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B. Venkatesh

AS INVESTORS, we typically lengthen our investment horizon when faced with losses. Suppose you buy, say, Arvind Mills at Rs 80 hoping to sell when the stock moves to Rs 100. You intend to hold the stock for one month. At the end of this period, the stock trades at Rs 60. What would you do? Chances are you will extend your time horizon! Why?

The reason is that you believe that some day, the stock will move to Rs 100. This is a logical extension of the general belief that stocks are less risky in the long run.

Empirical evidence does, indeed, suggest as much. But this should not be reason enough for you to hold stocks for the long term. Why?

If you are philosophically inclined, you may have heard of the black swan problem. It relates to the theory of induction put forth by Sir Karl Popper and later by David Hume.

It was, however, John Stuart Mill, an economist and philosopher, who put it in perspective: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion."

How does this link to the above issue on stocks? That stocks have outperformed all investments in the long run (and therefore less risky) does not necessarily mean that it will continue to do so in the future. In other words, your decision should not be based just on history.

What is the implication of the black swan problem? Suppose you, a risk-averse investor, are planning for your retirement income. Your financial advisor might allocate a sizable proportion of your investment to stocks because they are less risky in the long run. You can, perhaps, mention the black swan problem to your advisor.

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