Author: Arun

Selecting a decent equity mutual fund to build a portfolio was always confusing and difficult.

Unfortunately, in recent times, there have been certain changes due to which fund selection has become even more difficult.

Let us explore each of these in detail and also find out if there is a way out of this mess.

Problem No 1: Fund Managers and the game of musical chairs

In last few years, thanks to the bull market, a lot of fund managers have moved across fund houses and a few of them have even moved out and opened their own investment firms.

Sample this:

• Kenneth Andrade who was the CIO of IDFC Mutual Fund left in 2015 to start his own Investment firm Oldbridge Capital
• Anoop Bhaskar replaced him as he moved from UTI to IDFC in 2016.
• Vetri Subramaniam (earlier the CIO in Invesco Mutual Fund) in turn replaced Anoop Bhaskar as the CIO in UTI
• Taher Badshah who was the fund manager at Motilal Oswal has replaced Vetri Subramaniam as the CIO of Invesco mutual Fund
• Pankaj Murarka who was the head of equities at Axis Mutual Fund quit to start his won firm Renaissance Investment Managers
• Sudhanshu Asthanah who was a senior fund manager in Axis Mutual fund quit to start his own firm Tamohara Investment Managers
• Shreyas Devalkar – the fund manager in BNP Paribas Mutual Fund has moved to Axis Mutual Fund
• Gopal Agrawal, the CIO of Mirae Asset Mutual Funds quit to join Tata Mutual Fund – Now recently a Gopal has also quit Tata Mutual Fund!
• Vinay Paharia – the fund manager in Invesco left to become the CIO in Union KBC Mutual Find
• Ravi Gopalakrishnan – head – equities, resigned from Canara Robecco Asset Management Company
• Sunil Singhania, the CIO of Reliance AMC also quit last year to start his own firm – Abakkus Asset Manager LLP
• Manish Gunwani a fund manager at ICICI Prudential Mutual Fund quit to become the CIO in Reliance Mutual Fund
• In DSP Blackrock Mutual Fund there have been a lot of changes in recent years
  • Anup Maheswari the CIO quit recently
  • S. Naganath, the erstwhile president and chief investment officer at the fund house left in May 2017
  • Apoorva Shah, the previous fund manager also moved out of the domestic mutual fund unit to the fund house’s offshore division

Phew, my head is already spinning 🙂

Anyway the simple point is that, for most of the funds where the fund manager has changed, the existing track record becomes irrelevant while choosing the fund.

The fund houses will (obviously) argue that they have a robust investment process and a change in the fund manager will not have an impact, but I think it would be extremely naive of us to believe that.

All said and done, in my opinion, a fund manager is the biggest factor responsible for the returns from a fund. (Think Warren Buffet,  Charlie Munger, Ray Dalio, Howard Marks, Seth Klarman, Peter Lynch etc)

Problem No 2: SEBI and its new fund categorisation rules

In the recent past, the regulator The Securities and Exchange Board of India (SEBI) had rightly come to the conclusion that Asset Management companies had too many funds and there was no common definition for categories leading to significant confusion while selecting funds for investors.

So in October 2017, SEBI, called for the rationalization of mutual fund schemes and defined various categories of funds, along with the scheme characteristics for each fund category. (see circular for categorization and rationalization of mutual fund schemes).

It brought down the list of categories under equity mutual funds to 10.

Source: FundsIndia

And to avoid duplication, SEBI has also mandated that each fund house can have ONLY ONE scheme in each category.

As a result of the above changes, many mutual fund schemes are either being renamed, recategorized or merged/ terminated. This whole revamp is expected to get completed by June-18.

If interested, the summary of the entire changes can be found in Funds India website here

Thus adding to our existing problem of several fund manager changes, the recent SEBI fund re-categorization, has also made the historical returns of several funds (where there is a dramatic change in mandate) irrelevant.

Thus if you are someone who picks funds only based on past performance or other quantitative metrics then please remember that for many funds the past returns and metrics may not be relevant anymore.

Also I have earlier discussed here and here as to why past returns are not a great way to pick funds. I usually check for

1. Consistency in performance across market cycles versus peer group and benchmark
2. Downside risk via capture ratios
3. Fund Manager – do I understand the investment philosophy, process and does he/she stick to it

Given the context of recent changes, consistency and downside risk measurement based on past returns would be irrelevant for many funds going forward.

