The Imperfect Investor

Spare a moment to recognise and think about your cognitive biases and other behavioural quirks, and you might just make a lot more money

In December 1999, a friend asked for “a few stock tips in the IT sector”. His construction business was doing well and he had cash to spare. He had never invested in shares before. But the stockmarket was in the middle of an internet-infotech frenzy, and he was seduced by the lure of quick returns.

I offered some names, made the usual noises about high risks and forgot about it. We lost touch when our lives went in different directions. As the year turned and 2000 rolled on, Yashwant Sinha produced a terrible Budget. Then the internet boom turned into a bust and the Ketan Parekh scam broke. The stockmarket tanked.

Over a year later, we caught up. He had a bone to pick. Our friendship ended with the argument that followed. He’d lost a lot of money. My recommendations had first doubled in value, and then halved, and halved again.

He hadn’t called to ask for follow-up advice. He had not booked profits. He hadn’t booked losses. He had no intention of booking losses. Having seen his portfolio double in value once, he was confident that the magic would happen again. But he blamed me for putting him on this emotional rollercoaster. For all I know, he still owns those shares.

Irrational behaviour? Yes, it was, on many counts. But not abnormal. If you spend time in the company of retail investors and traders, you learn that normal, sane, intelligent people often behave irrationally when money is on the table.

Behavioural scientists like Danny Kahneman, Amos Tversky, Sheena Iyengar, et al, have shown that as a species, we are not very rational in weighing risks and choices. Evolution wired cognitive biases into us. Brains optimised to hunt mammoth and avoid sabretooth are not necessarily perfectly equipped to navigate a financial jungle.

There are many cognitive biases, and you (and I) are undoubtedly prone to some. If you know your own biases, you can apply corrective measures. So, let’s take a look at some typical biases. The examples that follow are real-life, though I’ve avoided any reference to personalities.

A rational person ‘should’ be as happy at the prospect of making a buck as s/he is sad at the thought of losing a buck. But for most people, the angst when a rupee is lost far outweighs the joy when a rupee is gained. Studies show that people suffer more than twice as much pain faced with the prospect of loss than they experience joy thinking of an equal gain. The unequal emotional weighting means that loss averse investors are reluctant to get involved with many potentially profitable investments where the odds are, say, 15:10 in favour. They want bets with odds more than 2:1 in favour. These are not so common.

A typical way of compensating for loss aversion is hubris, or overconfidence. If you ‘know’ every investment you make will turn up trumps, you need not fear the prospect of loss. Most people refuse to contemplate the prospect of loss. Studies show that women are slightly less prone to overconfidence. But this is relative—women also suffer hubris.

I initiate every conversation about trading techniques by pointing out that there is a 50 per cent chance any given punt will lose money. Sometimes I say there’s a 50 per cent chance any given punt will gain. The reactions tend to be different, although the statements mean exactly the same thing.

Almost always, when I point out the prospect of loss, I am castigated for being negative. Yet, this is rational. Stock prices can go up, down, or sideways. You will be wrong close to 50 per cent of the time. It’s useful to take that on board before you put money on the table.

Overconfident investors punt more often; they put down more money per trade than they can afford to lose; they only compound initial errors by refusing to admit that these were errors.

Hubris often leads to the fallacy of sunk cost, which leads to throwing good money after bad. The classic instance is of the moviegoer who discovers at the hall that he’s misplaced his ticket. Does he buy another ticket? Whatever he does, he’s not going to recover the cost of the lost ticket.

To extend the thought-experiment, say you book a movie ticket and then learn from friends that it’s dreadfully boring. Do you watch it anyway rather than ‘waste’ the ticket? If you do, you may add the cost of boredom to the financial price you’ve already paid.

Harking back to a sunk cost doesn’t help make rational decisions for the future. But it is something that humans and associations, like governments and multinational corporations, are prone to. Acknowledging a bad decision and stanching the resultant loss means overcoming hubris. It’s psychologically easier though financially damaging to simply pump more money into a mess.

A typical case of a sunk cost fallacy is persistent averaging. The following example of DLF is taken from real life. An investor I know bought DLF shares in mid-2008 at an average price of about Rs 500. Since then, he’s averaged several times, buying more stock when the price has fallen. He now holds about six times as many DLF shares as he did in 2008. His averaged cost is about Rs 310, roughly a third more than the prevailing price, which means a 35 per cent loss.

Through this period, he has focused only on DLF. Other stocks have become multi-baggers while he’s bled. All he wants is to someday, eventually, make a profit on DLF. Admitting that he made a mistake way back in 2008 would cost him more emotionally than the losses he has accepted since.

When the law of averages is invoked, investors indulge in the gambler’s fallacy. Let’s say, for example, that a gambler bets on ‘tails’ for a sequence of coin tosses. The coin comes up ‘heads’ thrice in a row. He assumes the chances of its coming up tails is now enhanced. It isn’t—the odds remain precisely 1:1, assuming a fair-weighted coin. A coin has no ‘memory’ and the outcome of the next toss has nothing to do with the last toss.

