Mindset of an Investor
Depending on how you would like to participate in the market, you can choose to speculate, trade or invest. All three types of participation are different from one another. One has to take a stance on the type of market participant he would like to be. Having clarity on this can have a huge impact on his Profit & Loss account.
o help you get this clarity, let us consider a market scenario and identify how each market participant (speculator, trader, and investor) would react to it.
RBI in the next two days is expected to convene to announce their latest stance on the monetary policy. Owing to the high and sticky inflation, RBI has hiked the interest rates during the previous 4 monetary policy reviews. As we know, an increase in interest rates means tougher growth prospects for Corporate India – hence corporate earnings would take a hit.
Assume there are three market participants – Sunil, Tarun, and Girish. Each of them views the above scenario differently and hence would take different actions in the market. Let us go through their thought process.
(Please note: I will briefly speak about option contracts here, this is only for illustration purpose. We will understand more about derivatives in the subsequent modules)
Sunil: He thinks through the situation, and his thought process is as follows:
- He feels the interest rate are at an unsustainably high level.
- High-interest rates hamper the growth of corporate India.
- He also believes that RBI has hiked the interest rates to a record high level and it would be really tough for RBI to hike the rate again.
- He looks at what the popular analysts on TV are opinionating about the situation, and he is happy to note that his thoughts and the analyst thoughts are similar.
- He concludes that RBI is likely to cut the rates if not for keeping the interest rates flat.
- As an outcome, he expects the market to go up.
To put his thoughts into action, he buys call options of State Bank of India.
Tarun: He has a slightly different opinion about the situation. His thought process is as below:
- He feels expecting RBI to cut the rates is wishful thinking. In fact, he thinks that nobody can clearly predict what RBI is likely to do
- He also identifies that the volatility in the markets is high. Hence he believes that option contracts are trading at very high premiums.
- He knows from his previous experience (via backtesting) that the volatility is likely to drop drastically just after RBI makes its announcement.
To put his thoughts into action, he sells 5 lots of Nifty Call options and expects to square off the position just around the announcement time.
Girish: He has a portfolio of 12 stocks which he has been holding for over 2 years. Though he is a keen observer of the economy, he has no view on what RBI is likely to do. He is also not worried about the policy’s outcome as he anyway plans to hold on to his shares for a long time. Hence with this perspective, he feels the monetary policy is another short-term passing tide in the market and will not have a major impact on his portfolio. Even if it does, he has both the time and patience to hold on to his shares.
However, Girish plans to buy more of his portfolio shares if the market overreacts to the RBI news and his portfolio stocks fall steeply after the announcement is made.
Now, what RBI will eventually decide and who makes money is not our concern. The point is to identify a speculator, a trader, and an investor based on their thought process. All three men seem to have a logic based on which they have taken a market action. Please note, Girish’s decision to do nothing itself is market action.
Sunil seems to be highly certain on what RBI is likely to do, and therefore his market actions are oriented towards a rate cut. In reality, it is quite impossible to call a shot on what RBI (or for that matter any regulator) will do. These are complex matters and not straightforward to analyze. Betting on blind faith, without rational reasoning backing one’s decision is speculation. Sunil seems to have done just that.
Tarun has arrived at what needs to be done based on a plan. If you are familiar with options, he is simply setting up a trade to take advantage of the high options premium. He clearly does not speculate on what RBI is likely to do as it does not matter to him. His view is simple – volatility is high; hence the premiums are attractive for an options seller. He is expecting the volatility to drop just before RBI decision.
Girish, the investor, on the other hand, seems to be the least bit worked up on what RBI is expected to do. He sees this as a short term market noise which may not have any major impact on his portfolio. Even if it did have an impact, he believes that his portfolio will eventually recover from it. Time is the only luxury markets offer, and Girish is keen on leveraging this luxury to the maximum. In fact, he is even prepared to buy more of his portfolio stocks in case the market overreacts. His idea is to hold on to his positions for a long period of time and not get swayed by short term market movements.
All the three of them have different mindsets which lead them to react differently to the same situation. This chapter’s focus is to understand why Girish, the investor has a long-term perspective and not really bothered about short-term movements in the market.