Apply psychology to construct individual portfolios

We list some of the applications of behavioural finance in the creation of individual portfolios. They can be implemented by individuals in self-managed and advisor-based portfolios. We call such portfolios “Emotionally Responsible Investment”.

One, core-satellite is a behaviourally optimal portfolio. The core portfolio consists of index funds. It moderates regret aversion arising from stock selection. This refers to the feeling of regret when a stock value falls after an investor buys it or when a stock value increases when she does not buy it.

Likewise, the active satellite is set-up to take advantage of short-term opportunities and helps moderate hyperopia. This refers to the regret that comes from creating a long-term portfolio while missing out on short-term price movements.

Two, bonds are essential to any portfolio as it reduces volatility. It provides “mental liquidity”. This refers to individuals' finding comfort in the fact that the bonds are “liquid” at maturity, as they are redeemed at par.

Three, empirical evidence of long-run return does not support investments in real estate and gold. The touch-and-feel factor of both these assets overwhelms their rather unattractive risk-return trade-offs.

Four, individuals' should review their core portfolio only once in six months, unless there are extreme market movements. Empirical evidence shows that individuals who frequently look at their portfolio feel the urge to trade often — which can lead to frequent losses.

Five, investors should predominantly create a mechanical system to enter and exit short-term positions inside the satellite portfolio. This is because individuals typically suffer from “clustering illusions” and “gamblers fallacy”. The former refers to how individuals see trend when there is none and the latter refers to seeing trend reversals when there is none.

Six, individuals should have disciplined approach to buying assets. Specifically, individuals should accumulate assets for their satellite portfolio to moderate the need to engage in downside averaging, which is the outcome of “cognitive dissonance”. This refers to the individual's bias to look only at the positive factors underlying the investment and ignoring the negative factors to justify the buying decision.

Seven, individuals should set up Systematic Investment Plans on index funds for passive core portfolio. This leads to automatic savings and investments. Individuals should increase SIP amounts when income increases.

Eight, individuals should have an emergency fund to supplement medical insurance and other contingencies, including loss of income. This moderates “psychological reactance” — a psychological urge for liquidity that prompts individuals to choose an investment with exit option over a better investment that has no such option till its maturity.

Nine, individuals who take direct exposure to stocks and trade for short-term profits should follow strict risk management rules to prevent “loss aversion” effect. This refers to the tendency to hold on to loss-making positions for too long and to sell profitable positions too quickly.

And 10, individuals should clinically evaluate their MF investments. Judging the quality of the investments only by results and not by strategy could lead to “outcome bias”. This bias rewards ill-conceived investments that turn profitable for a short while.

Conclusion

Individual investors suffer from various biases. They are typically satisficers, not optimisers — investors choose an option that satisfies their requirement, not one that optimises returns. Moderating these biases leads to optimal investment. We call this process “Emotionally Responsible Investment”. Such a process increases the likelihood of investors realising their objectives at the horizon.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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