Cognitively Yours 1.11

 

Raja R, Author

"We need someone who could modify the behaviour and moderate the fear-greed cycle and help the investor navigate across the various emotional cycles"

In the previous blogs, we discussed how mental shortcuts though needed to take quick decisions do induce us to make errors in investing. In the last blog, we saw how diversification helps us reduce risk and how it is almost a free lunch in minimising risk without reducing the returns.

In this blog let’s start with reference to a short story, "How much land does a man need?" by Leo Tolstoy

The protagonist of the story is a peasant named Pahom, who overhears his wife and sister-in-law argue over the merits of town and peasant farm life. He thinks to himself “if I had plenty of land, I shouldn't fear the Devil himself!”. Unbeknownst to him, Satan is present sitting behind the stove and listening. Satan abruptly accepts his challenge and also tells that he would give Pahom more land and then snatch everything from him. A short time later, a landlady in the village decides to sell her estate, and the peasants of the village buy as much of that land as they can. Pahom himself purchases some land, and by working on the extra land is able to repay his debts and live a more comfortable life.

However, Pahom then becomes very possessive of his land, and this causes arguments with his neighbors. “Threats to burn his building began to be uttered”. Later, he moves to a larger area of land at another Commune. Here, he can grow even more crops and amass a small fortune, but he has to grow the crops on rented land, which irritates him. Finally, after buying and selling a lot of fertile and good land, he is introduced to the Bashkirs, and is told that they are simple-minded people who own a huge amount of land. Pahom goes to them to buy as much of their land for as low a price as he can negotiate.

Their offer is very unusual: for a sum of one thousand rubles, Pahom can walk around as large an area as he wants, starting at daybreak, marking his route with a spade along the way. If he returns to his starting point by sunset that day, all the land his route encloses will be his, but if he does not reach his starting point, he will lose his money and receive no land. He is delighted, as he believes that he can cover a great distance and has chanced upon the bargain of a lifetime. That night, Pahom experiences a surreal dream in which he sees himself lying dead by the feet of the Devil, who is laughing.

He stays out as late as possible, marking out land until just before the sun sets. Toward the end, he realises he is far from the starting point and runs back as fast as he can to the waiting Bashkirs. He finally arrives at the starting point just as the sun sets. The Bashkirs cheer his good fortune, but exhausted from the run, Pahom drops dead. His servant buries him in an ordinary grave only six feet long, thus answering the question posed in the title of the story.

This is a popular story of Leo Tolstoy which we have read during our school days. The morale of the story which we understood at that time was “Radix Malorum est cupiditas” translated roughly as “Greed is the root cause of all evil”. The story mimics our quest for maximising returns to achieve our financial goals. Just like Pahom, an investor has all these emotions while earning money, saving it and then investing with the intention of maximisng gains.

True, Greed was one of the factors in the story of Tolstoy. Pahom did exhibit emotional bias of greed at the time of marking out land and fear when he was running in the end to reach the starting point before the sunset. But, where only emotional biases present? Were there was no cognitive bias? Ideally, like many investors who shoot in the dark and try to maximise returns and build the maximum wealth possible, he did not have a specified target in mind taking into account his needs, his speed to mark land within the allotted time and his capacity to mark land within the specified time. Had he this target, he could have reviewed his progress mid-way and re-adjusted his goal, if need be. There was a need to moderate his cognitive biases too.

The plight of Pahom is the plight of a common investor who is drawn out between cognitive biases which originate from faulty or lack of reasoning and emotional biases which result from impulsive feelings or intuitions. We need someone who could modify the behaviour and moderate the fear-greed cycle and help the investor navigate across the various emotional cycles.

Nobel prize-winner Daniel Kahneman and co-author Mark Riepe, who have made significant contributions to behavioural finance, describe financial advising as “a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interests”.

Serving the best interest of the client may be the recommendation of an asset allocation that suits the client’s natural psychological preferences – and may not be one that maximises expected return for a given level of risk. More simply, a client’s best practical allocation may be a slightly under performing long-term investment program that the client can comfortably adhere to.

Conversely, another client’s best practical allocation may be one that goes against his or her natural psychological tendencies, and the client may be well-served to accept more risk than he or she might otherwise be comfortable with - to maximise returns for a given level of risk. There is a hand-holding function for advisors which is important. Some people think that what they’re getting with a financial advisor is some kind of wizardry with respect to picking a portfolio. Mark Riepe says “But, what’s of even greater value is the financial advisor’s role as an emotional shock absorber”.

Ideally, one who provides you a process you can trust that ensures you’re considering the right information—and not just acting on emotion—no matter what decision you’re making. We can’t control the outcomes. We’ll win some and lose some. But, we can be confident that we did everything we could to make the right call in the moment. The financial advisor act as therapist for the investor.

Photo by Sebastian Herrmann on Unsplash

Reference: The future of wealth management: Incorporating behavioural finance into your practice by  Michael M Pompian