Operate within your comfort zone

Identifying the reason is the first step towards avoiding losses in the future

Trades and investments are based on incomplete information. It’s impossible to identify, let alone track all the variables influencing asset prices. Even if you somehow “knew” everything, you’d still have to guess the responses of other market actors. In practice, nobody possesses more than a few pieces of the factual jigsaw and we all make critical decisions on incomplete information.

Very few people try to understand the behavioural aspects. Of course, behavioural science is much more an art than a science. But while economic theory is based on the assumption that people act rationally, behavioural analysis suggests that this is simply not true, much of the time.

You may never get a handle on how other people behave. But your returns are likely to improve significantly if you understand your own patterns and optimise your trading-investment style to fit with your own comfort levels. If you can eliminate persistent errors and negative biases, even better.

Everybody has biases. Those can range from the very rational, to the completely irrational. Working within your comfort zone is rational. For example, Warren Buffett doesn’t buy technology stocks because he says he doesn’t understand these businesses (and also dislikes the short cycles of dominance in the industry). Yes, he passes up many opportunities but technology stocks are outside his comfort zone.

Similarly, there will be situations you personally feel comfortable with and vice-versa, opportunities you should pass up because they are outside your personal comfort zone. For example, if you understand IT but you don’t understand the pharmaceutical industry, focus on technology stocks and ignore pharma. This is rational because this deliberate bias plays to your strength.

Irrational biases are more difficult to identify or understand. For instance, you may have taken a losing position sometime in a certain stock. It is irrational to vow to never touch that specific stock again just because you’ve lost money in it. But it would be rational to identify the reasons for that loss and to avoid making that type of error again.

How does one embark on a voyage of self-discovery? Here are some suggestions. First, try and assess your overall risk-appetite. The financial planning (FP) routine of deciding overall asset allocation on the basis of age, income, anticipated future lifestyle and so on, is a blunt instrument. But it’s a good way to start. If your actual allocations are out of tune with the recommendations, list your rationale for being out of step.

Then, fine-tune further. Out of your equity allocations, how much are you prepared to lose? What kind of return do you expect and over what time-frame? Do you play complex situations like short positions and use derivatives or are you a vanilla, long-term investor? If you want just market returns, do you actually bother to invest actively, instead of sticking to diversified equity funds and exchange-traded funds? These are basic questions but a surprisingly large number of people never ask them.

Start logging all your investments and trades as you make them, with the reasons for each action. The reasons could be as random as “My next door neighbour’s cousin, who drives a BMW, recommended X” or as focussed as “I studied the industry peers and thought X had competitive advantage due to such and such”. List the reasons, expected return, time-frame and so on. List what you’re prepared to lose every time you take a position. Review those lists regularly and update gains, losses and changes in opinion.

All this seems like hard work but it’s useful and importantly, it’s all within your control. If you do it honestly, you will find patterns popping up for sure. You may discover that your risk profile is in reality, very different from what you thought it to be.

You will also find the same logic (or lack of it!) repeatedly popping up in your actions. If your ego can stand it, show your lists to a couple of friends and ask for their feedback. If you can persuade them to participate in the whole exercise of assessing risk-appetite and listing reasons for trades, so much the better. It will help you gain an insight into how others think.

Once you have some inkling of what your patterns are, you can try to change the bad ones and reinforce the good ones. If you persistently lose in certain types of situations, stop taking such positions or modify your methods. Yes, all the above requires self-discipline but that is an essential ingredient for consistent success in any field.