When ‘my-shirt-is-whiter-than-his’ bias leads to portfolio losses.

“For most things are differently valued by those who have them and by those who wish to get them: what belongs to us, and what we give away, always seems very precious to us.”— Aristotle, The Nicomachean Ethics book IX (F. H. Peters translation)

The share of equity investments is 8% of the total household financial assets in India. This is low by international standards (40% as per Ned Davis Research). However, the passion that Indian investors have towards equity investments is no less than international investors, especially towards investing directly in stocks.

As we get to see more and more equity portfolios from investors who want us to do a portfolio diagnostic analysis, we are shocked at some of the rubbish stocks that are part of their portfolio. Their passion, sadly, has not resulted in efficient portfolio management in most cases.

Everyone makes faulty investment decisions. Coming up with a faulty investment thesis is excusable. However, it is inexplicable that the investors do not sell losers in the portfolio even after realizing that they have made a mistake. As a result, over a period of time, typically at least one-third of the portfolio consists of stocks that have no hope of coming back to their purchase price. In fact, many stocks are either suspended from trading or close to it.

Theory of loss aversion has been propagated as the reason why investors refuse to cut their losses. It basically says that the pain of loss is twice the pleasure of gain. However, this is only part of the answer and also violates the standard economic theory that a person’s willingness to pay for a good should be similar to his willingness to accept compensation for selling the similar good. There is broader and more efficient explanation for this strange behavior of investors. It is called the Endowment effect.

There are two ways to look at Endowment effect. In a valuation-based scenario people expect to be paid more for something that they own than what they are ready to pay for the same thing.In an exchange scenario, people with a good are reluctant to trade it for another good of similar value.

Pros. Kahneman, Knetsch& Thaler conducted a study to see how the endowment effect influences our decision making.Participants were randomly divided into buyers and sellers.Sellers got coffee mugs as a gift. Sellers were asked for how much would they sell the mug and the buyers were asked how much would they pay for it.

Results showed that the sellers were willing to sell a mug for $7.12 while buyers were willing to pay $2.87 (median prices).

This experiment brings out the stark difference between Endowment effect and loss aversion. Sellers here got the mugs for free. There was no possibility of incurring a loss. Even then they placed a higher value on them just because they owned it.

Investors would do well to be aware of this Endowment effect (bias) and not let it get in the way of periodical cleaning of the portfolio. A professional advisor /planner may be better suited to do the spring cleaning of the portfolio since she would not get biased by the Endowment effect.

The writer of this blog is Abhay Agarwal MD & Portfolio Manager, Piper Serica. Piper Serica is a SEBI registered provider of Portfolio Management Services (PMS). It has generated industry beating returns. The objective of the PMS is to grow wealth over a long period of time by investing in LEADERS in sectors that COMPOUND earnings for a very long period of time with very little business volatility. To learn more get in touch with him at abhay@piperserica.com or visit www.piperserica.com

Is Anchoring bias the biggest killer of portfolio returns?

"People make estimates by starting from an initial value that is adjusted to yield the final answer," explained Amos Tversky and Daniel Kahneman in a 1974 paper. "The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient. That is, different starting points yield different estimates, which are biased toward the initial values."

This, in short, is Anchoring bias. Investors look at the current market price of a stock and immediately think of the past price that is anchored in their brain and then make an investment decision. This anchoring bias is probably the biggest killer of portfolio returns.

As per limited shareholding data available for the month June, 2019,retail investors added to their positions in 54 penny stocks. These include over-leveraged loss-making companies like MTNL, Sintex and Adlabs where retail shareholding has increased to as much as fifty percent of the total shareholding. Almost all of these penny stock companies are in deep trouble. Their core business is non-competitive, balance sheet is in deep distress, most of them are in the process of being dragged to the Bankruptcy Court by lenders and institutional equity investors have long abandoned them. So, other than daredevilry, what is it that attracts retail investors to these capital destroyers?

Answer can be found by comparing the current market price of these stocks with their peak price. Here are some,

Company	CMP (Rs.)	All time high price (Rs.)
MTNL	6.35	390
Adlabs	4.2	199
Sintex	2.6	302
Suzlon	4.6	460
RCOM	1.6	844
RPower	3.65	565
GTL Infra	0.65	106
Ballarpur Ind.	0.9	43

In the face of deathly odds, retail investors hope to make money by anchoring their mind to the all-time high price of these stocks and believing that one day they will get back to glory days. A recent study by ICICI Securities shows that only eight of the 228 stocks, which fell more than 75 per cent over a two-year period since 2010, have been able to reach their previous high. That is a success rate of about 3.5%. How can a retail investor win against a loss probability of 96.5% other than by being extremely lucky? Even then, how do you replicate that luck in the next penny stock investment?

Warren Buffet recently explained how anchoring bias damages returns in another way. Talking to CNBC he said, “It is a little hard when you look at something at x, and it sells at 10x to buy it. It shouldn’t be but I can just tell you psychologically it’s harder when you looked at it in the first place and passed at x, and then buy at 10x, It cost a lot of people money at Berkshire. They saw it at a lower price then and just said – “If it ever gets back there, I’ll buy it.” That’s a terrible way to think!”

This is the reason that retail investors miss out on investing in good quality stocks like Titan, Asian Paints, Interglobe Aviation, Infoedge, HDFC Life, ICICI Lombard etc. because they only recently saw these stocks at much lower prices and believe they would buy them at the same low price.

Once you combine the impact of both these biases, the retail investor is left with a portfolio that is long on penny stocks and short on high-quality stocks. You can easily imagine the impact of this on the portfolio returns. The only hope left for these retail investors is to hand over their portfolio to professional portfolio managers who can restructure the portfolio in a non-biased manner. Retail investors are often unable to restructure their portfolio themselves because of another bias called endowment bias where investors tend to overvalue the stocks that they already own. This leads to severe aversion to booking a loss. I will cover this in a later blog post.

The writer of this blog is Abhay Agarwal MD & Portfolio Manager, Piper Serica. Piper Serica is a SEBI registered provider of Portfolio Management Services (PMS). It has generated industry beating returns. The objective of the PMS is to grow wealth over a long period of time by investing in LEADERS in sectors that COMPOUND earnings for a very long period of time with very little business volatility. To learn more get in touch with him at abhay@piperserica.com or visit www.piperserica.com