Irrationality in financial decisions: A policy proposal

The high valuations of small- and mid-cap stocks in the Indian market seem indicative of irrational exuberance. In this context, Gurbachan Singh discusses the prevailing policy framework to deal with excess volatility in asset prices. Highlighting that the current policy approach fails to address the fundamental matter of irrationality or lack of adequate awareness among investors, he proposes a new framework pertaining to the market for financial advice.

In the Indian stock market, the price to earnings (P/E) ratio¹for the Nifty Smallcap 250 Index stands at 28.85 as on 29 February 2024. The P/E ratio for the MSCI Emerging Market Index is, in comparison, trading at approximately 12 over the next 12 months; this is less than half the figure for India. We have a similar comparison in case of mid-cap stocks. The valuation of the small- and mid-cap stocks is high, to the extent that the aggregate market capitalisation of stocks in India is now at an all-time high of 129% of gross domestic product (GDP) – with the long-term average being 82%. The valuations indicate that there is irrational exuberance in the market for small-and mid-cap stocks in the country (which is not to say that the prices can necessarily completely correct very soon). This is not just a current problem but a recurring one, though it can take different forms.

Irrationality is widely prevalent in asset markets. Efficient market theory does not hold unambiguously. There are, in practice, limits to arbitrage for sophisticated investors, and asset prices can be excessively volatile. All this is much better understood today – thanks to the advances in behavioural finance. However, this literature has not thrown up many meaningful policy solutions (see, for example, Gennaioli and Shleifer (2018), which mainly explains how economists can use diagnostic expectations instead of rational expectations in their studies and how some risks can get neglected in asset markets; however, the book does not give a policy solution). In this post, based on a chapter from Singh (forthcoming), I seek to make a contribution in this context.

We may classify investors as rational and irrational. Alternatively, we may view them as sophisticated investors and ordinary investors. The latter include even those who are well-educated, albeit in a field outside of finance. At the end of the day, they tend to use their own understanding, which can be inadequate, outdated, irrelevant, or even outright wrong in a given situation. Ordinary investors can get exploited in subtle, indirect, legal and inadvertent ways by ‘highly talented’ sophisticated investors. Further, the behaviour of investors and the markets matters for macroeconomic stability and for the economy more generally. What can be done about all this?

An asset market, like any other market, does not operate in a vacuum. It functions within a policy framework, including related laws, regulations and institutions. It is true that a change in policy cannot change the investors. However, it can make a substantial improvement in the market for financial advice so that the actual behaviour, after using sound, credible and independent financial advice, is close to being rational in the asset markets.

Although the motivation for wide usage of financial advice here is to safeguard against losses or very low future real returns on small cap funds in the stock market, the rationale is in fact broader. For example, losses of a common person in investments in chit funds and other parts of the shadow financial sector can be minimised, if not avoided. The issue of financial advice for investing in bank deposits though applicable is not very relevant as far as safety is concerned (given that these are de jure insured in India up to Rs 5,00,000), the de-facto insurance in public sector banks can be much higher.

Prevailing policy framework

Let us start with a discussion of the prevailing policy framework to deal with the excess volatility in asset prices – not irrationality per se – as a benchmark for a change in policy. This framework is in two parts. The first part is on regulation of the market for financial advice. This includes the Securities and Exchange Board of India (Investment Advisers) Regulations, 2013 (hereafter, SEBI regulations) - these were amended on 7 February 2023. A key component of the SEBI regulations aims to reduce conflict of interest, by separating financial advice from the incentives to sell selected financial products. However, the regulations are not very effective in ensuring that financial advice itself is by and large sound, affordable and easily accessible. Hence, the issue of irrational behaviour among investors remains.

Accordingly, we have the second part of the prevailing policy framework, comprising an amorphous set of policies and guidelines, along with subtle nudging by policymakers and influential voices in the economy. What follows here is not an exhaustive list of all that is used but it is indicative enough. Some of these have actually not been used in India so far, but they can be, given the somewhat common acceptance in developed countries. The listing that follows is not in any order of importance. The various measures have, as we will see, serious limitations.

i) The Reserve Bank of India (RBI) can raise interest rates to put an end to asset price But this is a blunt policy, which may also reduce real investment and in turn aggregate GDP and employment.

ii) The RBI's function of ‘lender of last resort’ can be extended to ‘buyer of last resort’, in a scenario of extremely low sentiment and asset A related intervention is the ‘Greenspan Put’², wherein the central bank can announce availability of liquidity when some asset market crashes. However, moral hazard is a serious concern here.

iii) Borrowing amongst investors tends to be procyclical (higher in times of boom, lower during economic downturns) and is a causal factor in the rise and fall of asset prices. The policy suggestion is that such borrowings should be regulated (Geanakoplos 2010). However, this does not go to the root of the problem, which is investors' inadequate understanding of asset pricing.

iv) There has been some significant work on financial literacy (Lusardi and Mitchell 2014), but while this is important, it has its Consider an analogy: In the field of medicine, we hardly require patients to have what may be called medical literacy, beyond a point for obvious reasons.

