Weigh, Don’t Vote

Conformity is good. It helps us survive as a species and is a foundational element in the construction of societies. Experiments throughout the world have borne out how we as individuals feel compelled to act in accordance with group norms. There is a popular video one can find if you key in ‘elevator group experiment’, where an unknown participant enters an elevator and all the initial occupants (who are actors) are facing backward. Invariably, the participant conforms to the group behavior and turns backward. Some researchers from Bethany tried to replicate that behavior and their findings were fascinating- men were more likely to conform than women, who showed higher degrees of independence. Younger participants were more easily influenced, and the size of the actors’ group also affected the degree of conformity. We are genetically predisposed to acting in sync with the group we are in.

This is why you shouldn’t invest in Bitcoin or Dogecoin. Or ‘play the markets’. Statistically, an average individual is far better off investing in a structured product, a mutual fund, or even a fixed deposit, than in individual stocks. That tip you received is not all that solid. In an age where we all live in virtual echo chambers, signals and noise can get amplified to a great degree very quickly. If you are already predisposed to take to such signals kindly, chances are you will be far more likely to be at the receiving end of ones algorithmically targeted at you. 

We continue to lack a lot of the market infrastructure that makes it easier for smaller stocks to be tracked: trading volumes for all but the top valued sticks, is anemic; there is scant analyst coverage for smaller scrips, activism is non-existent for them and there is hardly any threat that a strong-willed lone wolf or an early-stage private equity firm will discover a hidden gem amongst these and lead the charge on a fundamental value unlock. All of this means that the average retail investor is better off staying away from them, which pushes you towards the big-ticket stocks. And there, you do not want to rely on a 'tip' to invest. You want, instead, to construct a well-diversified portfolio that can generate returns over time but is also insulated from shocks.

As an investor, you are seeking to maximise your alpha, which is the part of the return in an investment that occurs over and above the overall market performance or the beta. If you construct a portfolio that is completely derisked, you get a beta of zero, and your returns are essentially the risk-free return rate plus the alpha. The beta goes up as a function of your risk tolerance, and that in turn dictates your overall portfolio return. Anything that you generate in excess of the risk tolerance component, essentially attributable to the fundamental value generated by the stocks you picked, is your alpha. And chasing alpha is tough.

It predicates the existence of entire investment management industries, and they are better at it than an individual for a reason; their whole raison-d'etre is to spot and capitalise on opportunities. And that is where your money should probably go, a mutual fund, where they can construct a portfolio and monitor it actively over time to ensure you get the best possible returns.

Often, individual investment decisions are driven by an irrational fear of missing out, rooted in an inherent predisposition that leads to flawed decision-making- the survivorship bias. We tend to attach strong meaning to success stories, we revel in them and re-tell them and secretly, believe that can happen to us. That is the reason Bitcoin and Dogecoin are having their season in the sun. That is the reason there was a Tulip Mania in Amsterdam in the 1630s. When you get on a ride that's headed up, you secretly expect that trend to continue. And it will, for a while, till there is a correction. That is not to say it will not recover from the correction. Most pricing charts look like waves for a reason. What goes up comes down, and what goes down often comes up. The question becomes whether you are the one participating in the ups or the downs. 

It's not easy to stay the course when you see the ticker wipe away your savings. It probably is the right move, if you're betting on a single stock or a single asset. But as an individual investor, in all probability, the most important factor determining your success will be how long you stayed in the market, followed by the diversity of your portfolio. Single stocks rarely make investor fortunes. Ben Graham, the economist and father of 'value investing' noted that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” - so put your eggs in a diversified basket and give them the time they need to hatch.

The author is Managing Director, Bexley Advisors

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.