Investing: Emotion Or Process?

Arvind, a good friend of mine is a typical conservative investor. He completely distrusts equities and puts away most of his savings in a Fixed Deposit. I recently bumped into Arvind at a shopping mall and on enquiring of his investment habits, he said he still keeps most of his money in bank FD’s, but on another friend's recommendation he decided to buy a small cap stock which is up 100% in last six months! Much higher than his expectations, but, like the average investor, he does not plan to sell the stock, as he believes it will rise further. The fact that risk is now substantially elevated in the investment is immaterial.

Arvind’s behaviour is not unique. Investment greats have struggled to time exits from an investment position. Neurological research has indicated that human beings are “wired incorrectly” especially when it comes to making buy and sell decisions regarding the timing of investments. Behavioural studies have shown that a successful investment (aka price appreciation) can significantly lower an investor’s perception of risk, while anxiety during a decline in value of investments can substantially lower the risk taking ability of investor and cloud his judgement. This limitation is what causes investors to hold on to stocks in a raging bull market instead of selling and to freeze in a stock market crash and not buy even though stocks are available at a deep discount.

At Quantum, we understand such limitations. Hence the drive to create a process based approach rather than depend on an individual’s ability to time entry and exits. This is also why we don’t follow the star fund manager approach, where only the individual who is a fund manager gets to decide the fate of the fund and if he goes wrong or let’s say is ‘wired incorrectly’; then this ‘incorrect wiring’ could impact the fund. Our team driven approach relatively insulates your hard earned money from getting thus affected.

Each company that our research team covers has a predetermined buy limit and a predetermined sell limit based on the long term earnings potential of a company and its long term valuation band, which is reviewed periodically. If a company comes below our buy limit irrespective of the state of the market (including panic because Lehman brothers was going bankrupt), the stock will come into our portfolio, similarly if the company exceeds our sell limit and we have no reason to upgrade our long term earnings estimate, we will exit the stock.

We believe this approach prevents us from falling prey to limitations of a specific human being’s emotions while making investment decisions. We hope our track record over a long period of time built on this process will prove the same.