Sep 02 2014 : The Times of India (Delhi)
Never allow short-term data to mask long-term prospects
R Raja
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We all believe that we remain logical and rational while making any decision. What we don't realize is that, as human beings, we are all prone to stumble into mental pitfalls.Ben Graham, the father of value investing, proclaimed, “The investor's chief problem, and even his worst enemy, is likely to be himself.“ If that is not true, how can we explain that passive investing in equities has given double-digit returns over the long term but is still considered risky . So it's said, “The fear of equity has done more damage than equity itself.“The emotional reactions to investing in equity often diverge from cognitive assessments of the risks of such investments. Markets have done well, but investors have not done well. Emotions are designed to trump logic. We do not realize that we are affected by many heuristic biases. What is a heuristic?
Heuristics are like back-ofthe-envelope calculations that sometimes come close to providing the right answer. But, such mental short cuts and rules of the thumb may tend to be off-target as the heuristics used are imperfect.
In this and the next two editions, we will take up 13 (today, we take the first one) of the common biases that we come across and which impact our decisionm a k ing ability when deciding on financial investments: 1) I know better coz I know more: This results from over optimism and over confidence. The great obstacle to discovery is not ignorance but it is the illusion of knowledge. The simple truth is that more information is not necessarily better information. What you do with information matters more than how much of it you have. The classic example is a retail investor getting pounds of data regarding the performance of mutual funds. If one does not know how to read and interpret the data, it is of no use to himher.
The following illustration drives home this point.
Richard Thaler studied the behaviour of MBA students managing the endowment portfolio of a small college and investing it in a simulated financial market: The market consists of two mutual funds A and B and you must allocate among them. Before the game begins, however, you have to choose how often you would like to receive feedback and have the chance to change your allocation every month, every year or every five years. The groups were given infor mation and were allowed to use that as often as possible. Thaler's group tested whether this intuitive answer is right by randomly assigning them to receive feedback at varied intervals.
At the end of 25 years of simulation, subjects who only got performance information once every five years earned more than twice as much as those who got monthly feedback. So how could having sixty times as many pieces of information and opportunities to adjust their portfolios have caused the monthly-feedback investors to do worse than the fiveyear ones?
The answer lies partly in the nature of the two funds the investors had to choose from. The first fund was a fund investing in bonds with low average rate of return but was fairly safe. The second was a stock fund. It had a much higher rate of return but also a much higher variance, so it lost money in about 40% of the months.
In the long run, the best returns resulted from investing all of the money in the stock fund, since the higher return made up for the losses. Over a oneor five-year period, the occasional monthly losses in the stock fund were cancelled out by gains, so the stock fund rarely had a losing year and never had a losing five-year stretch. In the monthly condition, when subjects saw losses in the stock fund, they tended to shift their money to the safer bond fund, thereby hurting their long-term performance.
At the end of the experiment, the subjects in the fiveyear condition had 66% of their money in the stock fund, compared with only 40% for the subjects in the monthly condition. Subjects who got monthly feedback got a lot of information but it was short-term information that was not representative of the true, long-term pattern of performance for the two funds. The shortterm information created an illusion of knowledge -a knowledge that the stock fund was too risky.
So more information may have led to less understanding. People who got the most feedback about the shortterm risks were least likely to acquire the knowledge of the long-term returns.
This is the first of a three-part article on human emotions that influence how we invest. The writer is with a leading domestic fund house
Heuristics are like back-ofthe-envelope calculations that sometimes come close to providing the right answer. But, such mental short cuts and rules of the thumb may tend to be off-target as the heuristics used are imperfect.
In this and the next two editions, we will take up 13 (today, we take the first one) of the common biases that we come across and which impact our decisionm a k ing ability when deciding on financial investments: 1) I know better coz I know more: This results from over optimism and over confidence. The great obstacle to discovery is not ignorance but it is the illusion of knowledge. The simple truth is that more information is not necessarily better information. What you do with information matters more than how much of it you have. The classic example is a retail investor getting pounds of data regarding the performance of mutual funds. If one does not know how to read and interpret the data, it is of no use to himher.
The following illustration drives home this point.
Richard Thaler studied the behaviour of MBA students managing the endowment portfolio of a small college and investing it in a simulated financial market: The market consists of two mutual funds A and B and you must allocate among them. Before the game begins, however, you have to choose how often you would like to receive feedback and have the chance to change your allocation every month, every year or every five years. The groups were given infor mation and were allowed to use that as often as possible. Thaler's group tested whether this intuitive answer is right by randomly assigning them to receive feedback at varied intervals.
At the end of 25 years of simulation, subjects who only got performance information once every five years earned more than twice as much as those who got monthly feedback. So how could having sixty times as many pieces of information and opportunities to adjust their portfolios have caused the monthly-feedback investors to do worse than the fiveyear ones?
The answer lies partly in the nature of the two funds the investors had to choose from. The first fund was a fund investing in bonds with low average rate of return but was fairly safe. The second was a stock fund. It had a much higher rate of return but also a much higher variance, so it lost money in about 40% of the months.
In the long run, the best returns resulted from investing all of the money in the stock fund, since the higher return made up for the losses. Over a oneor five-year period, the occasional monthly losses in the stock fund were cancelled out by gains, so the stock fund rarely had a losing year and never had a losing five-year stretch. In the monthly condition, when subjects saw losses in the stock fund, they tended to shift their money to the safer bond fund, thereby hurting their long-term performance.
At the end of the experiment, the subjects in the fiveyear condition had 66% of their money in the stock fund, compared with only 40% for the subjects in the monthly condition. Subjects who got monthly feedback got a lot of information but it was short-term information that was not representative of the true, long-term pattern of performance for the two funds. The shortterm information created an illusion of knowledge -a knowledge that the stock fund was too risky.
So more information may have led to less understanding. People who got the most feedback about the shortterm risks were least likely to acquire the knowledge of the long-term returns.
This is the first of a three-part article on human emotions that influence how we invest. The writer is with a leading domestic fund house