Thus the key to select funds will be to understand the fund manager, his investment philosophy, investment process, ability to stick to his process and track record.

Herein lies the third problem..

Problem no 3: Lack of communication

Unfortunately unlike the global fund managers, the level of fund manager communication in India via (newsletters, memos, updates etc) is extremely poor or rather non-existent. The only source for normal investors is their public interviews.

However, majority of the fund manager interviews in public magazines and websites are literally indistinguishable from each other.

Barring a select few, most of the interviews are a common script which will include a mix of fancy words such as – high quality business, decent cash flows, decent ROEs, scalable opportunity, sustainable competitive advantage, pricing power, right to win, reasonable valuation, growth, top down, bottom up, good management blah blah

If you don’t trust me, you can check a collection of interviews here..

• https://www.morningstar.in/posts/collection/interviews.aspx
• https://www.valueresearchonline.com/story/archive.asp?sec=62

This essentially means its a struggle from our side to find out what is the underlying investment process and philosophy. So if in case the fund under performs in the interim (which eventually happens), there is no way we will be able to hang on with conviction.

And unfortunately as evidenced by this vanguard study in the US (click here to read the study), even the best funds went through under performance vs their benchmark in at least five years of the 15 year period for which the study was conducted, and 60 percent had at least seven years of under-performance. Further two-thirds of them experienced at least three consecutive years of under-performance during that span.

This implies even good Indian fund managers will inevitably go through periods of temporary under-performance where their style is out of favor or they make some mistakes.

Lack of  communication on what is happening implies we will bail out of the fund as returns are the only parameter communicated to us!

Oops! We have a huge issue..

Thus for all of us looking to pick a few funds and build our equity portfolio we have three issues

1. Significant fund manager changes in recent times
2. SEBI’s new scheme re-categorisation leading to change in mandates for many schemes
3. Lack of communication from fund managers

Not all is lost..

While I have painted the whole industry with a broad brush on the lack of communication, there are a few exceptions where the communication has been good or has started to improve in recent times

1. PPFAS : These guys are by far the best and are way ahead in terms of their communication
   • You tube channel where they discuss various insights on behavioral finance, industry trends, investment process etc  https://www.youtube.com/user/ppfasltd/featured
   • They have an annual shareholder meet where they discuss their portfolios: https://www.youtube.com/watch?v=hrRLx-s1xsg
2. Motilal Oswal : They have a good website and have clearly communicated their process
   • https://www.motilaloswalmf.com/blogs/chairman-speak
3. DSP Blackrock: Recently the level of communication from the fund house has significantly improved
   •  Fund and Strategy communication: Insights
   • A detailed note on DSPBR Opportunities fund: Link
4. Quantum: While the website is a little clumsy and outdated, you can find decent communication about their process
   • https://www.quantumamc.com/
5. IDFC: Recently the communication has improved. Especially on their flagship product – IDFC Core Equity Fund (Link)
6. ICICI Prudential Mutual Fund – The details on the website is still not that great. But there are frequent interviews of the CIO Sankaran Naren from which we can get a sense of their investment philosophy and process
   
   • You can check my earlier post on this here
7. UTI: Again a recent move in terms of improving communication
   • https://www.utimf.com/articles/?filter-type=category&filter-value=blog

So while fund selection has become more complicated, the fact that some fund houses are improving their communication means we can still work around and build our portfolio.

In my next post I will explain my thought process on how I would go about selecting funds for my portfolio.

Till then, happy investing as always 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 4300+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

When I entered the investment world, I had a simple wish – to figure out how to enter exactly before a bull market, ride the wave and get out at the top.  Once I figure this out, I will be rich and can spend the rest of my life whiling away on the shores of some exotic beaches.

Let me take you through my journey in search of the holy grail..

Someone somewhere should have figured it out..maybe the mutual funds

I started with the logic that “If market timing was possible, someone somewhere must have figured it out”. My job is to figure that someone, somewhere.

In India, who do you think will be the most interested in solving this problem?