Yet, investors often think this way. A stock has tanked. So it’s likely to bounce back. It may indeed do so eventually. Stock prices do have some ‘memory’, if only because investors with memories have an influence on them. But there is no ‘law of averages’. A stock that’s falling could fall indefinitely. It can certainly fall for longer than an investor can remain solvent. Don’t bet heavily on a trend reversal occurring just because you want to bet on it.

Confirmation bias is the tendency to selectively digest information that confirms preconceived theories. The dangers of this are obvious.

There are reasons to believe that buying equity now could be a good idea. There are reasons to believe it may be a bad idea. If you have preconceptions, you will be partially colour-blind. You will only see either the green gainers or the red losers on TV/internet ticker tapes. All investments involve assessing multiple variables. Try and see all of them and weight them equally before you make a decision.

Some investors sell winners too soon. Other investors hang onto losers for too long. Many commit both these violations of common sense. Any successful trader or investor will tell you exactly the opposite strategy works: hold your winners and let go of losers.

The best way to handle a Disposition Effect is to set and reset mental ‘stop losses’. Before you make an investment, consider the possibility that it could go wrong, and set a cut-off loss limit. This could be 10 per cent, 50 per cent or 90 per cent—it’s up to your personal risk appetite. Whatever it is, do set a cut-off. And if that limit is hit, exit. If by some mischance, you start making a profit, review the situation and move the loss limit up. Keep reviewing the loss limit and shift it upwards if your profits increase. Traders call this a ‘trailing stop-loss’. The stop loss trails the price. It automatically limits losses while allowing winners to continue running up. When a winner turns sour, the cut-off also helps you book profits.

Many people tot up the number of winning decisions versus the number of losing decisions without paying attention to the amounts won or lost. Think of a stock investment like a coin toss. Ignoring the situation of an unchanged price, you have roughly equal (1:1) chance of being right or wrong. If you earn more money on ‘wins’ than you lose on ‘losses’, your overall return is positive.

Venture capitalists and private equity players bet at different odds. Eight or nine of every ten VC-supported businesses fail. Their odds are often no better than 1:9. But that one successful business offers better than 10:1 returns, generating overall profits. An oil & gas exploration outfit also operates with similar low strike rates and occasional high payoffs.

The philosopher-investor Nassim Nicholas Taleb has become a rich man by being wrong most of the time. He bets on extraordinary swings that occur very rarely but pay off hugely when they do occur. Equally, you can become a poor man by being right most of the time and making small gains, and being wrong once in a while and losing huge sums. Selling options—which is like insuring an asset against an unlikely disaster—is a common route to this sort of paradoxical bankruptcy.

Look at both the strike rate and reward-to-risk ratio before you take a position. You may not have the mental fortitude to adopt a Taleb-type strategy where you will be wrong 95 per cent of the time. But don’t trap yourself in a poor strategy by not knowing both strike and risk-to-reward. If you’re playing the stock market, put roughly equal amounts of money into all your positions. If you’re playing futures or options, make sure you understand the implications of leverage: slight price swings can result in vastly magnified profits and losses.

It is blindingly obvious today that Sehwag, Dravid and Laxman shouldn’t have been picked for the last cricket tour of Australia. Any random trio of youngsters would have performed as well or better, while being an investment for the future. Of course, it wasn’t quite as obvious when the squad was picked.

So don’t judge the quality of a decision purely on the outcome. Wars, riots, accidents, overseas financial crises can all have unpredictable effects on stock prices. If something unexpected happens, don’t berate yourself or your financial advisors. Review the scenario calmly in the light of the new information.

Another cognitive bias is the inability to distinguish between nominal and real purchasing power. The Reserve Bank of India targets an inflation rate of 5 per cent. If it achieves this, the purchasing power of Rs 100 in 2012 will be equivalent to that of Rs 50 in 2026. To retain its current purchasing power, your Rs 100 will have to grow at 5 per cent or better in those 14 years.

If you’re making retirement plans as a long-term investor, take inflation into account. Don’t accept an overall return on your portfolio that is less than the inflation rate (it’s been about 7 per cent for an urban consumer over the past decade). It is sensible to hold a mix of safe (low-return) and high-return (potentially risky) investments in your portfolio.

Can you recognise yourself or one of your friends in the examples above? All of us have cognitive biases. All of us make mistakes. If you can identify the kinks in your investment style, your financial returns will improve dramatically. A behavioural approach also offers a powerful tool for understanding why and how markets can behave irrationally. That helps keep blood pressure under control and your financial health in good shape.

As a closing teaser, since a few of you are probably reading this in the hope of getting a stockmarket tip, here’s my opinion: I’m bearish in the timeframe of the next 6-12 months and bullish in that of the next two years. I’ve been right slightly more often than I’ve been wrong in the past 20 years. My personal investment style takes the 50 per cent chance of error into account.

Whether you share my views or not, I’d advise you to invest in a systematic manner without putting next month’s EMI into the market. But do keep an equity component in your portfolio. The RBI has never managed to achieve anything close to its inflation targets, and that means any ‘safe’ investment will just erode over time.

About The Author

Devangshu Datta