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Use Your Head, Not Heart

During volatile times, investors who get swayed by emotions will be the ones to suffer the most…

A recent article in a business magazine started by cautioning investors against investing in the stock market at this point in time. According to the piece, investing, much like contract bridge, is a loser’s game which means that the best performers succeed by minimising their own errors and taking advantage of other people’s mistakes.
While we are not going to comment on that view, we thought that it brought to light an interesting fact. The problem with equity investing is not the “stock market” itself - it is how investors go about investing in it. Any market will go through highs and lows and steep gyrations. We have seen that in the recent years itself. Investors who get swayed by emotions and lose focus will be the ones to suffer.
Barclays Wealth recently came out with a report titled Risk and Rules: The Role of Control in Financial Decision Making. This was based on a global survey of more than 2,000 high-net worth individuals across 20 countries with the aim of providing an in-depth view of wealthy investors from a behavioral finance perspective. The report came to the conclusion that emotional trading can potentially cost investors up to 20 per cent in returns over a decade. It also revealed that investors who frequently use financial self-discipline strategies (eg: a spending out income, never out of capital, or avoiding frequent examination of a portfolio to help resist temptation to trade on short term market trends and stray from a long-term investment strategy) are on average 12 per cent wealthier than those who do not.
The report reveals a prevalent mistake of ‘emotional trading,’ which can tempt investors to buy high and sell low, leading to the Trading Paradox. Worldwide, 32 per cent of those polled believe that to obtain a high return in investing, it is necessary to trade frequently. Paradoxically, the very same investors who identify themselves as believing frequent trading is prerequisite for high returns are much more likely to say that they trade too much. In total, 46 per cent of respondents believe it is necessary to trade often to do well also believe that emotions force them to do this.
Investors too often get swayed by emotions. While currently the negative ones seem to be more prevalent, positive emotions are as detrimental. Ask any portfolio manager and he will tell you how money will flow into his fund when it is doing well - the “rear view” mirror effect as one put it. The fund manger of a value fund was sharing how when the fund was doing extremely well investors were keen on getting into it. However, his own personal view was that it was the wrong time to get into that fund and the best time would have been when the value stocks in his portfolio were not yet recognized by the market. Yet at that time, nobody looked at the fund or even considered its mandate. Recently, an email came to us where the reader pointedly asked us this question: “Should I continue with my systematic investment plan (SIP) even though the market has fallen?” This reflects the mentality of investors who actually want to enter the market only when it is on the rise.

Where are we headed?
We understand people’s apprehension on the market. It has been going nowhere for a while and neither does it seem poised to head anywhere. The news on the street is not good. The world is looking murky.
Globally, worries persist over the Eurozone and quantitative easing (QE2) in the US which ends in June. Then there is political turmoil in the Middle East which has resulted in the price of crude shooting up. Back home, we have inflation to grapple with. This has resulted in a more stringent interest rate regime by the Reserve Bank of India (RBI) which has moved to raise the cost of capital (and thus investment) in the economy and will result in projects now being unviable for Corporate India.
Then there is the deterioration in the asset quality of public sector banks, slow down in corporate earnings, corruption scandals and scams, dwindling inflows from domestic investors and the pull out of over a billion dollars this year by Foreign Institutional Investors (FIIs) from India’s stock market.
These developments will obviously get reflected in the growth numbers. The Gross Domestic Product (GDP) growth for the fourth quarter (FY11) has already been tempered down to 7.8 per cent. The Index of Industrial Production (IIP) growth also seems to be a signaling a slowdown. The average IIP growth for FY11 is estimated at 7.2 per cent over the last year. The revised growth projection for FY12 is in the vicinity of 8-8.5 per cent, from the earlier expectation of 9-9.5 per cent.
Little wonder that market sentiment is low. As on June 7, 2001, the Sensex has lost around 10 per cent this year, making it one of the worst performing stock markets in the world in 2011. And, there is not going to be an immediate reversal of fortune either.
Right now the market looks very range bound with a downward bias because of the negative news flow - globally and domestically. Frankly, there is no reason why the market should take off. Does that mean it has bottomed out? No one knows for sure. In fact, many are predicting a deeper correction around the corner.
Naturally investors poise the question: In such turmoil, is it wise investing in equity?
We would like to put it in another way: In such turmoil, why should you stop your SIP? It is actually the best way to ride the downturn.

Stick to the basics
Over the past several years, every major move in the stock market has caught market watchers and investors by surprise - be it the downturn of 2008 or the pick-up of 2009. So was the more recent correction. Those who tried to time the market have scrambled to catch up with events and have generally faced frequent periods of either lost opportunities or losses.
These occurrences are a perfect demonstration of how the conveyor-belt style of investing exemplified by mutual fund SIPs can easily take in its stride the worst gyrations that the stock markets can throw up. Investors who have benefited perfectly from sudden rallies have been those who have kept investing steadily through the lows, without paying any attention to which way the short-term movement of the market has actually been.
If you decide to terminate your investments in a downturn, you could lose out. That is because the SIP route to investing is not some magic trick. Neither is it a sort of a mathematical curiosity that can magically yield positive returns no matter what the state of the actual investment or the equity market.
In an absolutely fundamental way, regular, systematic investing has less to do with the investment and more to do with the investor. We know that the cost averaging that comes with SIPs is what generates the returns, but the real value comes from the fact that SIPs give investors a way of managing their own emotions. This is an investing tool, but its value comes from being able to manipulate the investor’s own psychology.
On a closing note, don’t let the state of the market get to you. Don’t let emotions dictate your investment style and pattern. The market will go through roller coaster periods. There will be bouts where it seems to be heading nowhere. Today is as good a day to continue with your SIP as was the month of December 2007. If you do not have an SIP but want to start one, please do so. But don’t keep away waiting for the market to pick up. The intrinsic benefit of an SIP is to stay with it through the downturns because that is where most of the units are accumulated. Don’t miss out on it.