Investment Strategy: 2012 and beyond

This artcile was originally published in IIK website

2011 was no easy  year from an investment perspective. Given the fact that Indian diaspora is mostly exposed to Indian stock market, it is disheartening to see that India figured among the worst stock market performers during 2011. However, this article is not about telling you where to invest in 2012. Rather the article is a humble attempt to sensitize readers towards more long lasting investment habits as I am sure there will be many more years of challenging times ahead as well as opportunities. For the sake of easy read, I would organize them as Do’s and Don’ts

DO	DO NOT
Have a plan for your savings	React to opportunities based on friends and relatives
Invest regularly in small amounts	Try and time the market
Update your current investment value on a monthly basis	Procrastinate
Spread your risk into various categories of investments	Place hug bets on a single company or asset
Plan and provide yourself insurance	Link insurance with investments
Seek financial advice from experts	Base your decision solely on this. Listen to your heart as well

 Have  a PLAN:

When it comes to investing, most of us go for the easy option of accumulating our savings in the bank and remitting the money back to India with deployment mostly in fixed deposits. In some cases, we will go by opportunities cited by friends and relatives either in the stock market or in the real estate with occasional gold purchases. In other words, we react to opportunities with no concrete plan backing it.

Instead , we should have a well laid out plan to deploy our monthly savings. This plan should take into account your family circumstances, your age, your ability to take risks, your willingness to take risks (this is psychological) and your current and future income. While creating a plan, it is important to foresee liabilities like housing, education, healthcare for elders, etc.

Invest Regularly

Since our earnings happen fairly regularly (say monthly), our investment should also happen fairly regularly. There is always this temptation to time the market be it stock market or real estate. However, please note that it is impossible to time the market. In hindsight everything looks to be crystal clear in terms of what is a top and what is a bottom. But if you have to look forward, we should understand that we cannot predict when the next crisis will hit and from where. Hence, systematic investment in regular interval can smooth the impact and save you the trouble. Technology has made this even easier today where you can instruct your mutual fund to invest even on a daily basis.

Update your investments

It may be boring, but it is the most important thing to do at least on a monthly basis. It is critical to list all your investments in an excel file and seek current market values in order to decide whether to keep the investment or dispose of the investment. Procrastination or tendency to postpone things (lets do it tomorrow) will lead to sometimes heavy damages. Alternatively, timely reckoning of events can save you a lot of trouble.

Spread your Risks

Different investment avenues have different risk profiles. For eg., equities are very volatile in that their prices can go up or down quite fast. Real estate is illiquid and may be documentation intensive. Fixed income may be subject to interest rate risk. Gold may be linked to US dollar. Even money market investments suffered during the financial crisis. Hence, it is important to spread your investments so that the risk of huge fall in your asset value is reduced. 

Plan for an Insurance

The importance of a bread winner in a family can be understood only in times of loss of life for unfortunate reasons (like heart attack/accident, etc). Many people do not take this risk seriously or even if they do they may not have taken enough insurance to protect their family after they are gone. Unlike in the past where we had only one insurance company, we now have several insurance companies offering a range of products to suit your requirement. However, care should be taken not to over insure (as it may turn out to be costly) or link insurance to investments.

Seek Advice

We have always been seeking advice from friends and relatives, but it would help to seek advice from a professional financial advisor who is trained in this profession of providing advice. Also, the age and experience of the advisor is very important if you have to trust the advice. However, remember even advisors can go wrong. Hence, do listen to what your heart says in the matter as well.

Behavioral Finance—Nothing New Under the Sun

This article was originally published in Arab Times

According to a recent survey, an overwhelming majority of members of the CFA Society of the UK believe behavioural analysis is a useful addition to modern portfolio theory but is insufficient to replace it. Following an earlier article in the Financial Times (FTfm supplement) Stephen Horan, CFA, head of professional education content and Mandagolathur Raghu, President of CFA Kuwait CFA discuss the role of behavioral finance in investment decision making.

