Financial markets have come a long way since Eugene Fama propounded the Efficient Market Hypothesis. Psychologists and neuroscientists now study how our thought processes affect asset price movements. Studies have shown that asset price does not move on real earnings or other fundamental factors of a company but on our perception of such factors. And perception manifests in our behaviour. Behavioural finance is, hence, an essential part of the portfolio management process. It studies market anomalies and investor biases.
This article discusses one such bias - the Regret Aversion Bias. It shows how such bias leads to sub-optimal returns and what investors can do to moderate the bias.
We sometimes avoid taking any decision because we feel that our action will prove sub-optimal on hindsight. That is regret aversion.
Take an astute investor who believes that BOC India will break out if it closes above Rs 162-163 levels. The investor buys 500 shares at Rs 161.75 in anticipation of a breakout. And sure enough, the stock breaks out four days later and hits the 20 per cent circuit breaker. If, on the other hand, the stock had moved down, the investor would have stopped the position based on some pre-determined risk management rule.
Now, consider a normal investor. This investor is confused about buying the stock in a wobbly market. She decides to wait for a trend confirmation. After four days, the stock breaks out. But the investor is unable to buy the stock as it hits the upper circuit. There is a strong feeling of regret- of not buying the stock.
But what if this normal investor had taken exposure and the stock instead declined sharply? There will be a feeling of regret - of having bought the stock.
The normal investor knows before the fact that she will experience this feeling of regret. She will, hence, make some sub-optimal choices now to avert regret ex-post.
Some sub-optimal choices due to regret aversion bias are:
Investors choose less risky investments such as term deposits or fixed maturity bond funds. This leads to sub-optimal returns because such investments run high inflation risk - the risk that returns will not be enough to counter the rise in price levels.
Investors do not sell their profitable positions due to the fear that they might forgo the upside potential. Often, riding winners without a trading plan is risky because the stock could reverse direction and wipe out all the unrealised gains.
Regret aversion forces investors to herd. The rationale is that the market cannot be wrong. Besides, if the investment does turn wrong, the investor can at least console herself stating she was not the only one who got it wrong!
At the extreme, investors suffering from regret aversion shy away from a market that has declined sharply. Their fear is that the regret will be higher if the market goes down further. In the process, they sometimes fail to seize the opportunity to buy stocks at a bargain.
Finally, investors prefer to invest in large caps and mature companies. The reason is that smaller high-growth companies are riskier. While high risk may eventually lead to higher return, it also means higher regret.
The core-satellite approach to portfolio management can help investors moderate some aspects of regret aversion bias. Here is how.
The core portfolio carries exposure to index funds or large-cap stocks. The satellite portfolio invests in active funds, arbitrage funds and high-growth stocks.
Now, consider the investor’s desire to herd and/or take exposure only in mature well-known companies. The urge to take exposure to such companies will be satisfied through the core portfolio. The opportunity to chase higher returns and to herd on momentum stocks will be provided through the satellite portfolio.
The same portfolio structure will also help moderate the aversion for bargain-buys on market downturns. Investors can add large-caps to their core portfolio after a market decline. The fact that the core portfolio is long-term holding will help moderate regret aversion. For the same reason, investors should avoid bargain-buys in their satellite portfolio.
The only way to avoid the sub-optimal decision to hold profitable positions for too long is to have a pre-determined trading plan. The trading plan could, for instance, allow for selling half the holding at the initial price objective (target price). The other half could be allowed to run with adequate risk management rules. This approach, called the incremental sale rule, helps the investor take profits, yet allow for upside gains.
It is important to identify behavioural biases and assess their impact on the portfolio management process. Regret aversion is just one such bias. Investors would do well to take the help of their investment advisors to moderate such biases.
B. Venkatesh
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