Here's how you can be a good investor

Amit Trivedi
Karmayog Knowledge Academy

Rupee hits a low, interest rates rise, stock prices fall, vegetable prices zoom – a common man is hit from all sides. What should one do with the investments in such a scenario?

Many an investors feel too much anxiety about their personal finances, especially when the investments are made in a market that exhibits price volatility.

Also read: Fitch warns India of downgrade if confidence falls further

Professor Sheena Iyengar of Columbia Business School in her book, the Art of Choosing, narrates one experiment carried out by a psychologist in the year 1965. Here is a short description of the experiment and the findings:

Dr. Martin Seligman and team began the experiment by leading mongrel dogs into a white crucible, one by one, and suspending them in rubberized cloth harness. Panels were placed on either side of each dog’s head, and a yoke between the panels – across the neck – help the head in place. Every dog was assigned a partner dog placed in another cubicle.

During the experiment each pair of dogs was periodically subjected to physically nondamaging yet painful electrical shocks.=, but there was a crucial difference between the two dogs’ cubicles: One could put an end to the shock simply by pressing the side panels with its head, while the other could not turn it off, no matter how it writhed.

The shocks were synchronized, starting at the same moment for each dog in the pair, and ending for both when the dog with the ability to deactivate pressed the side panel. Thus, the amount of shock was identical for the pair, but one dog experienced the pain as controllable, while the other did not.

The dogs that could do nothing to end the shocks on their own soon began to cower and whine, signs of anxiety and depression that continued even after the sessions were over. That dogs that could stop the shocks, however, showed some irritations but soon learned to anticipate the pain and avoid it by pressing their heads.

In the second phase of the experiment, both dogs in the pair were exposed to a new situation to see how they would apply what they had learned from being in – or out of – control.

Researchers put each dog in a large black box with two compartments, divided by a low wall that came up to about shoulder height on the animals. On the dog’s side, the floor was periodically electrified. On the other side, it was not.

The wall was low enough to jump over, and the dogs that had previously been able to stop the shocks quickly figured out how to escape. But of the dogs that had not been able to end the shocks, two-thirds lay passively on the floor and suffered.

The shocks continued, and although the dogs whined, they made no attempt to free themselves. Even when they saw other dogs jumping the wall, and even after researchers dragged them to the other side of the box to show them that the shocks were escapable, the dogs still gave up and endured the pain.

For them, the freedom from pain just on the other side of the wall – so near and so readily accessible – was invisible.

This is termed as learned helplessness. This is “giving up” even when help is available and feeling hopeless.
This is a very powerful insight – and it is not new. (The experiment was carried out in 1965). The feeling of control plays a vital role in exercising the choice. Having a choice is one thing, but being able to see possibility of a positive outcome is another.

In the markets, where the prices fluctuate out of no understandable reasons, as mentioned in the beginning, many investors feel great amount of anxiety. How do we see that in light of Dr. Seligman’s experiment? Is it possible to exercise choice? Or are we just plain simple vulnerable?

The answer to this question lies in the serenity prayer:

God grant me the serenity to accept things I cannot change, courage to change the things I can, and wisdom to know the difference

Let us understand why we invest in the first place. We invest for some purpose – for some, the purpose would be to meet some large lump sum financial requirements – what the financial advisors would call the family’s financial goals, or in some cases, the purpose would be to create wealth for oneself or for others. Whatever the purpose, the same must be central to the investment plan.

Towards this objective, we build our investment portfolios. However, the money must be invested somewhere. And that is where the worries start. We forget the serenity prayer and try to control the uncontrollable.

Many a times, investors try to predict the future movement of the price of their investments. Often, investors expect their advisors to be able to predict. Expertise is very different from ability to forecast.
It is here that the experiment mentioned earlier helps us. Repeated failure in trying to forecast and the inability to see the logic behind short-term price movements results into conditioning the brain such that we start forming certain beliefs.

Examples of some such beliefs are:

• Nobody can make money in the markets

• The market prices are manipulated

• The market is a casino

All these are conclusions that are not going to help anyone.

Let us look at this point from a different perspective – that of control. Any investment plan has two sides: the investor’s personal situation and the investments and markets. Between these two, the investor has a better control over one’s own situation and hardly any over the investments and the markets.

What is a good financial plan? It should take care of the basic need, i.e. getting the required amount of money at the time of the requirement. In such a case, the basic principles one can start with could be:

1. The loss on account of a default – which could arise out of inability or mala fide intentions – should be avoided as much as possible

2. At any point one needs money, one should not be vulnerable to the price fluctuations

3. Investment growth lagging the rise in goal value – another situation that must be taken care of

The first is the easiest – diversify your investments across different companies and industries. You may also diversify across geographies. What is proper diversification? The basic principal behind diversification is that the same must be done across “diverse” investments.  “Diverse” or “unrelated” is a very important word out here. It is actually the essence of diversification.

The second is a little more difficult. It can be managed by planning the finances in such a manner that at the time of the goal, there is sufficient money in investment avenues, which are not subject to price fluctuations. Such options are bank deposits, liquid mutual funds or cash in bank savings account.

The third can be countered by investing money in assets that has the potential to grow at a rate higher than inflation. However, let us visit out Math class.

Way back in secondary school, we were taught the equation of compound interest, which is reproduced below:

A = P * (1 + r) ^ n, where
A = amount accumulated or to be accumulated. In our context, it is the goal value
P = amount invested or to be invested. This could be one time investment or a periodic regular investment
r = rate of return on investment, and
n = the time period for which the money would remain invested

The goal to be achieved is A. For that, there are three variables on the right hand side. If one is able to reach the target amount through increasing the time horizon or the amount invested, one need not seek high rate of return on investment.

However, one must keep in mind that the goal value is subject to inflation and hence the goal value would keep rising as the time passes. In this context, for long term investment plans, one must factor inflation in. without considering the impact of inflation, there is a very high probability of regret in the later years – by then, it would be too late to take corrective action.

To summarise, an investor must consider the risks of investments, viz., risk of default, risk of volatility and risk of inflation while planning. If a portfolio is constructed with these principles, the investor would have better control over the situation and would lead to one taking better and correct actions when required. Focusing on things beyond one’s control is a sure-shot recipe for disaster.

Remember the old proverb: “You can’t direct the wind, but you can adjust the sails”. Similarly, “you can’t direct the markets, but you can adjust your own cash flows.”

The author is proprietor of Karmayog Knowledge Academy.