Cognitively Yours 1.9

 

Raja R, Author

"Our emotional reactions to risky situations vary from the cognitive assessment of risk as determined by calculations and in reality they often drive behaviour"

In the previous blogs, we discussed how mental shortcuts though needed to take quick decisions as well as fear of regret may also lead to biases which result in sub-optimal investment decisions. We had also discussed how impatience and need for instant gratification make us hardwired to short-term results. We also saw how we react to events and announcements on a stand-alone basis. We had seen how our predictions cannot be right all the times and we should accept error in order to reduce error and we can never be error-free in our predictions. We also saw with the help of a story, how we prepare for near-term outcomes and do not venture to look far ahead. Then we saw that as emotional travel is not our forte, we cannot predict how we will behave in future in the heat of the moment, pre-commitment and planning helps us in investment. In the last post, again with the help of a story, we saw how we treat the gains from our investment are perceived differently from our own hard-earned wealth.

In contrast to the interesting story of honey-moon couple, which we discussed last time; let us begin on a serious note - a quote from a serious thinker.

“The ‘word’ is never the thing. The word ‘wife’ is never the person; the word ‘door’ is not the door. The word prevents the actual perception of the thing or person because the word has many associations. These associations, which are actually remembrances, distort not only visual but also psychological observation. Words then become a barrier to the free-flow of observation.”

In our investment decisions, we use the word ‘risk’ with varied connotations. Risk does have a mathematical definition which presumes that the investors assess the desirability and likelihood of all possible outcomes of various alternatives and integrate the same through some expectation based on certain calculation to arrive at a decision. 

However, our emotional reactions to risky situations vary from the cognitive assessment of risk as determined by calculations and in reality they often drive behaviour. The additional weights that we assign to negative outcomes over positive outcomes is evident. The pain of losing $1 is much more than the pleasure of gaining $1. To put it lightly “Any Indian cricket enthusiast when mentioned the name of Chetan Sharma will recollect “last ball six off his bowling leading to India’s defeat rather than his hat-trick (all hitting the timber) in the World Cup”.

A few Perceptions about Risk

1. Riskier investments provide higher returns.

Especially in good times, far too many people can be overheard saying, “Riskier investments provide higher returns. If you want to make more money, the answer is to take more risk.” An investor is found to be unhappy with the returns in equity or equity mutual funds when its returns do not match that of the bank deposits. Might even think “I would have been better-off investing in bank deposits” would be the common refrain.

"But, riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier. Riskier investments are those where the outcomes are less certain. In other words, the probable distribution of returns is wider. When priced fairly, riskier investments should entail:

· Higher expected returns

· The possibility of lower returns

· The possibility of losses too, in some cases"

As Howard Marks puts it "Much of the risk is subjective, hidden and unquantifiable both in prospect as well as retrospect"

 

2. I do not wish to take risk

Lopes discusses a splendid metaphor for portfolio choice. He describes how subsistence farmers allocate their land between low-risk food crops and high-risk cash crops. Farmers first take care of subsistence needs, and then plant cash crops. Theirs is a very risky portfolio. Why? It is the only way they have a chance at meeting the goals to which they aspire.

A lot depends on your financial situation, if you can barely afford the basic household expenses, it would be nice to take greater risks to that you earn higher returns. But, if the market turns against you, the consequences could be dire. On the other hand, if you have more than enough money to meet the household expenses shooting for higher returns is less of a risk. As you do have plenty of money,  there’s also less incentive to try for higher returns.

Indeed, it’s one of the ironies of investing. The rich can afford to take risks, but they don’t need to. The poor need to take risks, but they often can’t afford to. 

This is similar to the dilemma of a team chasing a challenging total in limited overs. Playing safe and scoring by singles could keep your wickets in hand and be perceived as not taking undue risks, but the greatest risk of “falling short of one’s goal” will be looming large. Similarly, in investments too, one is interested in risk as well as returns. If one is more focused only  on reducing risks, he may fall short of his goals.

 

3. I have provided for the “worst-case” scenarios and hence I have taken care of all the risks.

We hear a lot about ‘worst-case’ projections, but they often turn out not to be negative enough. Howard Marks tells an interesting story “I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect. Maybe ‘worst-case’ means - the worst we’ve seen in the past. But, that doesn’t mean things can’t be worse”

 

4. My investments have given me great returns and hence not risky.

"No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word" - Nassim Nicholas Taleb

The much-acclaimed investor is one whose actions yielded good results. Was he or she lucky or good?

How much risk did she take? Do the returns commensurate with the risks. Risk cannot be judged by odd or random event and has to be judged over a long-term.

We acclaim the performance of our investment. What if the events have not played out the way it had and benefited us?

While chasing a total, the captain of the batting team promotes a pinch hitter to score some quick runs. He comes up with a great performance and all hail the decision of the captain. The quality of decision cannot be judged purely by the outcome but also by the costs of the alternative, that is, if the history is played out in other way.

"If you burn your mouth with hot milk, next time you blow on your yoghurt" - Turkish proverb.

References:

Howards Marks memo on Risk

Beyond Greed and Fear - Hersh Shefrin

Fooled by Randomness - Nassim Nicholas Taleb

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