Variance

Posted on by Devesh Deepak Asset Allocation, Diversification, Investment, Mutual Fund, Risk

Diversification – A lesson from Cricket

Indians treat Cricket not just a game but we eat, sleep and breathe cricket.  Cricketers are as popular as a movie star and every victory in the field is a festival for the masses. Since cricket is so much entrenched in our psyche that we think there is no better way but Cricket to explain the benefit of diversification in your investment portfolio. The cricket is the most watched sports in India and every other Indian claim to be the bona fide expert of the game. Even the youngster will tell, “I know my cricket as my mamma knows her household.”

But for few tyro, Wikipedia explain the game as – Cricket is a bat-and-ball game played between two teams of eleven players on a cricket field, at the centre of which is a rectangular 22-yard-long pitch with a wicket (a set of three wooden stumps) at each end. One team bats, attempting to score as many runs as possible, whilst their opponents field. Each phase of play is called an innings. After either ten batsmen have been dismissed or a fixed number of overs have been completed, the innings ends and the two teams then swap roles. The winning team is the one that scores the most runs, including any extras gained, during their innings.

So what are the basics, there are eleven players on the field for each team during a match and every member of the team has an assigned role to play. The top order players are the batsman, the middle order consists of wicket keeper and all-rounders and lower order players are bowlers. The team has to score runs and restrict the opposition team to score as many runs as they have scored to win the match. The players who score runs are called batsman and the players who restrict the opposition team to score are called bowlers. Hence the reward is to score as many as runs you can and risk is the rival team can score more run than what you have scored.

If scoring the runs is the most important aspect of the game then why we can’t have a team with eleven specialist batsmen to maximize the rewards or eleven specialist bowlers to minimize the risk? If you ask this question even to somebody who wasn’t a big cricket fan, they could probably tell you that everyone has a job to do during any given match. If you don’t have a bowler in your team, your risk will magnify and it would be difficult for your team to restrict opponent to score more run than your team. Similarly, the team consisting of only bowlers can’t expect to score many runs and thus lose out to the opposition. This exactly explains the reason for having a diversified portfolio – as in cricket, every asset class has a specific job to do within the portfolio.

So if you are an investor trying to build a portfolio, let see what Cricket can teach you.

Go for Diversification

Holding several investments in a single asset class doesn’t mean a portfolio is well-diversified. Generally, diversification may lower risk when investments are negatively correlated, meaning their prices typically move in opposite directions. Your portfolio should be diverse enough to weather all sorts of markets – a mix of aggressive and defensive assets, such as stocks and bonds, may reduce the general risk of investing in the market. Dividend-paying blue chip stocks or mutual funds could be the core of your portfolio, while smaller growth stocks can give your portfolio speed and agility.

Diversification doesn’t mean sacrificing return

A well-balanced cricket team with six specialist batsmen and five specialist bowlers will have greater chance to win. A good all-rounder only adds the strength. Similarly, diversification may boost returns while lowering risk when compared to a single asset class. It’s possible at times that a portfolio holding separate asset classes produces a total return greater than the respective returns of each individual asset class. Since the portfolio is not subject to the volatility of a single asset class and covariance among the assets also lower the portfolio risk.

Build a core for Long Term Success

A team works best when they are built for a long period of steady success rather than a single, brilliant season. The best teams build a talented core group of players and only make changes when they need to address weaknesses in the team. M S Dhoni and Saurav Ganguly was the most successful captain of the Indian cricket team and both back their players to the hilt and gradually built a core which remains constant throughout their captaincy.

It’s the same in your portfolio. Rather than constantly rebalancing your portfolio and guessing the next winner, find some mutual funds that you like and plan to hold them for long time period. You should not obsess over whether your portfolio is up or down on a given day. Plan for the long-term; it’s better to have your portfolio perform above average over years than to have a few big years but performing sub-optimally in most of the other years.

Identify and stick with steady Manager

In the first decade of this century, we have two very successful coaches – John Wright and Gary Kirsten. In between, we also have Greg Chappell. The records of these coaches speak for themselves. Rather than firing the players after disappointing performances, the successful coaches kept faith in their long-term ability to win and stuck with them, even in the bad times. Whereas, Greg Chappell’s firing policy proves a disaster for Indian cricket team.

An investor should do well to analyse the performance of the fund house instead concentrating on a single scheme. One should not quit a fund if it is going through a rough patch. A steady, successful fund management team always pull out of rubbles and steer the fund back to its winning way by adhering to winning strategies, putting up good numbers in the long run. The track record matters and investing in a hotshot new manager with no track record can be risky.

