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The concept of loss aversion

July 20, 2004 09:38 IST

How does one behave when one has to take decisions laced with risk? Tremble with fear - fear of making a loss.

Parag Parikh, chairman, Parag Parikh Financial Advisory Services, says that as far as our feelings towards losses are concerned, we suffer from a behavioural anomaly called 'loss aversion'.

Another anomaly to be understood is that we see losses and profits in isolation and not in totality. In the capital markets, one must see the portfolio as a whole and understand how certain losses are impacting the total portfolio.

This is a very good way of avoiding mistakes one would make due to loss aversion. People when affected by loss aversion go for sure gains, take more risk when threatened with a loss, have preference for fixed income securities as against stocks and have a tendency to hold on to the losers and sell the winners.

Parikh unravels the dynamics of market investment in an interview with Nikhil Lohade in Mumbai.


On the current spate of Budget-related volatility

The markets are in a very volatile phase -- mostly due to fear. Let's understand one thing: everyone wants the government to dole out sops and make everybody happy. Is it possible? We are already having a fiscal deficit problem. The government requires resources for its expenses and spending.

This has to come from different revenue streams and we have got to pay for it as taxes -- directly or indirectly. Then there is this feeling in the markets that the Left will stall the reforms process. But it has to be understood that if reforms go ahead there will be pain in the short run as every change is painful. But we do not want pain and yet want change. This is the real uncertainty.

Guru mantra

The emotionally difficult way of investing is a straight forward and an untiring approach.

Do not get carried away by sentiments. Try to control your emotions and don't follow the herd. Believe in yourself and the investment policy you have committed yourself to.

The intellectually difficult path as well as the emotionally difficult route lay stress on the virtue of patience as they consider the long-term approach to investment to be the only viable plan.

The physically difficult way of investing is more about trying to time the market, finding its direction and getting as much information as possible.

The current volatility is due to too many people trying to invest in the physically difficult way.

This fear is giving rise to loss aversion and at the same time provide an opportunity to buy fundamentally good stocks. The Budget per se is not that important. But the event is creating anxiety as people are always looking for the quick fix, for instant gratification. Instead, one must look for good opportunities to buy.

On achieving superior investment results

There are three ways in which an investor can invest and try to achieve superior results. One is intellectually difficult, another one is physically difficult and yet another is emotionally difficult.

Legendary investors such as Warren Buffet, Charlie Munger, John Templeton and a few others have taken the intellectually difficult path of beating the markets. This path is pursued by those who have a deep and profound understanding of the true nature of investing.

They spot the future trends clearly and have a good ability to understand business and the environment. They understand that patience is a virtue and thus take long-term positions. We admire them but usually in retrospect.

At the time of doing their best work, we see them as misguided. We do not want to do what they are doing because it sounds so unpromising. I would say that it is more due to our intellectual inability to grasp their point of view.

A majority is involved in the physically difficult way of beating the markets. How do they follow this physical way? They come to the office early and stay late.

They read a large number of reports very rapidly. They are always busy with meetings or on the telephone, putting a tremendous amount of physical effort to try and beat the markets by outworking the competition. But they don't realise that this is what everyone is also doing.

Most of us are not blessed with the mental competence to take on the intellectually difficult route, nor are we inclined to take the physically difficult way.

In that case one could choose the emotionally difficult way. This is a very straight forward and an untiring approach. Simply work out a long-term investment policy, which is right for you, and be committed to it.

Here is the emotionally difficult part: When your friends tell you about a great investment opportunity and they feel that it is a great time to buy or an opportunity will be lost, don't buy. Be absolutely uninterested.

When they tell you that the market is going to crash and the stock prices will nosedive, don't sell. Be absolutely disinterested. Here, you do not require any intellectual or physical effort, but for most of us this emotional discipline is very difficult.

Do not get carried away by market sentiments. They only help you to make blunders. Try to control your emotions. Try not to follow the herd. Believe in yourself and the investment policy you have committed yourself to.

The intellectually difficult path as well as the emotionally difficult one lay stress on the virtue of patience as they consider the long-term approach to investment as the only strategy which can enrich investors and increase their wealth.

Patience focuses an investor's attention on the goal of compounding money over a long period. Compounding can be magic even when the compounding rate is modest.

To give an example: if one were to compound money at a modest rate of 7 per cent, the money would double at the end of 10 years and it would be 16 times at the end of 40 years. Patience also helps one to control the transaction costs.

The more you churn your portfolio the more you pay the broker in terms of brokerage and of course the government has its share on the capital gains you make. All these costs could be avoided if one has patience.

The physically difficult trek is more about trying to time the market, finding the direction of the market and getting as much information as possible to make investment decisions.

Trying to do so many things only results in information overload. This clouds the mind and distorts thinking. Good opportunities come once in a while and you spot them only when you are cool and thus have the time to think.  The physically difficult way assumes that there are a lot of opportunities there and you got to be digging hard to be successful at investing.

The current volatility in the markets is the result of too many people trying to invest following the physically difficult way. Life is simple. We make it complicated.

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