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Of Behavioural Quirks

You should have the self-awareness to analyse your performance & the self-discipline to change bad methods…

A friend of mine is a bridge player of considerable skill. He plays a couple of high-stakes sessions every week and he wins far more often than he loses. But while totting up his bridge earnings over a specific three-month period, he found, on balance, that he was just above breakeven.
He is a successful lawyer so the money wasn't an issue. But the unexpectedly poor returns bothered him. Given a near-perfect card memory, he knew, without false modesty, that he had consistently played well throughout the period. I'm an average bridge player. But I helped him review his results, session-by-session, at his request. The problem was, my friend entered every session with a target: He wanted to win Rs 5,000 per session. Once he hit that limit, he made his excuses and went home happy.
On the days when the cards ran against him, or he suffered the errors of a moronic partner, he played on stubbornly, in the hopes of recovering some of his losses. Often this didn't happen. In the process, sometimes he lost a great deal. As his losses mounted, he would also start making more frequent mistakes in judgement.
Good bridge involves much more skill, and far less luck, than successful investing. But the same errors and behavioural quirks show up in both games. My friend used to cut off his winners by booking profits early and he let his losers run too long. What is more, when he was under pressure, he lost his cool and started making obvious errors.
Once he identified this, he applied remedies. Instead of setting upside targets, he switched to a maximum loss-limit. Nowadays, if his losses hit Rs 2,000, he pays up and calls it a day. During a session where he's behind, he plays with extra caution because he knows he can get flustered. When he's winning, he is prepared to play on.
Very few investors have the self-awareness required to analyse their own performances as objectively. Even fewer possess the self-discipline to change bad methods. Yet, it often doesn't take much in terms of time or trouble. All it really takes is the humility to admit that not all losses are due to ill-fortune.
Before entering into investing, an individual needs to ask himself a few questions. One is, how much is he prepared to lose? A second is, what is the minimum return he wants? The third is, how long is he prepared to wait for those returns? If the answers are honest and realistic, he has a template for investing methods. He knows his risk:return profile.

Pros and cons of passive investing
There are many ways to play the market. Each has associated risk and return expectations. If somebody just aims to beat inflation, a passive index-based strategy using SIPs is fine. This method will hold risk to the minimum that can be expected of equity and over time, it usually beats inflation.
It's difficult to state what the long-term inflation trends actually are in India. Official statistics are unreliable. But the Nifty has given compounded double-digit returns over the past 17 years and that is definitely more than inflation over that period. More to the point, the historical equity return is much higher than available from any other common asset class.
The risk for an index-based SIP strategy is low in the long-term. If you maintain an SIP on the Nifty for at least three years, the chances of losing money are quite low and the chances of beating inflation extremely high. If you maintain an SIP for five years, the chances of negative returns are minimal.
The longer the time period, the less short-term volatility matters. But the chance of a loss always exists when in the equity market. Equity is a non-linear asset — its movements are not predictable.
There have been phases and markets where returns have been negative over very long periods. Japan, for instance, saw the indices peak in 1989 — that's 22 years ago. An investor in the US DJIA would have lost money over the past five years. An Indian, who invested in the Nifty in 1994, would not have got meaningful positive returns until 1999-2000.
With a passive strategy, you do need patience. In my opinion, (many theorists will disagree), you also need to have a pain limit. Are you prepared to see a 20 per cent capital erosion every so often? Are you prepared to see a 50 per cent erosion? Both are quite likely to happen every so often. If you can't handle that sort of risk, cut your return expectations and minimise equity exposure.

A more active strategy
If you want a higher minimum return than the benchmark equity index offers, you must have a more active strategy. In that case, you must also be prepared to accept more risk. Be realistic. Maybe you would like to focus on midcaps where there are growth prospects?

Midcaps offer chances of multi-baggers and often outperform large-caps. Of course, the risk is also more than with large-caps. Even a mutual fund that tracks a midcap index closely will have more return volatility than the Nifty. But midcaps have more of a track record and hence, offer a greater margin of safety than small caps.
Everybody would like 500 per cent returns. But assets that offer that kind of return also carry very high risks. If you want only multi-baggers, then you probably need to bet on small stocks. Indeed, small-caps can produce massive multi-baggers. But there are also the chances of a given investment going down by 80-90 per cent.

Using leverage
Another way to boost returns is by using leverage. Again, leverage is a two-edged sword. A futures contract that moves your way offers 10:1 returns but if it moves against you, the losses are equally heavy. Similarly, if you are day-trading on margin, a move against you might wipe your entire capital just as easily as a move in your favour can double your capital very quickly.
The need to set pain limits is much more with active strategies. Other forms of due diligence are also more necessary. If you create your own portfolio, you must benchmark that against the market indices to ensure that the risk:reward characteristics are genuinely superior or at least, they should suit you better. After all, you don't want to discover that you have sweated your way through dozens of balance sheets in order to put together a portfolio that mimics the Nifty.
It's good methodology to set a minimum return target. It's prudent to set a loss-limit. It's useful to set timeframes. In the absence of explicit expectations, you cannot form realistic investment strategies.
Conversely it's stupid to set a cap on maximum returns, or to let your losses mount indefinitely. You could be the best stock picker in the world and you would still lose money. If you play a lot of poker or teenpatti in this season, the same advice will hold you in good stead.