Why you should not let emotional biases cloud your investment strategy

By Priya Sunder, Livemint article posted on 25 September 2019

Conquer your fear, greed and biases to be able to maximize long-term returns

I have concluded that it’s impossible to have a rational conversation about politics. I watched in disbelief as my genial dinner party degenerated into a volley of slander between Narendra Modi haters and supporters. The party ended abruptly with one family angrily storming out and the rest excusing themselves shortly after. I was distraught. They could have at least finished dinner and then left. That way I wouldn’t have to consume a whole pot of rajma masala for the rest of the week.

I wonder what makes people cling to opinions so tightly that they block out conflicting ideas, no matter how logical they may be. Sometimes you make important decisions predicated on your biases and look back at them in alarm a few years later. You realize those were based on emotions or a blinkered view of the world, and not on sound reason.

Such behaviour is fairly common and is called confirmation bias, where you seek to absorb or distil information that affirms your beliefs. Behavioural biases play a huge role in our approach to money too. We adopt a certain stance about our investments and close our minds to alternate points of view. The current economic slowdown is such an example. Alarmed investors want to move their entire portfolios to safe investments, disregarding that if the tenure of their goal is a decade away, it is irrelevant what happens to the markets in the short term. Do you recall what the market was 10 years ago? Or even five years ago? Exactly my point. It was nearly 20,000 points lower in 2009 and 10,000 points lower in 2014 compared to today. Similarly, today’s market gyrations will also become a blip in your memory five years hence. We have been through so many economic crises in the past—The Indian recession and the Asian financial crisis in the late ’90s, the dot com bust in the 2000s, and the subprime mortgage crisis in 2008. And yet the markets have delivered double-digit returns on average since inception. In fact, it is rare to have negative returns in any block of five years. In turbulent times, we often tend to believe that somehow things are different this time and the situation is dire. The scene is set for us to commit the same mistakes of the past.

Conquering our fear, greed and biases is the most critical factor in maximizing long-term returns, and not the selection of instruments. It is lack of persistence that causes portfolio losses and not a flawed investment strategy. If we let our biases make decisions for us, we would sit on the fence a lot of the times. During a rally, we would fear that we’ve missed the upside and stay out of the markets. During a fall, we would be alarmed by low portfolio returns and either withdraw or stop ongoing investments. Even investors who claim huge risk appetites cash out at times like this. When the markets move laterally, we will be frustrated by the lack of upswing in the portfolio. We will perennially live day by day, cycle by cycle, where today will take precedence over tomorrow. A plan that is expected to deliver in the next three, five or 10 years will suddenly be expected to perform with every market movement.

Richard Thaler won the Nobel prize for economics for his study of human behaviour on economic decisions. While most early economists’ projections were based on rational decision making, it soon became clear that humans are not always rational, and it is important to develop psychologically realistic models. Thaler challenged market efficiencies and pointed out human irrational beliefs as the main reason behind financial anomalies. He postulated that under-performing stocks of the past three years tend to rebound because investors overreact to dramatic news events, which drive down stock valuations.

Incidentally, I find that the more educated an investor is, the more likely he is to deviate from his investment plan. A philosopher once remarked that all of mankind’s troubles can be attributed to not having the ability to sit quietly! It’s difficult for an intelligent person, usually in control of his actions, watch his portfolio swing day to day and remain unperturbed about it. Though he conceptually knows that sticking to the plan will offer him the greatest possibility of success, he is unable to implement it consistently across his investment period.

I’ve learnt my economic lesson. I will avoid inviting pro- and anti-Modi friends to the same gathering because the law of diminishing marginal utility applies strongly to one-week-old rajma masala. Even the smartest of us are given to our moments of recklessness. For someone who studied irrational human behaviour all his academic life, Thaler famously joked that he intended to spend his Nobel prize money as irrationally as possible!