Cognitively Yours 1.12

 

Raja R, Author

"An effective strategy need not be effective in every single instance. SIPs work on this principle and each instalment need not be profitable but on the whole it aspires to strike an average and be successful"

In the previous blogs, we discussed how mental shortcuts though needed to take quick decisions do induce us to make errors in investing. We also saw how diversification helps us reduce risk and how it is almost a free lunch in minimisng risk without reducing the returns. In the last post, we saw the benefits of an advisor who can help you navigate you across the emotional cycles without amplifying your greed and fear.

This is IPL time. But, let us focus on building an innings in Test cricket. Building a Test innings is akin to building a nest-egg. In a Test innings, there will be plenty of dot balls, times when one has to be patient waiting for the loose ball or juicy full-toss times when it looks a long grind and boring like “watching the paint dry or watching the grass grow”

Choose the right shots, you don't need to play all your shots all the time.

At one stage in his career Andrew Strauss gave up on almost everything except flicking the ball off his legs. Anything off the stumps he learned to leave alone. This retraction slowed his scoring rate, but allowed him to build big scores when he was low on confidence. Closer home, we had Ravi Shastri play his pet stroke “Chapati shot” early in the innings, till he settles to switch to the top gear.

In investment, take a leaf from that. If we avoid the losers, the winners will take care of themselves. We too try to win by not losing. Riskier shots like cuts and cover drives look impressive, but in times of rebuilding, you are better off leaving them out. It's fine to leave outside the off stump for a while. If you have a shot that you play well and is low risk, then keep it going. Look to defend or leave balls you might otherwise have a go at. It pays off when the bowlers get tired and start feeding you bad balls.

Keep your focus

The hardest part of a long innings is keeping an iron concentration on the task. This is doubled when you are naturally attacking and feel forced to play outside your normal game. So, start by switching you frame a little. Instead of thinking "I have to play against my natural game", think "I am still an attacking batsman; I am just waiting for the right ball to attack". Between balls, develop a way to switch off and think about anything except the game. Some batsmen walk away to square leg, some garden, some adjust their pads. It's idle, but essential. Pick something that clears your mind and stick with it.

Building an innings and building a nest egg have lot of things in common. Investing also is boring and slow. "For excitement, one has to go to Las Vegas". The long grinding innings is built by scoring ones, twos and the occasional fours and the “maximum”. Similarly, wealth building is made possible by Periodic Investment Plans or called popularly as Systematic Investment Plans (SIPs).

What makes SIPs popular and why an investor feels comfortable in building the corpus bit- by -bit through SIPs?

1.       SIPs are habitual and conventional

“Worldly wisdom teaches that it’s better for reputation to fail conventionally than to succeed unconventionally”. Regret is especially painful if the action that was taken is perceived as departing from what is habitual. While, SIPs are habitual like making EMI payments on the first of every month, lump sum investing is not routine and it appears to be less prudent than the cautious step-by-step approach of SIP. SIP mimics regular deposits in a defined contribution plan. It serves as an anti- panic device when markets fall.

2.       SIPs inculcate a disciplined approach towards reaching a financial goal like retirement etc.

The psychological factors that prevent one to plan for future are:

i)         Myopia or shortsightedness leading to low tolerance for risk

ii)       Overconfidence leading to overestimating finances. Investors seem pretty biased about having sufficient resources in place for retirement.

There are at least two different ways that myopia can plague investors saving for retirement. First is insufficient attention to retirement as it seems to be far off. The second way, concerns investor’s attitudes towards facing risk. Many investors choose portfolios that are too conservative for the goals to which they aspire. SIP’s disciplined approach help investors to overcome these biases.

3.       SIPs help to overcome loss aversion

Systematic Investment helps people to frame the investments as multi round opportunities rather than each investment as a one-shot opportunity.

Let us take an example of lottery, whose outcome is determined by the toss of a fair coin. If the outcome of the coin toss is heads, you win Rs. 5,000/- and if the outcome of the coin is tails, you lose Rs 2,000/-. If one had the opportunity to play the stylised lottery only once, would one take the gamble? Losing Rs. 2,000/- could create regret even when there is probability of gaining Rs. 5,000/-. The pain of loss of Rs. 2,000/- is more than the pleasure of gaining Rs. 5,000/-

Survey reveals that only 40% of people take the bet. The size of stake is a factor for the people to take decision. If the amount of stake is lowered to Rs. 500/- instead of Rs. 5,000/- and Rs. 200/- instead of Rs. 2,000/- the percentage of people willing to take chance increases to 60%. But, the percentage of people willing to play increases dramatically when the offer to play lottery more number of times say 100. Tolerance for risk increases as the number of repetitions of gamble went-up. 

People evaluate one-shot gamble in isolation from other decision problems and record the possible outcomes for each of these gambles in separate mental accounts.

4.       SIPs help one to diversify across time

Mutual funds help one to diversify across assets and stocks. SIPs of mutual funds help one to diversify across time. Investing smaller amounts in the form of multiple bets offer time diversification, where the people may feel that they have law of averages by their side. 

The important element in time diversification is the ability to postpone or avoid altogether the realisation of perceived loss. 

5.       SIPs help one to overcome empathy gaps in investing

The inability to predict our own business behaviour under emotional strain is called as an empathy gap. Everyone encounters empathy gaps. For instance, just after eating a large meal, one cannot imagine ever being hungry again. When asked in the "cold light of day " how we will behave in the future, we turn out to be very bad at imagining how we will act in the heat of the moment. John Templeton says “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell”. Few would disagree. However, when everyone is busy despondently selling, it can be hard to stand against the tide and buy.

SIPs force one to be committed to investment across various cycles of the market - be it bearish or bullish and helps one to overcome these empathy gaps.

Predicting markets or human behaviour with some accuracy often involves accepting error in order to reduce error, that is better prediction by relying on general principles but acknowledging that we cannot be right in every single case. An effective strategy need not be effective in every single instance. SIPs work on this principle and each instalment need not be profitable but on the whole it aspires to strike an average and be successful.

In the next post, we will discuss what one should do to make Periodic Investment Plans really systematic and what one should do to reap the rewards of the nest egg built.

References: Beyond Greed and Fear by Hersh Shefrin; The slogger’s guide to building an innings by David Hinchcliffe

Photo credits: jcomp - www.freepik.com