Mutual Fund

Being rational always pays off: Leave emotions at bay, stick to theory

“Simplicity is the ultimate sophistication.” Leonardo da Vinci

Recently, I asked one question in various forums. Even when the mathematical answer was known to most still the choices opted by people differed drastically, and it is true in real life scenarios as well. Below was my post:

Sometimes basic financial questions can be very simple yet so complicated. Which bet will you opt for?

First bet cost Rs 1: If heads on a fair coin’s toss you get 2 rs else 0

Second bet also cost you Rs 1: If heads on a fair coin’s toss you get 5 rs else you pay 3

Those, who knew the basic laws of probability and knew how to calculate the expected return, have easily said that both options are having same pay-out and having zero expected return (*Calculations are shared in the end). Still I received all sort of answers from we should not opt any bet, I want to be the person offering these bets to people selecting option 1 or option 2. All are possible options & the choice is really difficult, let me explain why:

Reality vs Theory: The probability of 50% winning or losing on a fair coin toss is true on a very long-term average, what it means is that “When you toss a coin for 10 times, there is a possibility that you might win 8 times vs losing 2 times”. If you disagree, please try the coin toss and record the result of 10 times coin’s toss. I am very sure your result will not be 5 wins & 5 losses and I can take bet for this anytime. Even when theory says that the probability is 50/50, though in reality it can be realized as 100 winning to 100% losing and anything in between.

Reality creates Anti-Theory: Those explorers, who ditched the theory of expected returns or was unaware of expected return theory, start to take the bets. There will be one section of people who were more-lucky than others. They started taking more and more bets as well as started promoting this as an easy way to make money and slowly this cult started to grow.

On the other hand, there were some unfortunate people who faced more losses than wins and end up losing the money on the bets. These people never talked about it again to anyone about the best as who wants to publicize their losses. Though when asked to take a bet, they simply said no even when sometimes bets were in their favour by a margin.

In the last prevalent theory came in the market, which was known to people and well publicized, was that if you want to make money take the bet. And the phrase became “Betting makes money”.

Anti-Theory comes back to basic Theory by evolution: Those who were participating and winning the bets, continued betting and in the long run the law of averages started to work out. Some people felt that after 50 toss or for others it may be after 500. Though in long run everyone does end up being in a zero-sum game. They will start to create evolution theory like:

  1. If you were constantly winning, then go for second bet with higher upside because now you can afford to lose some of your profits
  2. Those who were winning by small margins preferred to stick to the first bet to limit their losses

In the end there will be only handful people, who purely by luck/chance, make money in these bets. All of us based on what we see and hear will have our opinions, those who knew winners would like to be one and others would just like to stay away for the inherent risk of losses they saw in their experiences. Still in theory it was a zero-sum game.

Why I talked about this example and situation is to create a simple parallel comparison with our today’s investors. Most of the new retail investors after the hype of mutual fund and equity returns over last 5-10 years jumped on the band wagon with many simple notions like below:

  1. In a long run they will generate better returns
  2. If you are young, then having a high equity exposure in your portfolio is must
  3. If you invest in mid/small cap stocks you will get better returns

As I said, that my aim is to focus more on education than pure pursuant of returns, returns are just the carrots for learning. Let me open your eyes on some of the factors on equity investing, which are rarely talked about.

  1. Even though the publicized notion is that we get 12-13% return while investing in equities. This is true on average but, there is a 17% chance that you might get a negative return in any given year & in >30% cases you will not be able to beat your return on traditional FD of 8%
  2. Even in the long term the chances do not improve drastically you still have >5% chance to lose you money or >30% chance to under-perform 8% FD return
  3. Having high exposure to equity means a volatile return. In last 19yrs data I calculated the 1yr rolling return. It can range anyway from -59% to +108% but important to highlight that you might end up losing ~60% of your amount. Imagine you have built a kitty of 10Lacs after hard saving and suddenly in a year it deteriorates to only 4lacs. Are you ok with that? (Ads just call out returns are subjected to market risks. Hope you understand that how big that risk is)
  4. Lastly investing in mid cap (Small cap will be worse) increases the risk of losing money in any given year to 30% (vs 17% in Large cap). Roughly one out of three years you will get -ve returns. Are you ok with that kind of returns?

1 vs 3 yr return

What should we do as an Investor? always remember the theory and do not get swayed by the aberrations. Theory says:

  1. There is no exact return possible to generate out of equities and we need to be ready to accept the swings of equity returns
  2. The chances of losses will reduce if we have a longer time horizon so that we can achieve the mean return
  3. Stick to your asset allocation to minimize the volatility, it is the easiest and most important aspect of the portfolio management. (Discussed earlier)

We will talk about how to calculate our odds (expected returns) and how to improve our odds in the game of investing.

Till then keep learning & Happy Investing!

*First bet -> (50% chance of winning * 2 + 50% chance of losing * 0) – 1 (the Cost of bet) = 0 Pay-out & for Second bet -> (50% chance of winning * 5 + 50% chance of losing * (-3)) – 1 (Cost of bet) = 0

2 thoughts on “Being rational always pays off: Leave emotions at bay, stick to theory”

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