INVESTING IS SIMPLE, BUT NOT EASY

Preparing ourselves for long term investment success

This article is written by Mr. Modan Saha, Managing Director, AxisDirect.
Many of us understand the simple truths of investing. Don't we know that we should not hold on to losing positions for too long or not panic and sell indiscriminately when the market corrects 10% in a single day? However, following some of the simple rules of investing is not easy. In the words of Warren Buffet, Investing is simple, but not easy. So why is investing in equity so difficult? The answer lies within us - an investor's worst enemy is himself. The behavioural skills needed to invest successfully are many a time in direct conflict with how we have learned to respond to familiar situations. If our house is on fire, we listen to our intuition and run for safety. This helps us survive. However, most of the times for investment decisions this behaviour lands us in trouble. 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 such investment situations. This type of behaviour hurts our portfolio performance. Our ability to control our 'inner demons' and side step the 'psychological traps' would determine our long term investment success. The good news is that human behaviour is irrational in a predictable manner, as examined by Professor Dan Ariely in his highly acclaimed book . Once we are internally alert and recognize these 'inner demons', we can then develop approaches to tackle them. Thoughtful investors can leverage this predictable irrationality of human beings by not getting swayed by the noise but deciding based on rationality and taking advantage of others' behavioural biases. One such inner demon is our overconfidence. Many a times we overrate our ability, knowledge and skills. Listening to 24 hour news channels and 'experts', we sometimes tend to believe we have become experts and take investment decisions based on superficial understanding. A couple of right calls and we think that we can time every up and down of daily price movements of the stock market. Overconfidence can lead to excessive trading and poor investment decisions. To be a successful investor, one needs to develop a zero based approach towards decision making and be a bit cautious and sceptical. In investment decisions it pays to be humble and not be overconfident about our past successes. Another common error is our tendency to anchor our views based on certain previous data. In considering a decision, we often give disproportionate weight to the first information we receive. As a result initial data colour our subsequent analysis. One of the most common anchors is a past event or trend. How many times we have 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. Haven't we many a times refused to sell a stock because it is below the purchase price? We need consciously think 'zero-base' about price and value of a stock in order to sidestep this error.

Another trap we frequently encounter is 'mental accounting', treating money differently depending on where it is kept, where it comes from, or how it is spent. Say you buy a stock at Rs. 100 per share that surges to Rs. 200 in one month. Many divide the value of the stock into two distinct partsthe initial investment and the profit, and treat each part differentlythe original investment with caution and the profit portion with significantly less care. Have you or your friend chosen an overtly conservative investment strategy for inherited wealth in the past as it is too sacred? We need to treat every rupee equal in order to avoid making irrational decisions. It does not matter whether we have received a sum of money by our hard work or inheritance, once we have received the money we have to treat them equally and plan our course of action accordingly.

'Loss aversion' is another behavioural bias we frequently exhibit. Research has established that a loss has about two and a half times the impact of the gain the same size. People feel a lot worse about losses of given size than they feel good about a gain of 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 get back their investment despite the fact that the original rationale for purchasing the stock no longer appears valid. Loss aversion is also a tricky emotion to understand and be conscious of as it manifests itself in seemingly opposite ways. At one end, it makes us hold on to our loss making investments longer than necessary as explained above. On the other end it also goads us to sell our stocks at the first sign of large drop in share price. Another important psychological trap we need to avoid is our tendency to follow the herd. Individuals 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 value and price. This herd like behaviour explains many of the booms and the busts we have witnessed in the past. These collective behaviour phenomena 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 a tough task. Our ability to control this behaviour can result in significant investment gain for us. Warren Buffet sums up the desired behaviour as 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 emotion to practice it in real life. There are many more demons that we need to tame, e.g. allowing emotions like anger or fear to override reason, becoming paralyzed by information overload, tendency to seek only information that confirms our opinions or decisions, etc. All of them draw from our tendency to behave irrationally in various investment situations or using mental short cuts while taking investment decisions. Needed: A disciplined approach towards investing So how do we fight these inner demons and side step these psychological traps? The only uncomplicated way for most of us is by following a disciplined approach towards investing. Some of the ways to bring discipline in our investment process are as follows: (1) Use 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, 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 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) Try to be more thoughtful while taking long term investment decisions. Losing one day's return would 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 decision is meaningful from a long term perspective, they opportunities would also remain tomorrow. (5) Have appropriate asset allocation, and rebalance the same periodically. Rebalancing automatically forces you to buy low and sell high.

(6) Invest at regular intervals. (7) Be patient, do not look for instant returns; do not change your investment decisions based on short term returns. (8) Overall be humble, and learn for past mistakes. When you succeed, consider which of your actions contributed to your success and which did not. Don't claim credit for successes that have occurred by chance. Avoid rationalization when you fail. Don't exaggerate the role of bad luck in your failures.

Summing up
Research has shown that behavioural mistakes reduce the return on investments that investors actually receiv by 10% to as much as 75%. So what would you need to do? It can be summarized in one word: discipline. One need not focus on becoming too smart; instead if one can avoid silly behaviour one would be 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 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 like it requires a lot of mental discipline and our willingness to forgo short term pleasures to wake up every day early in the morning and go for jogging for one's good health, it requires similar discipline and will power to follow the simple but powerful mantras of enhancing one's long term financial health.

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