General Thoughts

Why does an individual, in general, faces dismal odds of investing success?

It is remarkable what have our species, homo sapiens, have managed to achieve in the span of mere 70,000 years. Starting from a hunter-gatherer role, having no permanent establishment, ranking somewhere in the middle of food pyramid we not only moved to the top most position of it but rather have shaped the planet and its inhabitants.

Call it good or bad but our actions today will decide which species will survive next hundred years and which would go extinct, which direction will the temperature go over next several decades, how greener will landmasses be or not be. This is a phenomenon, for lack for any other word, achievement given the fact that we are just other any other animal in this vast kingdom (we share most part of our DNA with chimpanzees / apes)

In fact, what sapiens have achieved in last seventy thousand years is multiple times more of what Homo Erectus had achieved in over two million years of their existence on earth before they went on becoming extinct. Yes, we were never alone. In fact, there were three other species of humans (Homo Rudolfensis, Homo Erectus & Homo Neanderthalensis) but today there is only one – Homo Sapiens.

Yuval Harari has covered this evolutionary journey in his book Sapiens. The main reason for this achievement, he says, is attributable to the ‘cognitive revolution’ which happened during the period of those seventy thousand years. This revolution had two legs which set it going. One was ability to imagine things which may not otherwise exists and second was our ability to communicate.

Together these two meant that sapiens had the ability to mobilise a large group of individuals (100 or 500 people and as time progressed, even millions) and act systematically in order to achieve a common objective. This was unique to us. Chimpanzees, lions cannot do so at this scale though they can be doing it at a much smaller scale and for limited objectives coded in their genomes. Sapiens, thanks to their ability to imagine, were never restricted to what was built into their genes – we didn’t wait for thousands of years in order to develop fins to cross oceans – as other species did. Instead, we thought of building boats. We could imagine something sailing on water and which is big enough to carry us before we built it.

A short talk by Harari nicely put forth the basic tenets mentioned in his book. You can find it here.

It may come across as shocking but our ability to come up with stories (i.e. imagine things) and communicate it across masses, and hence act for a commonly established goal, explains why we are today what we are. Remember the age old saying United we stand, divided we fall. Our chief strength has been to act systematically (as imagined) in unity.

We can take this discussion fast forward to today with an exert from Mr Mauboussin’s beautiful work in his book More than You Know –

If you want to understand how broadscale sentiment shifts occur, you can start by thinking about the flu—well, actually, how the flu spreads. There are two key dimensions, both intuitive. The first is the degree of contagiousness—how easily an idea spreads. The second is the degree of interaction—how much people bump into one another. If the flu is very contagious but carriers don’t interact with others, it will not take off. If there’s a lot of interaction but the flu strand is not contagious, it will not take off. But combine interaction with contagiousness and you’ve got an epidemic.

Strong, convincing stories are contagious and this coupled with our innate need to interact (and hence spread it) results into a shift in sentiments. And this when something which otherwise has helped us as species over thousands of years of our evolution comes at odds when it comes to investing.

While biologically we may be right to act upon such stories or fictions in order to better ourselves & our community, as our evolutionary history would vouch for, it happens to be disaster when it comes to investing.

Why so? Successful investing is all about come up reasonable assessment of odds and acting if potential rewards more than compensate for the risk we are taking up. When it comes to acting based on convincingly laid out stories, amplified by the momentum which unfailingly kicks in, hardly any importance is given to looking up at those odds.

Individuals come to act when it could actually be the worst possible time to act paying little regards to think about what they are doing. Acting as their minds are wired to do over centuries.

In fact, after a point it becomes like greater fool theory – you are buying just to pass it on, at potentially lucrative gain, to even more resolute believer of the story. Dot com boom and bust in late 90s is the modern example in front of us.

Similar such episodes are well documented in a book by Charles Mackay called Extraordinary Popular Delusions and the Madness of the Crowds first published in 1841.

An outcome of this haphazard approach to investing has actually resulted the average mutual fund investor to earn only 4.4% p.a. much lower than 11.1% p.a. which mutual fund industry overall returned and even lower than 8.6% p.a. earned by an unmanaged collection of 50 largest companies called Nifty over last ten-year period. You can read more about this here.

How can an investor earn lower than the fund? It is precisely because he comes in at the wrong time and leave when he should actually stay put and commit more funds. He is influenced more by their rear view mirror than the windshield – hence resulting into an accident 🙂

Of course, incentives work in such a way that mutual fund operators have little reason to say no when they see funds coming to them without much of an effort, precisely at the time when they find it difficult to deploy funds on attractive terms for their investors.

Index investing helps to mitigate this randomness in inflows and outflows but even they are not fool-proof. In a growing economy like India investing in 50 large companies suffers on three counts, I believe (i) by investing in 50 companies, you are stretching ourselves too thin (ii) you are missing out on other phenomenally good businesses which may not make it to top 50 today (iii) there is no weighing of the attractiveness of the stocks and the odds it offers.

Still, since an index is least impacted by excessive speculation which may be gripping market participants in some specific sector (like during dot com boom) and general steadfastness associated with it, it actually promises investors to avoid costly mistakes rather than making excess returns.

When it comes to investing, the key lies in sticking with your commitments for decades navigating over the inevitable tsunamis and the opportunities it offers when it passes.

This simple yet effective hack enables us to overcome our otherwise fallible tendencies.

 

Niraj Bardia

 

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