The GCC stock market has for a long time depicted behavioral biases swinging between irrational exuberance and deep remorse. The speculative character of the market combined with lack of institutional investors lends itself to this problem. Retail investors in the region exhibit wild mood swings and distort valuation based pricing even during the medium term. This article aims to clarify certain recent trends in behavioral finance and how an understanding of this evolving subject can be useful for GCC investors.

What is behavioral finance?

Behavioral finance combines the classical theories of economics and psychology. In essence, it attempts to explain deviations from the standard view that economic actors make purely unemotional or rational decisions. In forecasting, for example, investors tend to be overly confident in their accuracy, place undue emphasis on recent experience, and anchor their expectations using others’ predictions. 

How long has the field existed?

It is often traced back to the late 1970s when academicians such as Daniel Kahneman, Amos Trversky, Robert Shiller, Hersh Shefrin, Richard Thaler and Meir Statman started researching investor decision making in a robust manner. As far back as 1934, however, in the first edition of Security Analysis, Ben Graham referred to investors having “unlimited optimism” followed by periods of “deepest despair.”

Around that same time, John Maynard Keynes spoke of “instability due to the characteristic of human nature that a large part of our positive activities depend on spontaneous optimism rather than on mathematical expectation.” Behavioral economists refer to this as optimism bias.

What role has behavioral finance played in the investment landscape?

The principles of behavioral finance do not lend themselves to mathematical modeling because they are typically advanced in the form of cognitive biases. Recognizing, for instance, that investors are often overconfident in their abilities does little to help them determine whether a particular asset (or the market) is over or undervalued.

Whether they are an accurate depiction of reality or not, most classical valuation and macroeconomic models are based on the assumption that investors are purely utility maximizing rational decision makers. The weakness of these models is that they often suffer from the illusion of precision. Although not suffering from the illusion of precision, at the opposite extreme, behavioral finance is extremely difficult to model.

What are the latest developments?

Recently, researchers have been using MRI technology to map the neurological reactions investors have to making a profit, suffering a loss, confirming an expectation, or experiencing a surprise. This fascinating research, called neuroeconomics, shows that reactions in the brain to some investment experiences can be similar to when an addict takes drugs or a gambler wins a bet. 

The field is also benefiting from evolutionary biology insights that help explain how heuristics, which can sometimes lead to “irrational” decision making, play a critical role in survival because they help people efficiently avoid catastrophic outcomes.

What are some remaining challenges?

Behavioral finance still lacks a set of unifying principles that tie together observations of human behavior and brain activity in a way that not only explains behavior but can also be used to model corrective action or profitable trading opportunities. 

Does behavioral finance create profitable trading opportunities?

Yes, in fact, many mutual funds exist that implement some level of behavioral finance in their investment strategies. A 2008 study of these funds in the Journal Investing, however, found that they did not generate abnormal returns during the period examined.

At its core, the discipline of value investing is largely based on behavioral finance principles. Implementing a strict value-based or contrarian investment philosophy can require exceptional fortitude, especially in volatile markets when it might be difficult to convince one’s investors’ of its wisdom.

What lessons can investors draw from behavioral finance?

Individuals can learn that they are susceptible to overreactions in both bull and bear markets. The best way to stay focused on a long-term investment strategy is to document it in an investment policy statement along with an investor’s return requirements, risk tolerance, and investment constraints. It can then serve as a useful reference in both quiescent and turbulent markets.

What are the lessons for fund managers?

First, managers might consider maintaining liquidity, limiting leverage, and creating other cushions in anticipation of possible market stress. If “irrational” investor behavior creates opportunistic mispricing, it may take considerable time to dissipate and may get worse before it gets better.

Second, even if strict behavioral finance investment strategies are not highly successful, managers might augment their existing strategies to avoid herding, overreaction, regret aversion, and other behavioral biases that interfere with their effective implementation. For example, a diverse investment committee can help to encourage fresh ideas and minimize groupthink; and procedures to measure, monitor, and control some behavioral biases can help improve decision making.