While all of us would obviously want to know the answer, the mutual fund industry has the highest incentive to figure this out as their entire business is based on providing returns.

Sample this – the top 3 mutual fund companies – HDFC, ICICI Prudential and Reliance make a profit of above INR 500 cr each.

This means they have enough money to subscribe to the best of research, tools, technology and hire the best of the brains.

Here is a sample of what the industry was paying its fund managers in 2016

Good. So hiring talent wouldn’t be an issue.

Most of the fund managers are very experienced, have great long term track records and have spent a long time figuring out processes to make money in the stock markets.

So logically someone from the mutual fund industry should have figured it out right?

Going back to 2007 – just before the 50-60% crash due to the global sub prime crisis.

Prashant Jain – HDFC Mutual Fund (26-Nov-2007)

Do you see a market crash in the near future?
In my opinion, a “crash” is probably too strong a word for the Indian market. But a correction can never be ruled out. It is true that the Indian market is somewhat expensive, but it offers a unique combination of size and growth. Global investors are increasingly looking at India as a mainline asset class and are therefore, investing with a long term view. If you look at Indian P/E’s of nearly 20, 15-20 per cent earnings growth, interest rates of 4-6 per cent prevailing outside India and an appreciating currency, then Indian P/E’s still look reasonable. India is somewhat expensive compared to the past and to the prevailing interest rates locally. But when viewed in the global context and in view of improved size, fundamentals and visibility of the Indian economy, the market does not appear to be unreasonably valued.

Source: Link

Mahesh Patil – BSL MF (28-Nov-2007)

Do you see a market crash in the near future?
I don’t see a major market crash in the near future. The long term trend is still up. However, after the smart rally we have seen in the last few weeks, one can expect a short correction of about 5-7 per cent in the near future.

Source: Link

A Balasubramaniam – Birla Sun Life AMC (24-Dec-2007)

Do you see a market crash in the near future?
During the recent run up of the market, post the US Fed cutting the Fed rate, we have seen the CNX MidCap under perform the larger indices. This has resulted in an increase in the valuations gap between large- and mid-caps. We analysed the results of all manufacturing companies in the BSE 500. We saw sales rise by 24 per cent while PAT grew by 70 per cent on year-on-year basis. Given the lower the inflation and a softer interest rate regime, we expect the coming quarters to go quite robust. This would widen the valuations gap between large- and mid-caps further. Hence we believe mid-caps would be very attractively valued.

Source: Link

Birla Sun Life AMC Factsheet (31-Dec-2007)

Investors have now started worrying about a possible US recession and the consequent impact on the emerging markets including India. We believe that a near recessionary US economy is unlikely to have as significant an impact on emerging markets as in the past. Indian economy, is resilient to the impact of any potential US slowdown (domestic consumption driven and low export-to-GDP ratio at about 15%). India has diversified its exports base – commodity and country wise – share of US exports now stands at 15% of India’s total exports from 22.8% in FY2000. Research indicates that for every 1% fall in GDP growth in the US, India’s growth will only be affected by 0.25%.

We believe India is entering a period of increased stability with limited impact on growth. India’s level of trend growth is expected to be sustained at  8% plus, due to  improved  macroeconomic stability, liberalization in a number of key areas and gradual improvement in infrastructure.”

Srividhya Rajesh – Sundaram AMC (6-Dec-2007)

Do you see a market crash in the near future?
While we are of the opinion that there may be a bubble (in terms of valuations) being formed in the market, we do not forsee it being pricked in the near future. Given the global liquidity conditions, we expect the bubble to last longer.

Source: Link

Anand Shah – ICICI Prudential AMC currently the CIO of BNP Paribas Mutual Fund (20-Dec-2007)

Do you see a market crash in the near future?
The rise is the reflection of very strong GDP growth rates in the last three years and expectation of the same being sustained in the foreseeable future. We believe that strong earnings growth of India Inc will sustain going forward and thus market valuations are reasonable on a one-year forward earnings basis. Also, the balance sheet of India Inc is stronger then ever. We are of the opinion that the market might remain volatile in times to come, however a market crash is unlikely.

