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NEW DELHI: Arun Kumar, head of research, FundsIndia, feels biases, such as that for authority, have a significant impact on investors in a bull market. According to him, asset allocation is the key to overcoming greed, fear and overconfidence which are common during a bull market. 

Edited excerpts from his interview with Mint:

In today's market conditions, what are you observing when it comes to investment patterns and investor mindset?

Based on behavioral patterns, at the current juncture we are seeing four broad categories of investors.

The first group of investors are those who sold their investments when the market fell in early 2020 and have not yet re-entered the market.

The second comprises those who did not exit their investments during the fall in early 2020, but wrongly anticipating an impending crash they exited after the market recovered a bit in mid 2020.

Both these categories of investors are facing the same problem of not knowing when to deploy their money back into the market. This is because they are constantly worried that the market will crash and are waiting for a crash to re-enter. However, the ‘crash’ that they are anticipating is not taking place leaving them confused.

The third group of investors is completely different from the above two categories. This group of investors who had excess money due to lower expenses and more savings during the lockdown, invested aggressively in the equity markets. They made great returns by remaining invested for the past 18 months. Further, low returns from fixed deposit and debt funds, are making them question if they require such fixed income instruments and they wish to increase their equity allocation.

The fourth category is those investors who focused on their goals and maintained a disciplined asset allocation strategy. Over the last 18 months they have simply rebalanced their portfolios and stayed true to their original plan.

What are the behavioural biases that are holding back investors from creating long term wealth?

In my opinion in a bull market, there are two common behavioral biases that play a major role in investment decisions taken by investors.

First is the authority bias. This bias says that subconsciously most of us have a natural tendency to be influenced by the opinion of some authority. This obedience to authority may work well as a shortcut, because for us to experiment and figure out what is right can be very time consuming. However, this may backfire when it comes to investing. This is because of a variety of people and sources having different opinions. In a bull market, there is no dearth of experts and media predicting a crash and giving advice to exit investments. So investors must take a step back and ask themselves if they can name 5 people who have consistently for a period of 5 to 10 years, exited their equity investments before a market crash and entered back at the right time. Investors will struggle to answer this question and as a matter of fact, hardly anyone manages to time the market or make consistently right predictions.

And what is the second bias or limitation that impacts investors in a bull market?

The second bias is called the anchoring bias. Typically in a bull market, whenever the market hits an all-time high, there is an intuitive feeling that maybe the market is going to fall as you are still anchored to the previous highs from where the market fell last time. Now if you really think through it, any asset class that grows will eventually have to hit an all-time high. For example, the Sensex which is at 55000 levels today, will eventually touch 1,00,000 and continue to go higher as long as earnings keep growing. Thus, for any growing asset class, it is inevitable that there will be a lot of all-time highs at different points. So while there are temporary drops, the market recovers and an investor who is looking at long term investing need not worry about all time highs.

In a bull market the other common emotions that come into play are - envy, greed and overconfidence. All of these result in an investor taking more risk than he/she can actually digest.

What can investors do to overcome the authority bias, anchoring bias and fear?

Most investors think that they must completely avoid a bear market in order to make good returns over the long run. But if you really look at data of the equity market, you will see that long term returns are made despite corrections. An investor should look at investing as a marathon where they take two steps forward and one step backward. While it is difficult to predict when the market will fall and how much it will fall, it is easier when one accepts that one step back is the small fee to be paid for long term returns.

The starting point is to have an asset allocation at a level where you can manage the equity volatility of 10-20% temporary declines every year and 30-60% temporary declines once every 8 to 10 years. Based on the extent of downturns you are willing to tolerate, the percentage of equity allocation can be decided. The simple tradeoff being - the more pain you can tolerate in the short term the higher the odds of better long-term returns.

A good way to approach a bull market resist the temptation to drastically change asset allocation. The equity allocation can be rebalanced back to the original allocation if there is a deviation of +/-5%. Whenever there is a temptation to exit equity exposure due to fear or increase disproportionately due to greed, the original equity allocation can act as a guide to quantify these emotions.

Once you have taken care of your asset allocation and put in place a regular rebalancing mechanism, your greed and fear will automatically be in check.

You can hear the entire interview here.

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