Sunday, 6 March 2016

Behavioural mistakes we make while investing, and how to avoid them

Behavioural mistakes we make while investing, and how to avoid them

Most of us understand the simple truths of investing. Haven't we been told not to hold on to losing positions for too long, or told not to panic and sell when the market corrects 10% in a single day? Although the basic rules of investing are simple enough to understand, following them can be quite tough. In the words of Warren Buffet, “Investing is simple, but not easy.”

So why is investing in equity so difficult?
An investor's worst enemy is himself. The behavioural skills needed to invest successfully are often in direct conflict with how we respond to familiar situations. If our house is on fire, we listen to our intuition and run for safety. This helps us survive. However, in the case of investment decisions, this behaviour can land us in trouble. The moment we see signs of panic in the stock market, we run to sell all our stocks; when we see euphoria, we jump into the market. We tend to behave irrationally and in a biased manner in many investment situations. Your long-term investment success is determined by your ability to control your ‘inner demons’ and sidestep ‘psychological traps’.

The good news is that human behaviour is irrational in a predictive manner, as examined by Professor Dan Ariely in his highly acclaimed book Predictably Irrational.

Once we are internally alert and are able to recognize these ‘inner demons’, we can develop approaches to tackle them. Thoughtful investors can leverage this predictable irrationality of human beings by not getting swayed by the noise and making rational decisions, thereby taking advantage of others’ behavioural biases.

One such inner demon is ‘overconfidence’. Many a times, we tend to overrate our ability, knowledge and skill. Watching 24-hour news channels and listening to ‘experts’, we sometimes tend to believe that we have become experts and take investment decisions that are not thought through. We think we can predict and time every up and down of daily price movements and invest accordingly. Overconfidence can lead to excessive trading and poor investment decisions. To be a successful investor, one needs to follow a zero-based approach towards decision-making, and be a bit cautious and sceptical. In investment decisions, it pays to be humble rather than being overconfident about past successes.

Another common demon we need to fight is ‘anchoring’. While making a decision, we often tend to give disproportionate weight to the first information we receive. As a result, the initial data colours our subsequent analysis. One of the most common anchors is a past event or trend. How many times have we concluded that a stock is cheap because it is at a 52-week low? Even if fundamental prospects justify a change in value, we find it difficult to erase historical prices from our memory.

Another trap we frequently encounter is ‘mental accounting’, i.e. treating money differently depending on where it is kept, where it comes from, or how it is spent. Assume you buy a stock at Rs. 100 per share that surges to Rs. 200 in one month. Many investors divide the value of the stock into two distinct parts, the initial investment and the profit. They tend to treat each part differently – the original investment with caution and the profit portion with significantly less care. Haven’t you heard of people who choose an overtly conservative investment strategy for inherited wealth as it is “too sacred”? We need to treat every rupee equally, in order to avoid making irrational decisions. It does not matter whether you have received a sum of money by means of hard work or inheritance; once you have received the money, you must treat each penny of it equally, and plan your course of action accordingly.

‘Loss aversion’ is another behavioural bias that we frequently exhibit. Research has established that a loss has about two-and-a-half times the psychological impact of a gain the same size. People feel a lot worse about losses than they feel good about a gain of a similar magnitude. Since it is difficult for investors to accept their losses, they tend to sell their winners too soon and hold on to their losers too long. This is because they don’t want to take a loss on a stock. They want to at least recover their investment, despite the fact that the original rationale for purchasing the stock no longer appears valid.

Another important psychological trap we need to avoid is ‘herding’. People tend to follow the actions of a larger group, independent of their own knowledge. This large-scale social imitation can lead to significant gaps between actual value and price. The herd-like behaviour explains several booms and busts that we have witnessed in the past. These collective behaviour phenomena can create profitable opportunities for individual stocks. But taking advantage of collective irrationality, either for a specific stock or for the market as a whole, is difficult. Since most of us have a strong urge to be part of the crowd, acting independently is not an easy feat. But if we’re able to control this behaviour, it can result in significant investment gain for us. Warren Buffet sums this up by saying: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful”. It requires significant control over one’s emotions to practice in real life.

There are many more demons that we need to tame. For example: Allowing emotions like anger or fear to override reason, becoming paralyzed by information overload, the tendency to seek only that information that confirms our opinions or decisions. They draw from our tendency to behave irrationally and use mental shortcuts while taking investment decisions.

The need of the hour: A disciplined approach towards investing

So how do we fight these inner demons and sidestep these psychological traps? The only uncomplicated way for most of us is to follow a disciplined approach towards investing. 

Some ways to bring about investment discipline are as follows:

(1) Use a ‘check-list’ approach towards entry / exit of stocks. Keep it short and reasonable.

(2) Do your due diligence before investing. Keep a margin of safety while investing; never invest to lose.

(3) Adopt a ‘buy and hold’ strategy with periodic reviews. The less frequently you track the market and check your portfolio, the less likely you would be to react emotionally to the natural ups and downs of the stock market. For most investors, checking the portfolio in a structured manner (once in three to six months) is sufficient.

(4) Be more thoughtful while taking long-term investment decisions. Losing one day’s return will not matter if you want to keep the stock for 10 years. When you see signs of panic or euphoria, the best advice would be to wait for another day. If the investment is meaningful from a long-term perspective, the opportunity will continue to remain a good one, even in the future.

(5) Have appropriate asset allocation, and rebalance your portfolio periodically.

(6) Invest at regular intervals.

(7) Be patient. Do not focus on instant returns, and do not change your investment decisions based on short-term returns.

(8) Overall, be humble, and learn from your mistakes. When you succeed, evaluate which of your actions contributed to the success, and which ones did not. Don’t claim the credit for successes that have occurred by chance. Avoid rationalisation when you fail. Don’t exaggerate the role of bad luck in your failures.

Summing up…
Research has shown that behavioural mistakes can reduce the return on investments by 10% to as much as 75%. So what do you need to avoid this? It can be summarized in one word: discipline. One need not always focus on becoming too smart. Instead, if one can focus on avoiding silly behavioural mistakes, one could become a successful long-term investor. Warren Buffet once said, “You only have to do a very few things right in your life, so long as you don’t do too many things wrong”. If we can avoid making big mistakes, the right decisions would take care of themselves. A disciplined approach towards investing allows you to do just that.

Like the central theme of the Mahabharata, the battle for investment success is about systematic adherence to dharma – financial dharma. As stated in the epic, “The road to heaven is paved with bad intentions.” Our journey towards financial heaven is filled with such inner demons. Our ability to identify and tame the ‘inner demons’ is essential for long-term superior returns. Just as a lot of mental discipline and willingness is required to forego short-term pleasures to wake up every day and jog for good health, a similar discipline and willpower is required to follow the simple but powerful mantras of enhancing long-term financial health.

Quote for the day

“In trading, you can't hide your failures. Your equity provides a daily reflection of your performance. The trader who tries to blame his losses on external events will never learn from his mistakes.” - Victor Sperandeo