Source: Link

ICICI Prudential AMC Factsheet (31-Dec-2007)

As we step into 2008, Indian economy seems to be in fine shape, more capable of handling global slowdown than many peers. Globally, subprime related issues are resulting into credit squeeze. Banks are worried to carry out normal borrowing and lending amongst each other. ECB and US Fed are pumping liquidity to ensure that credit squeeze does not result into recession. Our feel is that with minor hiccups central banks world over will be able to stimulate global economy with series of rate cuts, pumping of liquidity and pro-growth statements.

Indian economy aided by domestic growth is likely to be an oasis of growth among the global desert. Q3FY08 results are likely to be in line with market expectations, except for some treasury gains or losses which are difficult to forecast. Big queue of IPOs and QIPs expected in 4QFY08 will keep up the supply pressure and also maintain momentum. FIIs, after turning sellers of Indian equities in 3QFY08 will have to think twice before selling in 2008. Chinese markets are running at higher valuation than Indian markets and as long as that gap is maintained, there is not much worry on the de-rating of Indian valuations. The domestic investors led by retail, insurance companies and mutual funds are taking lead over FIIs in articipating in Indian equities.

Net-net, the outlook for Indian equities in 2008 seems to be positive on the back of:

• Economy, which is likely to grow above global average based on domestic factors
• Valuations which are at premium over other EMs but at discount to China H share market
• Domestic investors now stepping up to take lead over FIIs

Thus, despite the mutual fund companies having the best of intentions, best of brains, great long term track record, enough money to deploy the best of technology and vast research resources –

Yet, none of them were able to predict the short term!

Maybe your wealth manager..

The notion before joining my organization (a reasonably large and reputed wealth management firm currently handling around 10,000 crs in AUM) was that, “Hey, here are these guys advising the richest of the richest. Obviously they must be knowing the secrets to make quick money. Let me figure this out and get my life sorted!”

7 years down the line, after having the fortune to have interacted with some of the best investment minds, getting to work along with some of the largest family offices,  figuring out what the other wealth managers are upto and doing all permutation and combinations of trying to figure out a precise timing model, I realised –

None of us can predict the short term!

Maybe Mr Warren Buffet

Here is a man who is currently the second richest in the world!

He has a 52 year track record of compounding at 21%!

He reads 500 pgs every day!

He is accompanied by yet another genius – Charlie Munger!

And yet they too weren’t able to time their way out during a correction and had to go through several corrections – 49% down in 1974, 23% down in 1990, 20% down in 1999 and 32% down in 2008!

Oops! Even Warren Buffet and Charlie Munger can’t predict the short term!

Maybe the other popular global fund managers..

Prem Watsa referred to as Canada’s Warren Buffet:

While his hedging of equity portfolio made a killing in 2008, he has been quite wrong for several years since 2010-2016 post which he took a U turn on his call and removed all his hedges.

March, 2010: “Our reading of history—the 1930s in the U.S. and Japan since 1990—shows in both periods nominal GNP remained flat for 10 to 20 years with many bouts of deflation.”

March, 2011: “Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!”

March, 2012: “Ben Graham’s observation that ‘only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925’ continues to ring in our ears!”

March, 2014: “While it is very painful and costly waiting, we think your (and our!) patience will be rewarded.”

March, 2015: “While the deflation derivatives are very volatile, if we are right, these derivatives may become as valuable as our CDS derivatives became in 2007/2008.”

March, 2016: “We have warned you many times in our Annual Reports of the many risks that we see and the great disconnect between the markets and the economic fundamentals. These risks may be coming to a head in early 2016, as I write this Annual Report to you—right out of the blue!”

Howard Marks in one of his recent memos

“The memos that have raised yellow flags in the current up-cycle, starting with “How Quickly They Forget” in 2011 and including “On Uncertain Ground,” “Ditto,”and “The Race Is On,” also clearly were early, but so far they’re not right (and in fact, when you’re early by six or more years, it’s not clear you can ever be described as having been right).

Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time. I absolutely cannot disprove that interpretation. But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature.

I think it’s better to turn cautious too soon (and thus perhaps  under perform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses.”

Other famous investors such as Jeremy Grantham, John Hussman, Seth Klarman, Bill Gross and James Montier etc have all sounded the warning bells in the last few years which is yet to play out.

