An ideal portfolio objective must capture risk and return objective of clients very clearly. For long-term investment success, risk and returns both play a crucial role. However, the risk is more important as it is in our control, returns are not.
Unfortunately, for an average investor returns become more important in a bull market and risk becomes more important in a bear market. For seasoned and successful value investors, it is opposite; risk becomes more important than returns in a bull market and vice versa. That’s why Warren Buffet quipped – “Be fearful when others are greedy and greedy when others are fearful”.
Let us try to understand this phenomenon.
An average investor gets influenced by high returns made in short time in the past and get lulled in believing that it will continue in the future as well. He forgets that in past equity markets have fallen significantly after a rapid rise and there is a risk involved in equity investments.This behavior stems from recency bias which means a more recent event dominates a person’s decision making. Often this coincides with expensive markets and low risk perception. He starts chasing returns and gets complacent about existing investments which results in disappointing returns over the next few years. Inability to see risk doesn’t mean absence of risk.On the contrary, a smart investor’s risk radar gets more activated with rising markets as he knows that a more expensive market will have higher downside risk. A trigger for the fall can be any news in future which is not under our control. Since forecasting is not possible, it is important to focus on potential downside risk. Similarly when market falls, a smart investor knows the downside risk potential has reduced and he would increase his exposure towards equity. Whereas, an average investor would be exiting from equity, again influenced by past negative returns – a case of recency bias.
So what one should do for success in investment? Simply don’t chase returns. Always be conscious of your risk objective and give it as much importance to it as your return objective. Start reducing exposure in equity as market keep getting expensive and do the opposite in a falling market. It requires significant courage and patience to go against the herd behavior but it pays beautifully with long term success in investments.
Assuring financial peacefulness…
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