Risk has become just another four letter word and investors have (alarmingly) forgotten all about Golden Key and Sakvithi. Its time to remind ourselves that flat equity markets are not a sign that risks have abated, nor is a major correction in equity prices a bad thing.
Most investors are intelligent people, neither irrational nor insane. But behavioural finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others.
The trick, therefore, is to learn to increase our ratio of smart behaviour to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid. Here are some observations and behaviours to keep in mind.
Hanging on to losers too long
Investors tend to think about each stock they purchase in a vacuum, distinct from other stocks in their portfolio.
They are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, they can console themselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if they sold the stock and realized their loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it.
The rear-view mirror doesn't help you with the future (the lure of hindsight)
Wasn't it obvious in 2007 that financial institutions and financial markets were about to collapse? Well, it was not obvious to me, and it was probably not obvious to you, either. Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight. And it makes us over-confident in our certainty about what's going to happen.
Want to check the quality of your foresight? Write down in permanent ink your forecast of tomorrow's stock prices. Do that each day for a year and check the accuracy of your predictions. You are likely to find that your foresight is not nearly as good as your hindsight.
When you hear a voice that says that the stock market is sure to zoom or plunge, activate a "noise-cancelling" device rather than churn your portfolio.
Feel the pain today and enjoy gains in the future
Kicking yourself that you didn’t invest a few thousand rupees in the stock market back in 2008? You are not alone and neither should you regret your decision.
Emotions are useful, even when they sting. The pain of regret over stupid comments teaches us to calibrate our words more carefully. But sometimes emotions mislead us into stupid behaviour. \
Stop focusing on blame and regret and yesterday and start thinking about today and tomorrow. The best way to build long term wealth is to set up a regular savings plan and average in to the market. No one can pick the exact moment when markets are about to rise or fall.
Read that mutual fund brochure carefully
Have you ever seen the various lotteries advertise how many people have lost money? Of course not, all they ever want to highlight are winners and the size of the jackpot.
What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well since 2008.
Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don't chase last year's investment winners. Your ability to predict next year's investment winner is no better than your ability to predict next week's lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.
Wealth doesn’t make us happy; increasing wealth does
One of my most challenging client conversations came two years ago. As a trusted lifestyle adviser, investments make only a very small component of the advice relationship. Ganesh found out that his wealth fell from Rs. 6 million to Rs. 4 million. Malini found out that her wealth increased from Rs. 2 million to Rs. 3 million. Ganesh has more wealth than Malini, but Malini was happier. This simple insight underlies Prospect Theory. Happiness from wealth comes from gains of wealth more than it comes from levels of wealth. While gains of wealth bring happiness, losses of wealth bring misery. It is imperative to frame your outcomes in the correct context and always put your investment outcomes in the context of overall life goals you want to achieve. Seeking the “best returns” year in year out can never be an investment or lifestyle objective, but simply a personality disorder.
Being aware of your cognitive mistakes and behavioural failings are difficult. Understanding that your broker suffers from the same failings is crucial in defending your portfolio.
(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at kajangak@gmail.com). |
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