Opinion: The key to ride choppy markets is sticking to logic4 min read . Updated: 20 Nov 2018, 08:07 AM IST
Building one's own conviction before the market will be a sure- shot way of being ahead of the herd
Ramesh called and I sensed an urgency in his voice. So, we fixed up to meet over coffee and the conversation warmed up quickly. Ramesh was an aggressive advisor and a great believer in the Indian economic story. Through 2017 and 2018, he advised clients to bet big on mid-cap and small-cap funds. I was on the other side of the fence, moving clients out of long-term investments in mid-caps to safety. Ramesh wanted to know why a life-long investor was taking such a defensive stance. He genuinely believed the long-term track record of mid-cap schemes was sustainable. The charts looked eye popping and compelling. But, I was the sore thumb in his scheme of things and my dissent bothered him. “ How can you talk against mid-caps? The five-year record looks great and you made most of your wealth in that space." He was clearly going after a change of heart on my part. But conviction is not supposed to work that way. While he tried very hard to convince me, I clearly decided that I was not going to convince him out of his position. But I would place my points clearly, so he appreciated why.
Ramesh was only doing what most of us do. He was seeking support. He believes that with the right support to an idea, his idea would play out perfectly. This belief is quite normal and many of us tend to think so. When you are deeply convinced about something, you seek peer validation as a natural extension. When more people agree, you believe the prospect of being right increases. But reality may be different. The nature of the person whose validation you seek matters. And, merely going about adding numbers may not count for much. On the contrary, there are serious reasons to believe in your own conviction and stick to it.
Your conviction is based on your in-built biases and own logic. This may be very different from the conviction of others. Their conviction is built on their own biases and logic. Yet, most of us labour to get others to agree with us. The moment we try to get others to agree, their natural instinct would be to pick holes in our argument. This tendency is resident and visible in every investor. Rarely can an investor listen to the logic and biases of peers with an open mind. The urge to judge is so high that we tend to judge even as we hear the other person out. Yet, we actively seek to be judged and volunteer to judge others. We often find investors seeking peer ideas and quickly go about finding as many faults as possible. This can cause serious divisions among peers. So one needs to devise a sensible approach to peer validation and sharing. Peers need to share ideas freely and still let each other be the best judge.
I laid out my reasons before Ramesh. First, investment flows had played havoc with mid-cap valuations. Stocks were bought at very high valuations because of heavy inflows. That itself made return generation in mid-caps next to impossible. Second, the stock universe was not broad enough and too much money chased too few stocks. Third, mid-caps were arranged along themes which are cyclical and could face headwinds. As one theme after another loses sheen, stocks would take a beating. We saw this in non-banking finance company (NBFC) and housing finance company (HFC) stocks, the recent market darlings. Fourth, redemptions always happen in mutual funds exactly at the wrong time. And, if they happen soon, then impact costs will be significant as buyers will run scared when stock prices fall. Fifth, most retail investors do not have the risk appetite that midcap investing demands. They simply can’t see near-term erosion of 25-30% in their portfolios and sit patiently through that phase. So, while they initially average down aggressively, once valuations dip below a tipping point, investors lose conviction and exit hurriedly. I believed that when such exits happen in mid-cap funds, those who stay invested end up losing even more. The reason is funds sell the more liquid stocks to meet redemptions and the portfolio quality only becomes poorer. For such a portfolio to redeem itself, it may take much longer.
I laid out my conviction before Ramesh knowing fully well that he would not be convinced. But, I had played my part freely and fairly. We decided to let time be the best judge of our investment hypotheses and closed the discussion.
The coming months will see market preferences shift significantly. A new year will bring up fresh institutional thinking and advisors will hear new investment themes from fund houses. Building one’s own conviction before the market will be a sure- shot way of being ahead of the herd. A good advisor would do just that to keep his clients safe and strong.
Shyam Sekhar is chief ideator and founder, iThought