Average Bias
In the series of 21 behavioural biases we will discuss the
11th bias “Average Bias”
Law of Average definition as per Wikipedia is fallacious belief that a particular
outcome or event is inevitable or certain simply because it is statistically
possible. It is a belief that a sample's behaviour must line up with the expected value based
on population statistics.
To simply understand, let take an example,
suppose a normal coin is flipped 100 times. Using the law of averages, one
might predict that there will be 50 heads and 50 tails. There is only an 8%
chance of it occurring. Predictions based on the law of averages are
even less useful if the sample does not reflect the
population.
If I ask you to walk thru the river which is on average 4
feet deep. Should you walk? Most common answer is – I can walk. But wait. You
missed to ask me what is highest depth? Because the depth above your height is
most dangerous as you will surely drown.👍
In economic data representation this is not useful as much.
For example –
1)
Average
rain will be 100%. Flaw is, will all the states receive full rain? Will rain be
evenly spread over sowing season/Months?
2)
Index P/E is at 28. Does it mean all companies
are trading at high P/E and stock market is overvalued? Well not true. There
will be many companies which are trading at very high P/E and many at
historical low P/E. I am not suggesting that high P/E companies are expensive
and to be sold and low P/E companies are cheap so you must buy. They are there
for a reason, which only expert can understand and take informed decision.
In Investing, averages are not perfect and right barometer
of state of markets. If markets are currently expensive than logically, no one should
invest. Rather everyone should sell. Which in turn means, if there are no
buyers and only sellers, there will be no trade and markets will hit lower
circuits on daily basis till the index P/E falls to reasonable levels. Have you
seen that happening? To my knowledge, Sensex and Nifty has hit upper circuit in
2009 when UPA 2 came into power. The same indices hit lower circuit on 2008 due
to “Subprime crisis”. Just 2 examples in long history of Indexes.
There are lot of Investors who stay away in rising market
stating it’s expensive. There are many who stay away in falling markets also.
In my view they are partially right but what they are
failing to understand is, there can be pockets of opportunities which can
deliver some returns. So regular Investing helps.
Why should you stay invested has a reason. You are earning
and generating free cash on monthly basis which needs to be invested, surely.
Now if you keep that in Bank or FD, you will lose out on wonderful opportunity
of averaging the cost of investment.
The one who is waiting on side lines, are self-styled smart
Investors. They seem to understand the market than nobody else!!
My assessment
of decades, has made me firmly believe that “Market is God”. We don’t know what
will God do next and what’s thy plan? Same is true for markets😊
So when there is economic slowdown or crisis visible in markets, I
simply move investments to low risk products to avoid vagaries of markets and protect
capital. But never take cash calls on market as markets can turn the table
anytime. It works well for long term investing without much shocks.
If you are not investing thru us, you can move your
investments into Asset allocation funds or do STPs or SIPs till the time you
judge the markets can remain volatile.
Almost all of us are victim of the Averages, little discipline
can help overcome it.
What should you do?
1)
Do not judge performance of the fund merely by
the average returns. Especially for sectoral funds.
2)
Try to analyse the rolling return of the fund
instead of average returns.
3)
Look for range of returns (if they are
consistent or varying)
4)
Check the returns v/s the risk of the portfolio.
Is fund manager taking very high risk for superior performance?
5)
Look for period of bad performances and
duration. If a scheme has done best in 2 yrs out 5 yrs and remaining 3 yrs were
really poor. What if you need money in those bad periods?
6)
Check if the performance of the scheme is thru
active trading or mindful investing?
MF Trivia: It is myth that high risk means high returns. To
achieve higher returns, you need not take higher risk, follow Asset allocation,
discipline and active management is more than sufficient.
This article
is written by Bhavesh D Damania founder of Wealthcare Investments.
You can
reach him at 9833778887 and wealthcarein@gmail.com
"Risk comes until you know what, where and why you are
Investing"
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