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Australian cricketer-turned-commentator Dean Jones, in an interview for Wisden, observed that two-thirds of Sachin Tendulkar’s game is based around defence. Most of the shots in any Sachin century, he says, are based on forward defence, back-foot defence and letting the ball go. As any coach would vouch, letting the ball go is possibly as important as hitting good shots in the career of a batsman. In this essay, with analogies from the world of sports, we discuss why inaction is just as important a strategy in the world of investing as action.

In the investing world there are huge incentives to make correct decisions. No wonder it attracts among the smartest and brightest people who are well versed with the most complex statistical and valuation models. The modern information economy is constantly throwing out gigabytes of data, coaxing the receiver of this information to react. The institutional imperative for professional investors as recipients of the information stimuli is typically to react by trading in the markets. Over the years, automation and algorithms have significantly made it easier and faster to execute trades.

The outcome of all this is a market where sell-side analysts, incentivized by the number of right calls they make, are constantly nudging their buy-side clients to trade. For the 30 stocks in the popular Sensex index, the average research coverage per stock is 55 analysts. Between them, they made as many as 848 cumulative rating changes (either an upgrade or a downgrade in the research recommendation) in 2013. As an example, take Cipla, a healthcare stock, which is covered by 50 sell-side research analysts. It had 42 rating changes during the year 2013. In short, a portfolio manager would have received 42 calls to act on (buy or sell) Cipla in one year.

The buy-side managers succumb to the noise generated from various quarters, forgetting that bigger contributors of portfolio returns are factors such as bet sizes (portfolio construction) and the magnitude of returns generated therefrom rather than the frequency of right calls in the market. This is reflected in higher portfolio churn ratios, or in other words, shorter holding period of stocks in the portfolio. In fact, the median holding period of the top 100 stocks by market capitalization in the US has shrunk by one-third from about 600 days to 200 days over the last two decades.

Behavioural science uses the term action bias to explain such behaviour. Action bias is the tendency in uncertain circumstances to choose action over inaction, no matter how counterproductive it might be. It is the strong urge to act, despite the fact that an objective analysis of past action might repeatedly prove that the action did not produce the desired results.

In an interesting research paper, Michael Bar-Eli, et al, analysed 286 penalty kicks in top soccer leagues and championships worldwide. In a penalty kick, the ball takes approximately 0.2 seconds to reach the goal, leaving no time for the goalkeeper to see clearly the direction the ball is kicked. He has to decide whether to jump to one of the sides or to stay in the centre at about the same time as the kicker chooses where to direct the ball. About 80% of penalty kicks resulted in a goal being scored, which emphasizes the importance a penalty kick has to determine the outcome of a game.

Interestingly, the data revealed that the optimal strategy for the goalkeeper is to stay in the centre of the goal. However, almost always he jumped left or right. In short, goalkeepers choose action (jumping to one of the sides) rather than inaction (staying in the centre). If the goalkeeper stays in the centre and a goal is scored, it looks as if he did not do anything to stop the ball. The goalkeeper clearly feels lesser regret, and risk to his career, if he jumps on either side, even though it may result in a goal being scored.

Just like the goalkeeper, an investment professional too feels compelled to play every trade that is out there in the market. In most cases either the event is already priced in or it just does not play out in line with the popular belief. Despite data proving that frequent trading might be counterproductive, the norm is always to act. Action seems to always triumph inaction.

So the next time you feel compelled to place a trade in the market, remember sitting around and doing nothing may just be a better option. After all as Warren Buffett says, benign neglect, bordering on sloth, remains the hallmark of his investment process.

Amay Hattangadi and Swanand Kelkar are portfolio managers with Morgan Stanley Investment Management. These are their personal views.

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