These are some of the best guys, who had navigated the earlier sub prime crisis and dot com bubble successfully. Even these guys as seen above haven’t been able to get the direction of the market right in the short run.

Simply put, predicting what the markets will do in the short run is hard, in fact damn hard and almost impossible to do on a consistent basis. You can be amongst the best investors with a superb long term track record and yet the short term is still too random to predict.

Most of these experienced investors realize this and usually take calls which work over a longer time frame and look at producing reasonable returns over a complete market cycle (i.e periods covering both ups and downs).

Their intent is not to predict the future, but to evaluate the risks and margin of safety in the present scenario and correspondingly adjust their portfolios. This implies going through a period of pain where they look wrong and the key is to have the patience and conviction to stick to the decision which is far easier said than done.

If this is the case for the best investors, then we need to realize the fact that the utopian world where we don’t fall but yet capture the equity returns upside is extremely difficult pull off on a consistent basis. Or to be honest, I would put it as wishful thinking.

How do we deal with this?

This brings us to the uncomfortable question, if experienced investors find it this difficult then then how do we normal investors deal with this uncertainty.

My answer is simple – we accept corrections as a part of life rather than trying to avoid them.

And hence, the maximum extent of decline which we are ready to accept will decide our equity exposure.

Here lies the proof of the pudding – Indian fund managers despite their inability to predict short term returns have had a phenomenal long term track record.

So lets wrap our heads around this new perspective of actually facing the corrections rather than trying too hard to completely avoid them

• Equity market is all about faith: Equities in the long run is basically a bet on human progress. You are simply betting that entrepreneurs (who take higher risks) on an aggregate will get compensated with higher returns
• Market corrections are not a bug but a feature – and it is next to impossible to predict when the next one is coming, how steep the decline would be and how long it will last
• It is prudent to assume that our equity portfolios will go through a 30-50% decline at-least once in every decade
• 10-20% corrections should be expected to be a regular affair
• It is ok to realise that you wont be able to predict the fall and in fact you don’t need to predict the fall to create long term returns
• The way you behaviorally respond to a fall (which is completely under your control) is all that matters for your long term returns
• Now if you won’t be able to handle a decline of such an extent, it is better to reduce the equity allocation correspondingly and use a combination of equities and debt
• A plain vanilla, disciplined re-balancing strategy to maintain your equity allocation on top of this is a simple yet effective strategy
• While short term is still too random, taking a slightly longer view – as witnessed from the best of investors its possible to develop some reasonable and approximate estimates on expected equity returns (based on mean reversion in valuations and profit margins)
• You can check out my framework to estimate 5-7 year returns here
• If the estimated return environment is extremely low, you can focus on reducing overall risk (avoiding overvalued segments and practicing adequate diversification)
• Also remember that valuations are an indicator of risk and not a precise market timing tool – so if you are under weighting based on valuations, the actual time taken for the risk to manifest (based on the catalyst) is anyone’s guess. So be prepared to have the conviction and patience.As Keynes mentions – The market can remain irrational longer than you can remain solvent

• Overall a simple asset allocation + re-balancing + lower costs + long time frame + focus on risks + faith in equities + sticking to the plan = good enough investment returns
• And repeat “No one can predict the short term returns”

This is an evolving framework and would love to hear your thoughts. Do you think it is possible to time the markets?

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

This is the 4th post in the “behavioral biases during a bear market” series. You can check out the earlier ones here

1. Evolutionary roots and our three-in-one brain!
2. Loss Aversion, Cognitive bias and Pattern seeking
3. Availability Bias

Choose the correct line?

Let me start by asking you a simple question?

In the above diagram, which of the three lines numbered A,B and C is closest in length to the target line ?

If you answered C, congrats that is the right answer!

Of course, it was outrageously obvious right.

Now before you swear at me for insulting your intelligence, here is the shocker – in a famous experiment conducted in the 1950’s, for the same question majority of the people chose the wrong line.

But how could this be?

Were they actually that dumb..

Enter behavioral economics. Unknown to the participants, there was a secret behavioral trick played on these people which caused them to choose the wrong answer despite the correct answer being very obvious to them.

If you are curious to learn about this powerful behavioral trick read on..

Enter Mr Asch and his experiments..

