Wednesday, October 8, 2014

BEHAVIOURAL EDGE- In Investing


(An Extract from Multi-Act Equity Consultancy P Ltd’s newsletter)

 Back to the basics: Finding your “edge” as an investor.
There are 3 key elements that give an “edge” to an investor over other market participants–Information, Process & Behaviour.
Information edge is the possession of more information about a company quicker than others either by meeting management, through channel checks, meeting suppliers, customers and competitors, etc. This does not necessarily mean inside information.
There are 4 issues with trying to develop solely an information edge –
1. It is difficult to replicate over time as it depends on the availability of “differentiated” information.
2. What one sees as information may in fact be “noise” and could have already been incorporated in the structure of prices 3. Technology has helped bring down both the cost and time to gather information; which is in many cases, widely disseminated over the internet and hence has led to a diminishing information edge: and
4. Regulators and companies are more sensitive about ensuring a level playing field between institutional and retail investors in getting the relevant information in the public domain as quickly as possible.
Behavioural edge is when an investor is able to control his emotions by eschewing either greed or fear and is conversely able to exploit these twin emotions of other market participants in his favour.
We believe a behavioural edge can be more easily developed by having a sound investment process and having the confidence to follow that investment process. We believe a “process driven” behavioural” edge that benefits from the mood swings of market participants is a sustainable edge as (study and observation of)  human behaviour has been ingrained in our DNA, our “wiring” as Buffett calls out, over millions of years.

Markets movements have an uncanny ability to distort the vision of an investor. In a bull market as market prices go up, the downside risk keeps getting blurred and there arrives a point at which the only parameter visible to the investor is the upside potential. In the current market, certain pockets (especially in the cyclical space) have reached a point where investors seem to be completely driven by the potential upside and are willing to fully factor positive outcomes into the future, while completely ignoring the probability of a negative outcome which could prove to be a much bigger risk on the downside. We feel it is extremely difficult, if not impossible, to predict a particular outcome based on a particular narrative (for example in the current context that economic growth will revive) that sounds plausible but has uncertain implications for market process of specific companies. A process driven investment approach therefore, can help an investor avoid behavioural traps, have a clearer roadmap as to what action to take and thus on average take more correct than incorrect decisions.

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