Experience Matters, So Invest Small Amounts and Learn From Mistakes
MAS Team | 15 July 2013
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Older investors are far more skilled than younger ones, because of experience and learning from mistakes. What do you need to do to learn better?

We all make mistakes while investing and we are all very overconfident that we can overcome the mistake the “next time”. But unless we make a determined and systematic effort, few of us can naturally overcome our mistakes. Another point is, there is no substitute for experience. It is only with repeated mistakes learnt over a long period of time that we can improve our investing process. A paper titled “Getting Better: Learning to Invest in an Emerging Stock Market?” has used Indian stock market data to arrive at these interesting findings. The paper, authored by John Y Campbell, Tarun Ramadorai, and Benjamin Ranish, cites investor biases and factors which affect experienced investors much less.
 

The authors found that investment performance improves as one grows older. Secondly, the paper found that older accounts, i.e., people who have invested in the market for a long time, have made profitable asset allocations, particularly towards value stocks and stocks, with low turnover. Moreover, investors under-diversify instead of re-balancing portfolios over the long period of time. Only with experience do they improve.
 

Thirdly, two of the three potentially harmful investment behaviours, namely, high turnover and the disposition effects, are less prevalent among older accounts (the first being under-diversification, as explained above). Long term investors are well aware about the impact of fees and transaction costs in long-term wealth generation. They are careful not to keep buying and selling, because transaction costs and losses eventually eats into returns. Many inexperienced investors panic, and eventually under-diversify or stick to losing investments, or simply jump on to fads with high turnover.
 

The third bias, namely disposition effect, is when an inexperienced investor sells his shares when the price has increased, but overall assets have lost in value. For example, there are two stocks—A and B—of which A is making money and B’s price is going down. However, an investor has more money in B than A, yet he sells A but does not sell B. In other words, he is clinging on to his losing investment and selling (perhaps) too soon on his winning investment. Overall, he does not make money. However, experienced investors learn from this mistake and slowly start training themselves to get rid of losing investments while letting their winning investments make money.
 

Fourth, according to the paper, all three investment behaviours—under-diversification, high turnover and disposition effect—diminish in response to painful experiences. In other words, investors slowly learn and become better. The paper finally stated: “Putting these results together, investors appear to learn from stock market participation, at a rate that is influenced by their investment experiences.”  Furthermore, the paper states: “Indian stocks held by experienced, well diversified, low-turnover and low-disposition-bias investors deliver higher average returns even controlling for a standard set of stock-level characteristics.”
 

Now, it is not easy for novice investors to control their enthusiasm, brace themselves for mistakes and learn slowly even after reading this. So what should they do? One, write down every investment made with reasons and two, make really small investments. The second will prevent them from getting wiped out and/or get discouraged by equities. And the first will at least be a source of great entertainment a few years later.