In the 1950s, psychologist Solomon Asch invited students to participate in a vision test and the students were split into several groups.

Now each group was asked a similar question on the lines of –
Which one of A,B,C lines resembled the line on the left?

But there was a small twist. Only one of the participants in each group was for real. All the others in the group were secretly set up by Asch!

All the participants had to shout their answers aloud in front of the group, but the actors set up by Asch were always made to answer first and the real participant was always the last to answer. In this way, Asch ensured that the real participants listened to everyone’s answers before they gave their own.

During the first part of the experiment, the actors set up by Asch answered the questions correctly and as expected so did 99 percent of the real participants.

But here comes the interesting twist..

In the next part of the experiment, however, Asch secretly asked his actors to deliberately give the wrong answers.

And guess what happened?

When people heard these incorrect answers, they conformed to the majority’s wrong answer more than one-third of the time!

3 out of 4 people ignored what they could see so evidently with their own eyes and answered incorrectly at least once!

You read that right – 3 out of 4 had conformed to the group although they were wrong!

And sadly, only 1 out of 4 could stick to their own views.

The Asch experiment demonstrates that people have a strong urge to conform to the opinion of the group – they would rather be wrong as a group than right as an individual

Everyone is doing it syndrome..

Now while this is an old experiment, scientists have been able to replicate Asch’s results consistently in various other set ups as well. In fact, there is evidence that even chimpanzees have this strong urge to conform.

Also check out this funny video on this pattern repeating in a different context

But why do we conform?

1. We want to fit in with the group
2. We believe the group is better informed than we are

And from an evolutionary perspective, this makes perfect sense..

When our ancestors were living in tribes and clans, they mostly survived by unhesitatingly following the herd, in the absence of better information. Even if the herd was not correct about which way to run to avoid the predator, an individual if he moves away from the herd would make a more easier target on his own as opposed to keeping with the herd.

Further, we are social beings, and what others think about us is remarkably important for us. In our need for a sense of identity we seek to belong and so easily conform with what others are doing.

This behavioral tendency of ours to conform with the group is referred to as social conformity or social proof.

Uncertainty is the breeding ground for social conformity..

Social conformity is at its highest especially in situations of uncertainty.

When faced with an unfamiliar or uncertain situation, an unsure individual would feel the need to refer to other people for guidance.

Bear markets + Uncertainty = Social Conformity on steroids

Now if you are wondering on what this has to do with investing – enter the bear market. Uncertainty is at its highest for investors spending sleepless nights wondering how long will the fall last and how steep will it get.

So in uncertain periods like these, the easiest and fairly intuitive option is to look around and follow the crowd.

And unfortunately, the crowd usually panics at exactly the wrong time.

What was a useful trait for our ancestors and for us in several other contexts, unfortunately fails us miserably during a bear market.

So our behavioral enemy no 4 during a bear market is Social Conformity i.e our inherent tendency to follow the crowd.

What is the solution?

Now while the obvious solution is not to follow the crowd, it is far easier said than done. So instead of fighting this urge, we need to play along this urge.

I would suggest finding a group of experienced investors or fellow investors to discuss during times of panic. If this sounds difficult, you can take advantage of the internet and identify your “investors to track” list and follow them closely for their views and interviews.

While the intent is not to follow anyone blindly, staying calm and getting a sense of what the sane and experienced guys are doing will definitely be of some help.

And also keep your what-if-things-go-wrong-plan ready. For details you can refer to my earlier posts here and here

As always in the coming weeks, we shall explore the other behavioral enemies and come up with a solution.

Till then, happy investing as always..

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

Recently my wife has banned me from riding my bike. And as weird as it seems, the reason is rooted in behavioral finance. Read on to find out why..

“Bike is banned for me” – your faithfully me (a behavioral finance victim)..

A few weeks back I had written an article here on how to wrap our heads over the fuzzy concept of “risk” in investing. And I had used the analogy of riding a bike to explain my understanding of risk..

This is how it went..

“When we say a higher speed is risky, what we really mean is that if there is some unexpected external event not under your control (say a broken road, an unexpected swerve from the car in front of you, a dog suddenly crossing in front of our bike, a drunkard crossing the road etc) your ability to maneuver the bike is a lot lower at higher speeds and hence the possibility of an accident and the expected impact from it is also very high.”

