Suppose I offer you a bet: I flip a fair coin. If it lands up heads, I pay you Rs 2000. If it lands up tails, you pay me Rs.1000.
Would you accept the bet?
Rationally speaking, you should accept the bet. If the coin is fair, there is 50% chance of heads and a 50% chance of tails.
So the expected outcome is 0.5*2000-0.5*1000 = 500
You would expect to win, on average, 500 rupees per flip of the coin.
Most people however do not accept the bet. Why not? Because there is a 50% chance of losing Rs. 1000. Behavioural scientists have estimated that in humans, the pain of a loss is more than the pleasure of a profit. Some studies show that on average, humans value the pain from a loss at 2.5 times the pleasure from an equal gain. Thus we are likely to feel pained 2.5 times as much in losing Rs. 1000 as the pleasure of making Rs 1000. Alternatively speaking, the pain from a Rs 1000 loss is equal in intensity to the pleasure of a Rs. 2500 profit.
What implications does this have on investing? Many, but we shall discuss one.
If you are an investor with a portfolio, your portfolio is going to fluctuate every day depending upon what the market does. If your portfolio goes up, you will feel pleasure. If it goes down, you will feel pain. So, if you look at the value of your portfolio every day, you will swing between pleasure and pain. You would have a emotional roller-coaster ride, feeling happy one day and sad another day.
Assume you indeed are such an investor who looks at the value of your portfolio daily. If you had been invested in the Nifty-50 since 1991, here is what you would see (I shall spare you the statistical calculations):
Chance of making money = 52%
Average Daily Profit = 1.26%
Average Daily Loss = 1.27%
So 52% of the times you would have felt happy making money while 48% of the times you would have felt the pain of losing.
Assume that each percentage gain gives you one unit of pleasure. So one percentage of loss would give you 2.5 units of pain.
Considering 4308 trading days, the total pleasure accruing to you will be 0.52*4308*1.26*1 = 2822 units of pleasure.
And the total pain you would feel would be 0.48*4308*1.27*2.5 = 6565 units of pain.
So you would have an emotional balance of 2822-6565 = 3743 units of pain.
Overall, you would have felt a lot of pain!! OUCH!!!
Instead, you decide that you would look at your portfolio only once every year on 31 March of each year.
During this period, this is what you would have noticed:
Chance of making money = 66%
Average Yearly Profit = 59%
Average Yearly Loss = 15%
Total number of periods = 17
Your emotional statement would look like this:
Pleasure = 0.66*17*59*1 = 662 units of pleasure
Pain = 0.34*17*15*2.5 = 216 units of pain
Net Balance = 662-216 = 446 units of pleasure.
Overall you would have felt some amount of pleasure rather than net pain experienced in the first case.
Also note that your chances of making money go up from 52% to 66%
And in both cases, you make the same amount of money.
So, by not looking at your portfolio once every year rather than once every day, your chances of making money over the period of observation goes up and you feel more pleasure.
Extending this even further, If you chose to look at your portfolio over longer periods, the chances of making money go up further to 75% (3 year period) and 77% (5 year period).
By taking a longer term view of your portfolio, you increase the chances of making money over that horizon. Not only that, you also are saved of the emotional turmoil of pain and pleasure and overall face much less emotional stress and tension.
Ergo, don't look at your portfolio all to frequently. It will only drain you emotionally without adding a paisa to return.
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3 comments:
Hi Shashank,
Investing, in stock markets, either directly or through mutual funds, should be seen as a long term wealth creation activity.
This is something where you invest regularly and build your wealth brick by brick (or should that be rupee by rupee) over the long term.
Equities, as an investment option, give above average returns over a period of time.
What this means is you strip of the excitement of daily ups and downs and make it investing a staid boring activity.
But, I guess adrenaline pumping has more followers so an active participation is more attractive.
When headlines scream that investor wealth has increased by Rs. 4,00,000 crores, you get that heady feeling and a sense of belonging. The pain is more intense when the reverse happens.
The last four paras of your blog hit the nail on the head.
Hi Anil. Thank you for your reply.
Speculators and traders seek capital appreciation. Investors endow an operation with capital or money or both. In this context most of us are not investors but traders. A person who wishes to buy with a very long time horizon is as much a trader as a day trader; after all both seek capital appreciation from their buying decisions. So we all are traders with different time horizons and different trading methods.
Buying based on fundamentals with a long term horizon is popularly called investing. So the term short term and investing is contradictory.
The jury is still out on whether you should invest regularly building wealth rupee by rupee. Most successful investors are in fact 'market timers' in the sense they wait for markets to offer attractive opprtunities and then buy with scale. Time diversification (eg SIP) is a defensive strategy of not losing more money than otherwise under certain scenarios.
Equities give above average returns is a myth that many hold and is spread around by mutual funds and other money managers. It depends upon what you mean by long term and what you mean by average.
The period of 1992-2003 was a poor period for Indian equities (Sensex returns -3% compounded) even as the India's GDP averaged close to 6% per annum. For most, a 10 year period is a very long period. No wonder that by 2003, few were in the markets and stocks had no takers.
Similarly, the period of 1964-1982 in the USA was a terrible period for stocks, giving zero returns on the index over the longer 18 year time period.
There are times when equities outperform and there are times when they underperform even over long horisons. The trick to get above average returns is to recognise broadly what aset class does well under what circumstances.
But you are right in saying that investing indeed is a boring activity and should be devoid of all the adrenaline boosting daily movements of stock prices.
But doing something as boring as investing or trading is not our nature. Boring is, well, boring and hence we seek excitement from investing as well. If someone seeks excitement, perhaps a casino is a better option. At least you can have some fun.
Yes, the media encourages the rush of emotions by screaming out how so many crores have been lost or made. Not to berate them, its their job to sell news for money.
BTW, Warren Buffet does not have a TV in his 'office'. He does not look at the markets on a day to day basis either.
I can see that you are well read on investing as well. While many people have read 'The Intelligent Investor', not all have read 'Fooled by Randomness'
regards
Shashank
Very Nice article :)
Manish
http://www.jagoinvestor.com
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