The Hindu Business Line : Of investors and auto drivers

Consider this. It is late evening and you want to go shopping. It is one of those days when there is huge demand for autos. Yet, eight of ten auto drivers that you ask tell you that they are heading home to retire for the day! Their behaviour defies economics. We behave in a similar manner when it comes to constructing our investment portfolio! What is the linkage?

Save for the rainy day

Take a typical auto driver. Philosophy aside, he earns and lives for the day. On a good day, he will earn a decent sum well before the evening. There is, hence, a tendency to retire home early. On a bad day, he works for long hours without much success. That is bad economics. Why? Logically, auto drivers should work hard on good days so that they can earn more money to save for the rainy day — when there is low demand for autos. And on those days, the auto drivers should retire early.

But why do auto drivers do just the apposite? The reason is that they do not look at their total income for a month. Rather, they are interested in earning some amount each day. In other words, each day is independent of the other.

Downside and upside

Investors behave in a similar manner. Modern portfolio management calls for an optimal diversification of assets. Yet, empirical evidence has suggested that we do not diversify as much. We buy insurance, which is risk-averse, and yet hold highly undiversified portfolios, which is high-risk. Why?

Behavioural psychologists argue that we do not look at the portfolio as a whole. Rather, we tend to view them as two tiers, an upside-potential layer and a downside-protection layer.

The downside layer is invested in risk-averse assets because we do not want to lose money. The upside layer is invested in high risk assets so that we meet our aspirations of becoming rich. Each layer is constructed independent of the other. Often, both layers do not effectively combine. This leads to sub-optimal asset allocation and lower total returns.

(The author is an investment strategist.)

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