Maximising returns can harm financial health

Imagine this scenario. It’s the final of a 50-over national level tournament. The host side batting second needs one run to win with three balls and one wicket to spare. Fortunately, the better batsman is at the striker’s end. Knowing his penchant for hooking, the opposing side’s captain sets an appropriate field and the bowler bowls a bouncer. The compulsive hooker goes for his shot. The fielder on the boundary positions himself to take the catch. Much to the crowd’s joy, however, the ball sails over the boundary rope.

When asked why he chose the risky shot, the batsman says he knew it would work out. He is a contender for a slot in the national team. The selectors watching the match, however, are not impressed and don’t pick him, citing lack of temperament.

We were discussing investment strategy with Varun, a client with a large sum to invest. We decided the money should be invested in a mix of equity and balanced advantage funds. It had to move from a liquid fund, so we then discussed the pace of transfer. Varun said he “knew” the market would fall over the next six months. He wanted to invest a lump sum after the market hit the bottom.

I recommended the unsexy, but effective, systematic weekly transfer over 18 months. I tried to convince him about the superiority of following a process that has a good probability of achieving your objective, rather than trying to win big via a risky move.  

“Individual decisions can be badly thought through, and yet be successful, or be exceedingly well thought through, but be unsuccessful, because the recognised possibility of failure in fact occurs. But over time, more thoughtful decision making will lead to better overall results. More thoughtful decision making can be encouraged by evaluating decisions on how well they were made, rather than the outcome.” I forwarded this quote from Robert Rubin, former US Treasury Secretary, to Varun.  

However, I soon realised it was no use arguing with him as he already “knew” (just like the batsman) when the market would hit the bottom. Instead, I concentrated on demonstrating possible payoffs. We estimated the value of the investments after 10 years, assuming things went as he predicted, to be 100. We estimated it would be around 70 if he followed our approach. I then asked Varun the probability of him being exactly right. He put it at 20 per cent. We worked out that in other cases the investment value would be around 60. If we did things his way, the payoff was 68 (100 into 20 per cent plus 60 into 80 per cent) whereas the approach indicated by us had a slightly higher probability of 70 per cent.

If Varun followed our advice, over a 10-year period the wealth would grow, but be 30 per cent less than if he timed his entry into equity to perfection. But on an overall probability basis, the payoffs were almost the same.

In theory, 100 looks far superior to 70, but when you look at it from an overall payoff perspective, 70 begins to make sense. For our ancestors living in the jungles one mistake meant instant death. Hence, the need to be always right is baked into our evolutionary consciousness. But you don’t need to be right all the time while investing. You just have to be right most of the time.

Investments should carry a statutory warning: “Any attempt to maximise returns can be injurious to financial health.”

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; 

Twitter: @harshroongta