v) It is often argued that some financial products should be available exclusively to accredited investors (read, wealthy investors). However, many accredited investors may not be able to assess risks, while many who have the ability to assess and handle risk may not be accredited. Thus, there can be two types of errors: first, some of those who are accredited cannot handle risks. On the other hand, some of those who are not accredited can handle risks, but they are not allowed to participate in some markets in the first place.

vi) In the years up to the Global Financial Crisis (GFC) in 2007-08, several innovative and complex financial products were being used. The risk was, however, not well-understood. It has been suggested that such developments should not be encouraged very much (Bookstaber 2007). But that is a blunt policy, and can discourage even what can be useful.

vii) Increasingly the emphasis is on index funds. Yet, this whole approach has its own drawbacks (Singh 2020). Consider an example: After economic liberalisation in India in 1991, the BSE (Bombay Stock Exchange) Sensex shot up massively. Leaving aside the fluctuations on the way, the nominal rate of appreciation from an index fund would have been zero for about 10 years from about 1993 to about 2003. The investment halved in real terms over a decade. The point is that investment is very risky if the valuations are very high to begin with.

Overall, there is a basic problem with the prevailing policy framework as it does not confront the matter of irrationality. What can be done about this?

Proposed policy framework

The proposed policy framework pertains to the first part of the prevailing policy framework, which deals with the market for financial advice, and encompasses several existing SEBI regulations as well as other regulations considered hereafter – somewhat obviating the need for the second part of the current policy framework discussed above.

Let us first understand the basic problem in the market for financial advice. The quality of “money doctors” is, by and large, not high even in developed countries (Gennaioli et al. 2015). This problem is even more serious in a country like India. Unfortunately, the training of financial advisors and other participants is often not rigorous and comprehensive. Hence, the size of the market for financial advice is small.

Financial advisors have their own difficulties. They need to advise on an asset market that is driven not just by fundamentals but sentiment as well. If an asset market runs significantly on sentiment, and if other financial advisors advise on the basis of fundamentals and sentiment, an individual advisor cannot meaningfully advise on the basis of the fundamentals alone. In an ideal scenario, there could be some coordination among all the advisors such that every advisor could focus solely on the fundamentals. But this is missing.

Finally, we have the right to property, and freedom of choice in the Indian Constitution. So, investors cannot be forced in any way to invest or not to invest in some financial product at a given time.

The result of all this is what we see, which is that asset prices can go haywire and for long periods of time. Considering where we are as far as the prevailing thinking on policy is concerned, the proposed policy package here can only be ‘radical’, in the original sense of the word, which is to get to the root of the problem. The proposed policy package includes three elements in addition to the prevailing SEBI regulations.

i) Students or mid-career professionals who are interested in specialising in financial advice ought to be selected carefully; they need to be ‘fundamentals-minded’. Such quality checks already exist in the form of entrance exams and assessments, and are needed in institutions involved in finance in adequate measure. It is also important to substantially improve the education, training, examinations, certification, and the process of issuing and renewing licenses of financial This can take care of the quality of financial advisors.

ii) The core training of financial advisors should be in terms of the fundamentals, and not the prevailing/expected sentiment in asset markets. It can help if the advisors are also required to take an oath to that effect – similar to fields such as medicine. This can mitigate the coordination problem mentioned earlier.

iii) It should be mandatory – for a while – for investors to seek professional financial advice before they participate in asset markets. However, though the financial advice is to be mandatory, investors should be free to choose whether to accept or reject it. This can more or less take care of the respect for private property, and freedom of choice, if the change in policy is communicated effectively. Also, the idea behind the use of financial advice is not to discourage risky investments like equity; these are much needed in India. The idea is to invest with awareness, and invest wisely and sustainably.

Given the nature of the proposed policy framework as a whole, we can have a large enough market so that sound financial advice can be a reality at a reasonable fee. The question is whether the investors would actually act on the financial advice received. Consider analogous situations. People do take medical advice (or legal advice) by professionals seriously. This suggests that people are likely to accept financial advice too if it is credibly sound.

Concluding remarks

The claim here is not that the asset markets can become unambiguously efficient with the proposed policy framework for financial advisors. But the framework can help in moving towards an outcome in which the role of sentiment or ignorance in asset markets is substantially reduced.

Grinblatt et al. (2011) find that investors with high IQ (intelligence quotient) earn significantly more on their investments than investors with less IQ. This is not surprising. However, under the proposed policy framework, an investor's own IQ can be quite irrelevant in determining returns on investment, just as in the field of medicine a patient’s own IQ can be irrelevant if they are treated by a competent medical practitioner. This separation of returns on investment from IQ is an important step forward.

It is true that there can be issues of information and affordability of financial advice for many people in India. This problem is similar to the difficulty in other fields like health, education, housing, etc. And, just as we have some government intervention in these areas, we may need a programme under the proposed policy framework as well.

The views expressed in this post are solely those of the author, and do not necessarily reflect those of the I4I Editorial Board.

Notes:

The price-to-earnings ratio helps compare the price of a company’s stock to the earnings the company generates. This comparison allows for an understanding of whether markets are overvaluing or undervaluing stocks in the aggregate.
Greenspan put is the label for the policies implemented by Alan Greenspan during his tenure as Chair of the Federal Reserve. Under Greenspan’s leadership, the Fed was extremely proactive in halting excessive stock market declines, acting as a form of insurance against losses, similar to a regular put option.