Investing is simple but not easy.  It is simple as principles are fairly basic - buy the right company, buy when prices are low, let time play its role in compounding earnings.  It is not easy, because successful investing requires one to act often against the “defensive/emotional” instincts of the human mind.     Hence, the role of client behaviour  – particularly how they react during times of market stress - is seldom appreciated. 
 Our investment framework is a confluence of “Quality, Growth, Valuation and Behaviour”.   We predominantly influence the first three and rely on clients for the fourth (Behaviour) to do our job well.    
 Let me explain.   Research done by Andrew Lo, an MIT scientist, explains the differential functioning of various layers of the brain when faced with different stimuli.
  • Our brain has different layers that control rational, emotional and defensive instincts.  Each layer could be predominant over others in response to different stimuli.
  • During calm markets, the “rational” layer predominates which makes us more optimistic and think long term.   During times of acute stress, the defensive instincts are predominant over the rational instinct making us more pessimistic and short term oriented.   
  • Sharply declining stock prices trigger an urge to “Sell”, to protect capital from further losses.   Similarly, rising stock prices result in an “emotional” feel good factor, and the fear of missing out which trigger signals to “Buy”

History confirms the above.    Net inflows into Mutual Funds are correlated with high market multiples.   Even seasoned analysts are vulnerable.  I recently read a research report on a large Private Indian bank where the author argues “rationally” and very persuasively that the bank was significantly undervalued quoting at about 50% of its fair market value - yet, he would not recommend a buy as there were no triggers for rerating.   Or take recent examples of the extreme euphoria  to extreme despondency with the Modi Government – a classic example of the fight between the rational vs the emotional/defensive layers of the brain. 
 We believe client behaviour, especially during times of market stress, is a strong variable that influences long term returns. 
  • Falling share prices should make even the most seasoned investors re-introspect their investment case.   It requires courage to buy further into stocks that have declined significantly from initial purchase as acting contrary to a natural instinct is not an easy thing to do.   
  • Clients could transfer their nervousness to fund managers and affect their conviction/courage by too frequent an inquisition or by advising booking of profits or capping losses.   
  • Even if a Fund Manager was to make smart choices, client returns would be poor if they pulled out money by panicking during market meltdowns
 Keeping the above in mind, our advice to prospective clients is
  • Spend time understanding our investment process to ensure alignment on approach
  • Go beyond standard Asset Allocation questionnaires to assess their risk appetite.   Responses to questionnaires are often a reflection of what we would like to be perceived as, rather the way we actually are.  Revisit your brokerage statements to recall your behaviour during past episodes of market stress. 
  • If you decide to invest in equities, agree to a lock in clause.  Increase allocation as confidence builds.   Have at-least a 3 year horizon if not longer. 
 Investors underappreciate their role in investing success.  Alignment of principles, understanding of self, and the right chemistry between fund manager and clients can result in magical wealth creation when combined with a good investment process and the compounding power of time.