The Hindu Business Line : Shorting against the box: Strategy for minimising loss-aversion cost

Investors failed to take losses and move into cash when the market crashed in January. Most of them still carry large unrealised losses on their portfolio. This article discusses a strategy to reduce the cost of holding such loss-making shares and suggests an optimal approach to buying shares in the current market.

B. Venkatesh

After reaching an all-time high of 6357 on January 8, 2008, the S&P CNX Nifty fell sharply to 4448.50 just 10 trading days later. The index has since struggled to move past 5545. This has left many investors wondering what strategies they should adopt till the market trends upward.

This article first addresses these issues. It first discusses the error — downside averaging — that investors make in the current market structure. It then discusses a strategy to minimise the cost of the error and also suggests a buy-strategy that they can adopt till the market trends up. The article draws on behavioural finance for explaining the process.

Concorde Effect

A retail investor bought Bajaj Hindusthan at Rs 320 in early January. She then bought more shares between Rs 270 and Rs 250. The investor currently holds 500 shares at an average cost of Rs 280.

Retail investors typically engage in such downside averaging.

The logic that “if a stock was a value-buy at Rs 320, it should be a steal at Rs 250” does not, however, hold water.

Household goods should be bought cheap but such a strategy may not always be optimal for buying financial assets. The reason is that household goods are used for personal consumption whereas financial assets are bought for selling at a profit.

Now, profits can be generated only if there is demand for the stock at higher price levels.

And such demand is driven by noise trading, traders’ emotions and analysts’ perception of fundamentals.

In the above example, the estimated intrinsic value for Bajaj Hindusthan may be well above Rs 320 but unless there is demand from traders, the stock is unlikely to go there anytime soon. This increases the opportunity cost for the portfolio. That is why downside averaging could be an expensive strategy.

We call this process the “Concorde Effect”. It is named after the famous joint project by Britain and France to build the Concorde. Interestingly, like most retail investors, these two countries sunk good money into the project even though they found it to be unviable.

Shorting against the box

Investors resort to downside averaging because they are reluctant to take losses and move into cash. Behavioural psychologists call this as the loss-aversion effect.

This refers to our behaviour to hold on to our losses for too long and to sell our winners too soon. A case in point is the retail investor’s behaviour with Bajaj Hindusthan.

The opportunity cost on the portfolio due to loss aversion is very high. Investors should, hence, trade on their loss-making holdings to minimise the holding cost.

Here is a simple strategy based on the retail investor’s holding of 500 shares of Bajaj Hindusthan: Sell 250 shares at, say, Rs 215. Then buy-back the quantity at, say, Rs 200. This trading strategy would fetch a gain of Rs 3,750 not including brokerage commissions. The strategy should be exploited as many times as possible to lower the holding cost.

We call this strategy as “Shorting against the box” — the box representing the place where share certificates were kept in the days of non-electronic trading. This strategy can be implemented either by reading chart patterns or by seeking advice from professionals.

It is important to note that this strategy should be only implemented till the market whipsaws or moves sideways. Investors should switch to “normal” trading strategies after the market trends up.

Accumulation, not downside averaging

Some retail investors who hold cash seem to be in a hurry to buy shares at the current level. We provide here a strategy for optimally converting cash into assets.

A retail investor has to first identify the stocks to buy and the quantum of exposure for each stock. The following strategy presumes that it is difficult to catch the market turn.

Suppose an investor wants to buy 500 shares of BHEL. It is optimal for the investor to decide a price range for buying these shares. For instance, the investor can decide to buy between Rs 1,800 and Rs 2,000. It is best that the investor buys at price points that are far apart. This strategy is called “Accumulation” and is different from downside averaging.

In downside averaging, the retail investor will typically buy 500 shares at one price point and will continue to sink more money into the stock should it go down.

In the case of accumulation, the investor starts with the assumption that the stock could move down. Importantly, the investor stops with 500 shares, even if the stock goes below the average cost price.

Finally, tone down your expectations from the market. That way, a bad outcome can feel good if you expected something worse!

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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