Empathy gaps and investing. On the face of it, the previous sentence throws up two concepts which are seemingly totally unrelated to each other, and let’s face it, many of us may not even know what an empathy gap is. But, let me assure you, these two concepts are very much related to each other and anyone who understands and absorbs the relationship between the two concepts will come out a much better investor. So now, let us first understand what an empathy gap is.
In his book titled The Little Book Of Behavioural Investing, the author James Montier, defines an empathy gap as a situation where people behave in a way that is contrary to rational behaviour when they are put under pressure or experience euphoria. In other words, the author says that people behave in a way they shouldn’t when they are overcome by either positive or negative emotions, which ends up yielding negative results. Let’s look at a few examples to understand.
Let’s say there is a student who is gearing up to face an exam. The pre exam period and actual exam week obviously bring with it pressure and stress which the student has no choice but to put up with. Rational behaviour would suggest that the student, while of course taking on the stress, should continue to remain calm and patient, because sooner or later the exam will be history. But in reality, the opposite is most likely to happen. The student is almost always likely to end up getting bogged down by the pressure, resulting in an empathy gap, which sees him deliver sub optimal performance.
Let’s take a look at an empathy gap caused by euphoria. Imagine a talented new kid on the block in a multinational. Let’s say that the employer is so happy with the new breakout star’s performance that he decides to elevate him to a level to which he should ideally have been elevated in six months, in just four. Rational behaviour would suggest that the new employee must continue to work hard, keep delivering, and prove that his employer’s faith in him was now misplaced. On the contrary, there is a very good chance that the employee would be so blinded by his own euphoria as a result of the premature promotion, that he would get overconfident and arrogant, resulting in an empathy gap, which may lead to a drop in his performance standards, and thus he may ultimately get himself fired. So much for empathy gaps. But, how does an empathy gap manifest itself in the world of investing?
In a rip roaring bull market (something akin to what we are seeing in India right now), where stock prices touch new highs and a feeling of optimism and euphoria overrides the markets, rational behaviour would suggest that investors should keep selling at regular intervals since it is likely they would have made a hefty return on their investments. In reality though, the investors are likely to be so excited and jubilant to see their investments do well, that they can’t imagine stock prices falling, so they continue to buy in spades, resulting in an empathy gap. As a result of the empathy gap, when the markets crash (which inevitably they will), investors burn their hands so badly, that they go home with their tails between their legs, petrified at just the thought of entering the markets again.
On the flip side, in a depressing bear market, where fear and pessimism have the markets in a vice grip, rational behaviour would suggest that it is the best time for investors to buy truckloads of their favourite stocks and be patient because almost all stocks would be available at dirt cheap prices. But, in all likelihood, investors would be so badly paralysed by fear that they don’t buy even though they may have sacks full of cash available to invest, resulting in an empathy gap, which sees them miss out on the best part of the inevitable recovery in the markets.
I know all this seems easier said than done, but it would help to maintain target selling prices and sell when those prices are hit in a bull market without regretting any further increase in prices post sale, and having a wish list of stocks which you would like to buy, so that you have a shopping list ready when the next bear market hits.
As a parting shot, I would like to once again remind all readers of this piece that empathy gaps and investing go well together and that understanding how they work in tandem would give them an extra edge over other investors in the market.