As fate would have it, I met with a bike accident while on my way to office a few weeks back. Call it coincidence, it was a dog running in front of my bike and crossing the road!

I crashed into the dog which sent me flying and my bike skidding in different directions.

Since I was wearing a helmet and was at sub 40 km/hr speed the bruises were not major except for a few scratches here and there on my knees and arms.

But unfortunately I got dizzy and went unconscious twice post the accident. My worried folks had me admitted to a hospital and soon we found a doctor who was hinting possibilities ranging from a fracture, a brain concussion to an abnormal ECG reading which meant my heart might need a stent.

And of course, it scared the daylights out of me!

But as we took each and every test, the fracture, the heart issue and brain concussion were gradually ruled out. Several tears down, my wife Shalini heaved a sigh of relief. And I heaved a much bigger one.

This is definitely our most emotionally traumatic 3-4 hours ever.

Once the formalities were done and we came back home, she looked at me straight with a mix of relief and anger and shouted..

“No more bike. Ever! Bloody, start using our car!”

Mind voice of a behavioral finance victim..

Now while I completely get her point of view and I am equally scared on riding again,  here is a little backdrop..

I was wearing a helmet and was going at very reasonable speeds during the accident. And thankfully, the final outcome was a few scratches which have healed now. This is exactly how we want to interpret this whole incident.

But the whole trauma of several possibilities which could have instead played out (further worsened by the inexperienced doctor) suddenly makes the whole activity of riding a bike look a lot more riskier than it actually is.

And here is the scary part – I had done a lot more crazier stuff like riding all the way to Goa, Kerala etc from Chennai with a stupid windbreaker and a cheap knee guard for protection. This included the likes of highly idiotic stuff such as high speeds on unfamiliar roads, sleepless rides, night rides in the ghats amidst pouring rain, absolutely no safety precautions blah blah. And both of us never worried about the risks then.

While I survived all this, finally, a mellowed down “on-my-way-to-office” bike ride finally got me into trouble.

As expected, we suddenly find the whole bike riding activity (a 10 km drive to my office) too risky.

Now here is the point:

All along there were times where my behavior had been really risky and yet bike riding was still fine. Now when I am a lot more matured in my riding, the sudden accident has made it look a lot more riskier than it is.

I don’t blame us as this is normal human behavior to overestimate the risk post an accident. And yes, behavioral scientists have a name for this behavioral quirk – Availability bias.

Behavioral finance has the answer..

Availability bias is a cognitive bias that lead us to overestimate the importance of information that are most available, more recent, more vivid, that were observed personally, and are more memorable.

Under the influence of this bias, we rarely check the reliability of the information we have readily available nor do we try to search for patterns beyond a time horizon that our memory can serve.

The main reason for this bias is that our lazy brain always chooses the path of least effort. In my case, accessing the fact that for 10 long years, I had thousands of rides and was pretty safe takes quite a bit of effort for our brain and hence we avoid it.

What does this have to do with investing?

Unfortunately the same bias plays out during a bear market. As we have earlier learnt, a bear market puts us under severe emotional stress (almost 2 times our pleasure during a similar upside) and most often than not, we sell out of equities and hope to get back in at the right time.

Now just like my accident, the memory of the emotional stress and market crash is fresh in our brains and it leads to us overestimating the risks in equity market.

Thus we end up staying out of equities for a far longer period as we are still fighting our “previous battle”. And normally the recovery from a bear market is damn swift and by the time we realize, we have missed a huge part of the recovery.

Check out what happened during the initial part of the market recovery from the 2008 crisis.

This mistake is not jut reserved for the average investor like us but has even happened to experienced fund managers (check the March 2009 cash holdings of equity mutual funds and you will be in for a surprise)

Availability bias spares none!

Thus, availability bias becomes our behavioral enemy no: 3 during a bear market!

Now while it’s too late to prevent my bike ban (as both of us are scared and hope we come over it in sometime), dear reader please take sufficient precaution so that you don’t get banned out of equities when the next bear market strikes.

As always in the coming weeks, we shall explore our other behavioral enemies and finally try and come up with a solution.

Till then, happy investing as always..

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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments