Is the glass half full or half empty?

There are different interpretations of the recent bounce-back...

During the first UPA regime, there was a period when India received less FDI than Botswana. In the past six months, FIIs have been net sellers of Indian equity while investing in even Pakistani stocks. In 2011, India has been the worst performer among emerging markets.

Investing involves decisions on the basis of incomplete information. Every investor develops his own methods. All of us also have both conscious and unconscious biases that influence our decision making and our asset allocation strategies. It’s useful for an investor to be aware of his biases. A conscious bias can be a positive feature of an investment style, while an unconscious bias is likely to be a bug. What are the most common biases investors display?

One is a love for churning. Some investors are inherently impatient. They rarely hold assets for the long term. They continuously and unnecessarily, tweak asset allocation. This inflates transaction costs and causes sub-optimal returns.

The opposite bias is an excessive love for status quo. Some investors display an extreme reluctance to switch asset-allocations even when their portfolios show long-term under-performance. For example, somebody’s grand-dad bought a stock and so, he will never sell it. Others simply hate booking losses.

Finding the right balance in terms of monitoring and switching asset allocations when required is quite difficult. It helps if you know that your personal bias is towards churning, or towards status quo. Then you can then take corrective action when your biases are overriding rational logic.

Another opposed set of behavioural biases are visible when it comes to the subject of research. Some investors are happy to plunge into long-term investments or short-term trades, purely on the basis of rumours or recommendations, without any independent research. Others sweat to learn every last detail and by the time they make a buying decision, there isn’t much upside left.

Too much research can actually be as risky as too little research. Investment is a game of incomplete information. An investor needs to learn enough to make independent decisions. But don’t expect to learn everything. You never will, and if you spend too long information-gathering, the investment will lose its rationale.

A more subtle set of biases are involved when people are optimistic or pessimistic while mentally framing expectations. Let’s say a given investment has a 65 per cent chance of achieving the targeted return. The optimist will classify it as having a “65 per cent probability of success ” while the pessimist will classify it as having “ 35 per cent probability of failure”. The positive thinker is more likely to go for it. Investment advisers are aware of this quirk and highlight the positives, while glossing over negatives. If you are an inherent optimist, look at the downsides, and vice-versa.

Loss aversion is another well-documented bias. People feel happy when they make money. They feel pain when they lose money. But a loss usually seems to cause more pain than the joy from the commensurate gain. This loss aversion can affect investment decisions.

Very few investors have the stomach for venture capital style strategies where there will often be more losers in the portfolio than winners. Each winner may be a multi-bagger and the overall return could be highly positive. But the low strike rate puts people off their stride. Even with a broad, passive portfolio, a few multi-baggers may help generate net gains, while many stocks log losses.

None of us ever finds the perfect balance. Every investment strategy has some weak spot or another. If you know that you consistently make irrational decisions because of behavioural biases, some of those weak spots could be plugged.

The reason why I was thinking about biases was of course, the recent gyrations in the stock market. First, the Nifty swung down by 8 per cent. Then it jumped up 9 per cent. This seesaw occurred in just 10 sessions. It leaves one completely nonplussed about the possible near-term future. The optimist would have reason to claim the market was now into recovery mode. The pessimist would also have reason to claim this is a dead-cat bounce.

Should you shift more cash into equity in the hopes that the uptrend will continue? Or should you wait for another downtrend? My bias is pessimistic. I’d be tempted to sell into the rally assuming that the long-term trend is still firmly negative. Obviously, I may be wrong. India’s fundamentals haven’t changed much and the long-term technical signals for Indian equities still look weak. But if the Greek situation does ease, the global currency markets will get less skittish. That could mean higher forex inflows into rupee assets. Indeed, that happened in the last 10 sessions when FIIs bought heavily. In that case, there might be an upside till 6,000 Nifty and a floor at 5,400. Is the glass half full or half empty?