that the Indian story has hit a pause button and not worthy of very high valuations. But at some point, we need to admit that the tide has turned, and prices keep moving north. Our conviction is worth the paper it was never written on — but we carry the weight of it on our shoulders altogether too long. Such irrationality can cost money —a trader that stays short despite a stop loss being broken, almost in anger against such a furiously rising market, continues to lose until eventually giving up. An investor who decides a stock is great and watches it fall, keeps buying until the stock becomes an abnormally large investment, and later feels serious regret when other stocks do better.
If you strongly believed in the Indian telecom story, it was lost on the stocks. From Bharti Airtel to Reliance Communications, the stock prices are way lower than their highs in 2007. We have more air travel than ever before, but airline stocks are in the doldrums. India is spending an enormous amount of money on infrastructure, but the road-builders and power-plant-owners are scraping the bottom of the barrel in the markets. Yet, the question I first get when I say all this is: "Good time to buy?"
The correct way to deal with markets is to expect to be wrong. You have to consciously look for information that counters your thought process. If banks are supposed to be in trouble, then look at their positive results, and look at how strongly the RBI is supporting the system. If buying IT companies on a falling rupee sounds exciting, consider reports that customers are quite aware of the fall and demand corresponding concessions, which they don't reverse easily as the rupee recovers. If you like to buy stocks when they make a new one-year-low, test out how many times you would have made money investing in a broad array of such stocks in the past. (I have checked, and results are horrendously negative at a portfolio level though there are a few that will shine)
It's not easy to stay fluid and keep switching sides as the tide turns — society values loyalty much more than rationality. Being wrong is okay, but staying wrong is evil; in the markets, we can't get married to our opinion.