Believing in a better tomorrow

Optimism and an ability to overcome loss aversion seems to be the key for doing well as an equity investor

Believing in a Better Tomorrow

The one quality that successful investors must have is optimism. If an investor is not an optimist at heart, then nothing else works. In recent weeks, I often find myself thinking about how well-equipped optimists are at dealing with investing whenever equity markets are either doing exceptionally well or exceptionally badly.

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We are at that sort of a time right now. The most often heard opinion about the equity markets is that given the level, direction and pace of corporate earnings, stock prices are too high. The logic goes that if they are too high, then they must be about to fall. And if they are about to fall, then surely one shouldn't invest in them. Each step in this chain of beliefs is fallacious, and they are all fallacies that will damage your investment prospects. What's most important is that it's the non-optimists who are especially prone to these problems. These are the sort of times when the non-optimists (which is a much broader category than optimists) start making some fundamental mistakes.

I must admit that the non-optimist logic appears to make perfect internal sense. The problem is that there is always some awful view of the future which can be justified. There is always uncertainty in what is going to happen. There is always a gloom-and-doom scenario that can be justified. The result is that pessimists always seem knowledgeable. They always sound wiser, as if they have a deeper insight into what is driving events, and how your happy beliefs about what is going to happen is just puerile cheerleading. The problem is that beyond some short period, these people are always wrong. Always, without exception.

Think of the past decades and it turns out that while there were plenty of situations where the optimists were wrong over a period of months or two-three years but longer than that they were always right. What is normal uncertainty and volatility, looks like an unimaginable calamity if your horizon is a few weeks or months. In the coming months, the Indian equity markets could go anywhere. From a decline, to a stagnation, to a continued rise, anything is possible.

However, volatility and uncertainty are actually your friends. They are the source of the profits you will make, provided a couple of basic things are in place. One, you must not have any money in equity that you expect to use over the next three years. Two, you must keep investing in equity regularly through any kind of a downturn. And three, you must have a certain amount of your portfolio allocated to fixed income investments. When equities are earning more than fixed income (which is usually the case), you must shift gains from equity to fixed income and thus maintain this balance. Needless to say, balanced mutual funds do this automatically.

This is not just theory. In the past, investors who have taken care of these simple points have proven the non-optimists wrong quite easily. Even when the equity markets have thrown the worst at them, as in 2001 and 2008-09, they have done nicely. Eventually, each of the above three points have combined to ensure that losses were minimal, and when the markets turned, the gain back was fast. The strategy is impeccable. However, to actually make it work, an investor has to implement it. And to implement it, the biggest requirement is not the strategy itself (which is quite straightforward) but an optimistic outlook on the future.

The biggest enemy that investors have is an overpowering loss aversion. Loss aversion is defined as the 'tendency to prefer avoiding losses to acquiring equivalent gains' Apparently, some research suggests that a loss has twice the psychological impact as potential gains. In fact, this could be the basis of why some people always make money in equity and some do not. Loss aversion is not an iron rule. Some people are able to believe in the eventual benefit and overcome it, others cannot. Perhaps optimism is just another aspect of this.

Is it possible to shift from being seriously loss-averse to someone who can believe in the future? That can only be answered by someone who tries it.

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