Conclusion

The great team doesn’t build in a jiffy; it takes years and load of patience. Even the best team loses sometime hence one should not lose sleep if your portfolio gives negative returns when market capsizes. We all are well aware of the history of US stock market crash of 1929. Some investors must have first-hand experiences during market meltdown in 1999 and 2008. The reality is that some market crashes are so sudden that even the most diversified portfolios suffer. Risk can only be minimised, can’t be wished away. However, portfolio diversification may stabilise risk to help lower a portfolio’s sensitivity to market volatility.

 

 

Posted on by Devesh Deepak Risk

Are we Loss averse or Variance averse?

How many times you have compromised on return and invested in a relatively safer instrument; or fretting about the potential loss before making an investment, or worst sold the investment whenever there was the slightest dip in the value of the portfolio. This impulse to protect you is called the safety first principle or “loss aversion.”

The influence of emotions on decision-making is widely accepted. Neurophysiology evidence suggests that loss aversion has its origins in relatively ancient neural circuitry (e.g., ventral striatum). This evidence also helps us to understand while modern finance theories tend to see risk as related to variance in expected returns; the psychology literature tends to link risk to probability or size of potential losses.

The assumption of modern portfolio theory about the efficiency of market and rationality of investor is long been nullified. Individuals do not tend to act rationally when making decisions in a risky environment. Most of the times individuals have little information, process such information using simplified routine, and are influenced by the way in which information are presented to make a decision.

Before the advent of Modern Portfolio theory (MPT), the investment risk is measured in terms of absolute loss or relative loss vis-à-vis of a market index. Variance as a measure of Risk was first introduced by Economist Harry Markowitz in MPT in a 1952 essay, for which he was later awarded a Nobel Prize in economics. This idea of variance as a measure of Risk is so new that it never percolated in the psyche of investors, despite the fact that all the subsequent development in Risk Management – Risk-adjusted return, Value at Risk, EWMA, Downside Deviation or GARCH – uses variance as a building block.

The significance of standard deviation (the square root of variance) can be gauged by the fact that 68.2% of the time your return of the investment will lie between one standard deviation above and one standard deviation below the mean value, 95.4% of the time your return of the investment will lie between ‘2’ standard deviation above and ‘2’ standard deviation below the mean value and 99.7% of the time your return of the investment will lie between ‘3’ standard deviation above and ‘3’ standard deviation below the mean value.

We don’t have empirical evidence to conclude whether individuals are loss averse or variance averse but our experience in the field of investment suggest that individual is more loss averse than variance averse.

Dan Ariely, James B. Duke Professor of Psychology and Behavioural Economics at Duke University, and the author of ‘Predictably Irrational’ and ‘The Upside of Irrationality’, both of which became New York Times bestsellers opined that “People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.”

The asymmetrical behaviour of the individual under the fear of losing money tends to make these common mistakes:

First, they ‘overweight’ the lesser probability and ‘underweight’ the higher probability and sometimes totally ignore a minor event.  Their response to a loss is more extreme than the response to a gain of the same magnitude. Instead of cutting loss, they try to recoup the loss by liquidating their profitable assets—that could run counter to their long-term investment goals.

Secondly, they often increase their risk-taking in order to try to escape losses and fall victim to the sunk-cost fallacy. The sunk-cost fallacy is behaving as if more investment alters your odds, believing the more you put in, the more it will pay off.

Third, they fail to distinguish between a bad decision and a bad outcome. Individual regrets bad outcome of a good company like a weak quarterly result or low returns over a period, even if they have chosen the investment for all the right reason. In such case, regret can lead them to make a decision to sell. This means selling at the bottom instead of buying more.

Lastly, they justify holding the safe investment by comparing the alternatives with respect to a specific point of time, that is, they always evoke Internet bubble of 2000 or Lehman Brothers collapse of 2007 to justify not investing in stocks – thus losing the chance of potential return.

It is interesting to note investors – amateurs and professionals alike, regardless of intelligence or skill level – act intuitively under risky and uncertain condition forgetting that today’s uncertainty won’t likely last forever.

Risk aversion is important. This is natural check and balance – keep us away from financial fraud and also keeps our expenses in control, and helps us to save for a rainy day. But loss aversion is short-sightedness. It happens when we lose sight of our long-term goals, and focus too much on short-term events.