Rule-based investing

Individuals typically take their investment decisions based on affect or emotions. This article shows why a rule-based system is optimal and explains how to create an such an easy-to-manage system.

Last week, we discussed why it is important to stay invested in equity even during market downturns. We stated that investors would do well to apply a rule-based approach to investing and taking profits to moderate the pain and regret caused due to market volatility. In response to the article, we received several queries from readers who wanted to know how to set up such a rule-based system.

This article briefly discusses the advantages of a rule-based system. It then shows how to set up such a system as part of the satellite portfolio to capture short-term asset price movements.

Why rules?

Investors typically focus on returns while professional traders focus on managing risk. Managing risk predominantly requires managing emotions, especially regret and fear. Consider investors who suffered large losses in 2008. Many have either significantly cut their equity exposure due to the pain caused by the losses or have created aggressive positions in the hope of recovering such losses. Both decisions appear sub-optimal.

A rule-based system can help such investors for two reasons. One, using judgment could lead to sub-optimal decisions, as investors are typically biased by the outcomes of their past decisions. An investor who bought Reliance Industries in September and lost money would be reluctant to buy the stock again in December even if it shows signs of moving up. Two, judgment-based trading requires market-timing skills. And not all investors can boast of possessing such skills. Moreover, market timers who are successful are those who manage their risks efficiently. Non-professional traders typically suffer from loss-aversion effect — the tendency to hold on to their losses for too long. A rule-based system prompts investors to initiate trades based on some pre-determined rules, removing emotions from the investment decision. The question is: How to create an easy-to-manage rule-based system?

What rules?

Investors can combine systematic investment plan (SIP) with a systematic withdrawal plan (SWP). The strategy should be applied on individual shares and ETFs, not on mutual fund units.

The process is as follows: First, create an investable universe. These are stocks and ETFs on which investors would eventually set up the SIP and SWP. We prefer to trade on ETFs such as Nifty, Junior Nifty and Bank Nifty.

Second, decide the amount to be invested each month. Assuming a three-asset-class portfolio consisting of stocks, bonds and gold, individuals can set aside 25 per cent of the proposed yearly investment for rule-based trading. The monthly SIP would require one-twelfth of the proposed investment. Third, to further capture short-term volatility in the market, investors can split the monthly investment into three SIPs falling on, say, 5th, 15th and 25th of the month. An amount-based SIP would ensure that the investment is within the desired allocation limits. Fourth, investors should decide on the minimum return required on the investment. Suppose an investor requires 5 per cent return, the SWP should be triggered when the investment has generated 5 per cent of unrealised gains. Fifth, profits from the rule-based approach should be transferred to the core portfolio to buy either core equity or bonds. That way, the investor harvests short-term profits to move towards long-term investment objective.

Conclusion

Individuals typically take their investment decisions based on effect or emotions. A rule-based system provides a disciplined approach to trading. Importantly, it removes the urge to buy a stock based on excitement about a possible upside or to sell a stock on reaction to negative information. We would have preferred to apply an incremental-sale approach on the SWP. That is, if the investor's required return is 5 per cent, she would sell 50 per cent of her holdings at 5 per cent profits, 25 per cent at 7.5 per cent profits and likewise. But an incremental-sale approach complicates the application of the strategy. Our objective is to keep the strategy simple and effective for investors to use. In line with this objective, the strategy, which is part of the satellite portfolio, should be applied to not more than five stocks and/or ETFs.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com.)

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