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Irrational behaviour, born out of incomplete understanding, biases, overconfidence, fear or greed, has led investors to make less than half of what they could have in the capital markets, says Erik Hon.
The capital markets attract people for many reasons.
There are the 'get rich quick' speculators, who revel in market ups and downs and risk their all in every move.
There are the traders, who view it all as a challenge and bring their research, study and technical analysis to bear while trying to outsmart the rest of the market.
And then, finally, are the long term investors, who enter the market warily, having understood that investing in it is probably the only way to ensure that their hard earned wealth will beat inflation, and possibly, grow.
The trouble begins when, having once started, investors get pulled into behaving like the speculators or traders.
Celebrating or worrying with every market rise or fall, studying complex charts and ratios, trying to make sense of what all the different experts are saying, and generally getting caught in the game of beating the benchmark.
Several studies across the world, has proven that irrational behaviour, born out of incomplete understanding, biases, overconfidence, fear or greed, has led investors to make less than half of what they could have in the capital markets.
No wonder then, that investor behaviour or behavioural finance is a specialised field of study today.
Let's look at four behaviours that can help you invest profitably over the long term.
1. Save regularly
This one, simple habit helps you avoid some of the major pitfalls of investing.
When you invest small amounts regularly, you get to spread your risk across different cost points.
Investing fixed amounts at regular intervals is even better, as it gives you the benefit of the 'cost averaging' approach, which means that you will always buy more units when the prices are low, and less when the prices are high -- one of the key tenets of rational investing.
This approach also releases you from the stress of timing your investment, or wondering whether you have enough to start investing at all.
2. Watch your asset allocation, not the market
Market predictions rarely, if ever, come true entirely, and the effort and stress of trying to get the timing right are rarely ever worth it.
The length of time you stay invested in the market has proven to be a much better determinant of successful investing than timing the market as it is difficult to know when the market is at its bottom or its peak.
It's easy to be caught up in the market sentiment when the momentum swings between fear and greed.
Studies have shown that most investors buy high and sell low because they focus on momentum and sentiment instead of earnings growth and valuation.
Earnings ultimately drive the market over time when the noise settles down.
Asset allocation, or how you distribute your investments across different asset classes (equity, debt, liquid), has a far greater impact on your eventual wealth generation -- and this is as true for professional fund managers as it is for retail investors.
By focusing on asset allocation, you remove the emotions and the noise in your decision making.
So work hard to get your initial asset allocation right, and review your portfolio periodically to ensure that the allocation ratios are broadly still in place.
Rebalance in a disciplined manner to bring the portfolio back to its original allocation when you find that some securities have grown too fast, making one asset class overweight.
This is usually when greed comes into play; you will be tempted to let the outperforming asset class grow and fail to take profits because you are afraid of losing out if the market grows further.
Remember, however, that the portfolio risk will grow in the same proportion as the overweight asset.
3. Don't try to beat the benchmark
It's very easy to get caught up in benchmark comparisons and start to feel bad about your investments every time they don't generate 'alpha' or over the market returns. But stop for a moment and ask yourself how important it really is for you to beat the market.
Are you investing to meet your financial goals, or to outperform the Sensex?
Another important question here is how much are you willing to spend (in terms of cost) to earn this alpha?
Generating alpha requires active management and time to monitor the markets, all of which involves a cost.
Remember that over time costs will compound too and eat into your overall returns.
There are several products today like index funds and exchange traded funds that allow you to earn close to market returns, at a fraction of the cost of actively managed investments.
According to Warren Buffet, 'If you invested in a low cost index fund where you don't put the money in at one time, but average in over 10 years you'll do better than 90% of the people who start investing at the same time.'
Not bad, even if you don't beat the market, right?
4. Diversify
Expert studies have found that investors prefer to stick to familiar investments, despite some very obvious benefits from diversifying into other investment sectors, markets or products.
Known as the 'familiarity bias', the strongest example of this is seen in cases where investors show a marked preference to invest in their own domestic markets, instead of diversifying by investing abroad.
Even in the case of a highly rewarding market like India, there is a strong case for investing abroad to reduce the volatility risk and currency devaluation risk in your portfolios. And, with India's Liberalised Remittance Scheme, investors can deploy up to USD 2,50,000 every year in direct equity, mutual funds, ETFs, or bonds in foreign capital markets.
Failing to diversify leads to sub-optimal portfolios, which means that you earn less than you could have, and attract more risk and possibly more taxes than you would if you had diversified your portfolio well.
Remember that success in investing can only be measured against the goal it was meant to fulfil -- not generic market parameters. Work hard on getting your goals and their priorities right, get the right advice on the composition of your portfolio, and select your investment products with care.
Once your portfolio is made, focus on maintaining the health of your portfolio rather than worrying about market movements.
Don't go seeking excitement in the capital markets! Happy investing.
Erik Hon is managing director, iFAST Financial India Pvt Ltd, a digital multi-asset advisory platform for investment advisors.