Biases that impact investor returns
It is often said that investment returns are greater than investor returns. This is primarily due to behavioural biases, some of which are listed below:
- Investor overconfidence: You have an overconfidence in your ability to pick up the right stocks and end up ignoring evidence that contradicts your choice.
- Looking for trophy investment: You are constantly looking for trophy investments that sound good and can make you famous instead of investments that are stable and can potentially generate substantial long-term returns.
- Over-exposure or under-exposure: Again, as individuals, we are all biased. As a result, we tend to hold too much of things that we like and too little of things that we don’t like. However, sometimes the things that we like might not be good for us while those that we do not like might be great for us.
- Trying to time the market: It is well known that trying to time the markets is a redundant exercise. Yet, we try to do it all the time, i.e., buy at market lows and sell at market highs. In an attempt to time the market, we sometimes miss out on good investment opportunities.
- Follow the herd: We are all guilty of following the herd. The general assumption is that if everyone is buying a particular stock, then it must be good. However, ‘popular’ does not always equate to great.
- Sell winners too early and hold on to losers for too long: This is very closely linked to greed and fear. When we start losing money, we hold on to losers in the hope that they will eventually turn into a profit. On the other hand, when we start making money, we end up selling the stock a bit too early in the fear that it will fall in value.
How can you avoid these biases and optimise investment returns?
Now, it is well-known that passive investing can be highly helpful in minimising the impact of behavioural biases. It simply involves holding all the constituents of an index in an attempt to replicate index returns. In the case of passive investing, the returns you generate can never be higher than the returns of the index. Further, the performance of passive index funds is often dominated by larger companies that will inevitably form a larger part of the index. Another major shortcoming of index funds is an inability to select good investment opportunities or proactively manage risk. All you can do is buy all the constituents of the index, in the same proportion as their weight in the index and hold tight. At the other end of the spectrum is active investing which enables you to select stocks for alpha generation and proactively manage portfolio risk. However, they do not eliminate behavioural biases and can in fact, exacerbate them.
So, what do you really need? A good mid-path that can combine the benefits of both the traditional active approach and the passive approach.. Something that we like to call the Passive+ approach. This approach combines the strong suits of both the traditional active management approach and the passive investing approach to create a rule based investment portfolio that enhances stock selection and risk management and eliminates behavioural biases.
The Passive+ approach enables:
- Stock selection: Stocks can be selected through a robust quant model that incorporates multiple momentum and other relevant filters that can help in capturing alpha.
- Optimal risk management: In-depth back-testing and validation of the quant model to enable proactive risk mitigation that can help in enhancing the overall risk-adjusted returns of the portfolio.
- Focus on investment process over discretion: The Passive+ approach is not discretionary in nature. Instead, it establishes an investment process that helps in stock selection and portfolio rebalancing.
- Elimination of behavioural biases: Due to the non-discretionary nature of this approach, behavioural biases are proactively eliminated and the best portfolio decisions can be taken.
Often, investors end up settling for sub-optimal investment returns because of a paucity of choices. However, with the Passive+ approach, investors no longer need to settle. They can enjoy the benefits of both passive investing as well as the traditional active approach through a single investment strategy.
(The author, Anup Maheshwari, is Chief Investment Officer (CIO), IIFL AMC. The views are his own)