On a cold January day, a 43-year-old man was sworn in as the chief executive of his country. His predecessor was a famous general who, 15 years earlier, had commanded his nation’s armed forces in a war that resulted in the defeat of Germany. The young leader was raised in the Roman Catholic faith.
Who am I describing?
If you have read Simon Sinek’s book, Start With Why, you will know the answer to the question, because I lifted this example from the very first chapter.
There are two perfectly correct answers - John Kennedy and Adolf Hitler.
Now, if I had given you at least ONE more fact, the answer would change.
Each of these four facts point to Kennedy alone.
- The predecessor was Dwight Eisenhower.
- The swearing-in ceremony took place on January 20, 1961.
- He had a 3-year old daughter at that time.
- The individual was American.
Each of these four facts point to Hitler alone.
- The predecessor was Kurt von Schleicher, the last Chancellor of the Weimar Republic.
- The swearing-in took place on January 30, 1933.
- Brought up as a Catholic, he grew up to hate Judaism and loathe Christianity.
- He was vegetarian.
Don’t assume that you always have the right answers. Your assumption may be right or wrong. But to be accurate, you need more facts.
Think about this in investing. We make assumptions all the time, and pompously believe that we are right. Which is perfectly fine, but the damage done to your portfolio can be brutal.
We assume that past performance of a mutual fund can be extrapolated into the future. No matter how often we parrot “past performance is not indicative of future returns”, there is the urge to ignore it. And investors pile into the latest theme or the best performing fund, only to cry foul later.
I am currently looking at a technology sector fund that has a 1-year return of over 100%. Who would not want such a return? But if you dig deeper, the volatility is evident. It was a top quartile performer in 2020 and is now the best performer when looking at YTD returns (year to date). But, in 2019 it found a place in the bottom quartile.
We assume a “safe stock” can be ignored. Take Exide Industries. Investors holding the stock would have experienced a 10-year CAGR of 1%. A decade ago the business had very good growth and high margins. Watchful investors would have made note of the margins falling and the growth declining, and the unrelated diversification into insurance.
A stock can languish for years on end. HUL barely moved during the market run-up (2003-2008), Nestle was more or less static (1999-2004), RIL too (2010-2018), and pharma stocks largely underperformed during the 2015-2019 period. ITC has not climbed much from 2016. Would you just make assumptions and react accordingly, or would you dig deeper?
We assume the market is going to fall. So we stay in cash. But the crash is nowhere in sight, and meanwhile our money lies in a savings account. Or, we assume that the bull run will last a long time; so tank up on stocks – valuations and asset allocation be damned.
Can you see the impact our assumptions have on our decisions? Which in turn, impact our finances?
Make smarter decisions by questioning your assumptions.
In a quote that has been attributed to Einstein, he reckoned that if he had an hour to solve a problem and his life depended on it, he would spend the first 55 minutes making sure he was answering the right question.
Our behaviour is a cocktail of assumptions, biases and perceived truths. We make decisions based on what we "think we know". Challenge the validity of your assumption by asking some questions.
- Assumption: The market is going to fall.
- Questions: Do you know when? Have you had consistent success predicting bear and bull markets? Did you predict such a spectacular recovery after the savage plunge of March 2020? Did you predict a global collapse in 2008?
- Instead of being reactive, control the narrative: Ok, so the market will fall. That is how markets move – up and down. So why is this bothering me?
When emotion rules, facts take a backseat. Control your emotions by examining the facts.
- Assumption: This fund has topped the performance chart and it will make investors rich.
- Questions: Why is it a chart topper? Is it just two or three stocks in its portfolio that are currently on a market high? How has it performed over the years? Does the fund manager maintain a very focused portfolio, and are you comfortable with that? Is it a good fit in your portfolio or will you be duplicating the type of fund?
- Instead of being reactive, control the narrative: How are the other funds in my portfolio doing? If they are consistently taking me to my goal of wealth creation, do I really need to run after this fund? What if this fund collapses next year, how will I feel about that?
The questions you ask will differ whether it is a stock you are evaluating or a fund or the market as a whole. But eventually, you must answer these two:
- Will my decision to act take me closer to achieving my goal of wealth creation or put my money are greater risk?
- If this is what I believe, on what am I basing my confidence?
By doing so, you create friction between the narrative you are buying into and actually acting upon it. Your portfolio will thank you later.
Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.