Addressing Behaviour gap through intelligent algorithms

As part of our ongoing series in understanding traders’ behaviour, we reviewed Carl Richards’s book Behaviour Gap.

Part 1 and Part 2.

Here are some points picked from what the book’s readers said about the book. The core premise is:

Managing your financial affairs is nothing more than using common sense and the avoidance of emotional decisions.

  1. Cycles and other factors do cause markets to go to ‘inefficient’ high and low extremes.
  2. Stocks should be treated as potentially useful, but also dangerous. And increased potential upside does generally come with increased risks (but the converse isn’t true: higher risk doesn’t always mean increased potential upside).
  3. In the long run, the vast majority of people who attempt market timing do worse than the markets, and we shouldn’t fall prey to the hope that we can rely on others to make such predictions. So it’s best to formulate an approach which will likely work well long-term regardless of how markets fluctuate in the short and intermediate terms, since the long-term trend is up; but this does assume that the future will repeat the past in the long-term, whereas there have been bear markets of more than a year in the past, so ‘riding out’ long bear markets can be a painful process which wouldn’t be a good situation for people nearing retirement or already retired.
  4. The most effective investors are moderate and humble rather than overconfident, and recognize their inability to reliably make accurate predictions. In fact, people with the highest proportion of accurate extreme forecasts tend to do worse overall. And because of the lack of predictability, rather than trying to adhere to rigid long-term plans, we should take a more flexible approach of adapting to evolving circumstances by making small but consistent course corrections. This means that we need to pay attention to what’s happening in timeframes of weeks and months in order to make decisions which will tend to work well over years, while ignoring intraday or day to day fluctuations, and recognizing that sometimes doing nothing is the best option.
  5. Following the herd and doing what’s popular will usually mean buying rather than selling when markets are high, and selling rather than buying when markets are low. Ironically, people who are relatively disciplined and really try to stick to their plans are most vulnerable to this, because they’re among the last to ‘give in’ and buy (near tops) and among the last to sell (near bottoms). ‘Safety in numbers’ isn’t a valid maxim for investing.
  6. Financial planning is part of life planning, and needs to be personalized – what’s suitable for one person may be unsuitable for another. Generally, we should only take as much risk as needed to meet our financial goals (rather than trying to maximize return and thereby taking on unnecessary risk), while keeping in mind that additional money has diminishing value in terms of enhancing our lives once we reach upper middle class (personal relationships, experiences, and the feeling of doing worthwhile work matter more, once our basic needs are met). The harm we suffer from a major loss is usually greater than the benefit we derive from a major gain, so loss aversion makes sense.
  7. Because of regression to the mean and the role of luck, funds which performed well in the past are less likely to do well in the future. Unlike most other fields, in investing, past performance is NOT a reliable indicator of the future, and may even be a misleading indicator. The only consistent correlation is that funds with higher expense ratios tend to perform more poorly.
  8. Because of good and bad luck, sometimes bad decisions will result in good outcomes, and good decisions will result in bad outcomes. Rather than being mislead by that, we need to stick to approaches which are likely to work longer term.
  9. Most of what’s reported in the financial media is just noise, and is best ignored. Try to keep your models simple and robust. That doesn’t mean we should ignore important developments on large geographic scales, but we should accept that context as ‘given’ and focus our financial planning decisions on where we can have an influence.
  10. A good test for evaluating a portfolio is to imagine being in cash and then asking how similar and different your portfolio would be if you reconstructed it. Don’t keep things the same just because of wanting to preserve the status quo, attachments, laziness, or wanting to ‘break even’ on an investment. A portfolio should be evaluated based on anticipated long-term future performance, not what has happened in the past to get to this point.
  11. Don’t fall prey to hindsight bias and compare your current portfolio value with a previous peak, as though the portfolio is at a ‘loss’ compared to that. Such extremes aren’t meaningful reference points. Instead, look at rate of return over longer timeframes. (It’s not mentioned in this book, but given that the long-trend of markets has been upward, buying low is a better and generally safer strategy than trying to sell high. And of course, things will usually look bleak – ‘blood in the streets’ – when markets reach lows.)
  12. If an investment option looks too good to be true, it probably is. Scrutinize such options intensively.
  13. Investing should be done dispassionately, rather than approached as an entertaining game. This will generally lead to better decisions. If you sense that you’re about to make an impulsive decision, sleep on the decision for one or more nights before deciding.
  14. Take responsibility for all of your investment decisions, rather than selectively taking credit for gains and blaming others or situations for losses.
  15. Don’t be penny wise and pound foolish in making financial decisions. Maintain perspective on what really matters by considering absolute dollar amounts, and prioritize your time accordingly.

Losses weigh more heavily

Koppel defines loss aversion as the natural preference for avoiding a loss over acquiring a gain. Behavioral economist Daniel Kahneman won the Nobel Prize in economics for his research with Amos Tversky that showed the psychological impact of a loss is two and a half times as powerful as that for a gain.

FundExpert and Auto-Pilot:

Human beings aren’t hardwired to be good investors. What ‘feels right’ may not be financially right.

So the quest at FundExpert is to set that right. We do that here at FundExpert with our Robo Invest for Mutual Funds and with our Auto-Pilot for equities.

Autopilot

Autopilot

The algorithms monitor the markets and make intelligent calls. As long as you do not panic and press PAUSE and let the algorithm runs, which invests unemotionally, you’ll get the returns that are stated for that strategy. We had launched Auto-pilot in a semi-automatic SMS mode where the user had to approve each trade and do the trading. We found that the time gap that it brought plus the user applying his emotions, degraded the performance of our algorithms and the returns we got were different from what we had expected. So, we launched the fully automated Auto-pilot  (the arrow on the top right of the strategy says its auto tradeable) which trades on your behalf and that product is our shining hero – Zero behaviour gap product for equities.

One differentiator between Auto-pilot and FundExpert is that Auto-pilot requires a person to be capable of a lot more risk taking ability than FundExpertFundExpert is suitable for every kind of investor – any age, any income bracket, any risk appetite, with even a small amount of cash to spare.

 

FundExpert robo-invest algorithm

FundExpert robo-invest algorithm

If you see above, every time the parachute opens up, there was a market crash/correction. FundExpert’s intelligent market monitoring algorithms (we have a bunch of algorithms doing different things) popped opened and saved your investments during those times. The end result?

A SIP that would have returned 23,87,706 went upto 28,20,956. An extra 2.7%! If you had any financial goals around that time, we’d have been able to save you right in time.

So, a robot in our context is not to de-humanize investing or wipe away traditional finance planners. If at all, we’re just trusted aides in both cases. That friend who warns you when you set a wrong foot.

The beauty of the Robo-invest lies in its ability to stay awake 24*7. It’s ability to take actions based on intelligent data, without emotional biases.

We aren’t taking away any bit of intelligence away from humans. We’re just complementing human intelligence where emotions run amuck. After all it’s your hard earned money. Who want to lose money?

About the author

Subha Viswanathan

Share the joy

Comments

Leave a Reply

Your email address will not be published. Required fields are marked *

*
*