If you think you are behaving appropriately with your money, you are (most) probably wrong.
Given the way our brains are wired, it is almost impossible not to let your 'emotions overpower reason'. As such, it is almost impossible not to make the most obvious mistakes.
And, this reflects in many of our day-to-day money matters too.
End Result: Wrong investment decisions.
In the academic circle, this is known as Behavioural Economics or Behavioural Finance.
You will often come across these terms: Anchoring, Mental Accounting, Confirmation Bias, Hindsight Bias, Gambler's Fallacy, Herd Mentality, Prospects Theory, Availability Bias and much more.
However, for simplicity sake, I have excluded all these high-sounding terms from my discussion.
As I have often advised... Keep Things Simple.
So let's look at some of the common examples, of (mis)guided actions in our personal finances and investments.
Example 1
Deepak has Rs.4 lakhs @9% p.a. in a fixed deposit. He is also servicing a 3-year personal loan of Rs.4 lakhs @15% p.a. taken for his sister’s marriage.
His one pocket is earning Rs.36,000 per year. But the other pocket is losing Rs.60,000 per year.
'Logically' it makes ample sense to prepay the loan using the FD amount.
Let's look at it differently.
If Deepak continues with his FD and Loan running simultaneously, after 3 years his loan would be fully repaid and his FD would be worth around Rs.5.20 lakhs.
Alternatively, let's say he immediately prepays the Loan. And, the amount equivalent to the EMI every month (i.e. Rs.13,866), is invested in a Recurring Deposit @9%. Thus, after 3 years his RD would be worth around Rs.5.70 lakhs.
So, by behaving 'illogically', Deepak stands to lose Rs.50,000.
However, having money in a fixed deposit is of great psychological comfort. Hence, this irrational behaviour. I am sure you too will feel jittery if you had to zero your FD. It is a herculean task to overpower the emotions and take decisions based purely on reason. [By the way, I know many Deepaks who are sailing in the same (illogical) boat.]
Wrong comfort zone! Wrong investment decision!
Example 2
Mr. Tandon is a so-called 'intelligent investor'. As common sense dictates, he always buys low and sells high. He has got his investment basics right.
Therefore, he tracks the stocks that have hit the 52-week low or the 52-week high. Accordingly, he buys the stocks that have hit the lows; and sells those that have hit the highs.
Contrary to his expectations, Mr. Tandon has not made any money. The buy-low sell-high strategy is not working for him.
Problem?
Choice of an "arbitrary" reference point, which has no relation whatsoever to how the stocks are likely to perform going forward!
Like many others, he wrongly presumes the 52-week high price to be some sort of "ceiling"; and the 52-week low price as some sort of "floor".
And this is where Mr. Tandon has got his logic wrong... he has chosen a wrong fact.
It is quite possible that the stock has soared to its 52-week high, as the company has made an important discovery. This is likely to add super-normal profits to its bottom-line. As such, its stock may hit many new peaks over the next few years. So, it is wrong to sell the stock even at 52-week high.
Or, the stock has dropped to its 52-week low, because it has lost an important customer. This is likely to further erode its customer-base. As such, its stock may make many new lows going forward. So, it is wrong to buy the stock at its 52-week low.
In short, there is no reason whatsoever that share prices should adhere to calendars. Therefore, our fixation with 52-week prices as a reference point, is totally illogical. Rather, we should be focusing on the company's business prospects.
Wrong reference point! Wrong investment decision!
Example 3
Ajay is extremely happy with his investment in 'Mutual Fund ABC'. In last 5 years, it has given him average 19% p.a. returns. He had started this investment to accumulate the down-payment required to buy a house. He has successfully met this target. In fact, he has some extra money left over, with which he can also buy a new car.
Moreover, his fund has beaten the index by around 5%, which has gone up by 14% p.a. only during the same period.
But his excitement is short-lived. He discovers that his friend Rahul has made 22% p.a. in 'Mutual Fund XYZ'.
Beware!
It is impossible to predict the top performing funds. Moreover, (unless we are a fund manager) becoming the "best investor" in town is not our objective. Instead, we have to invest, keeping our needs and desires in the mind.
Ajay has not only made good returns, but also comfortably met his objective. Therefore, he should remain happy with his investment. If he gets disheartened by other peoples' returns, he is likely to end up making wrong investment choices.
Wrong comparison! Wrong investment decision!
Example 4
If you analyze the stocks' portfolio of a large number of investors, you will notice two clear trends:
a) There are very few multi-baggers
b) There are quite a few failed stocks.
Why?
Because, people hate losing money. Therefore, if the stocks they buy depreciate, they prefer to hold on rather than taking a hit. They fondly hope and fervently pray for the price to recover. Even a break-even price would satisfy them. There is a clear aversion to book losses.
Instead, if they booked losses "early" and moved to better stocks, they would probably end up with far better results.
Similarly, when the stocks appreciate, they become extremely anxious to book profits. A fear always lurks at the back of the mind, that the markets might correct and they may lose the gains they are presently sitting on. This tendency to sell early, leaves little opportunity to own stocks, that may go on to become say ten-baggers.
Wrong timing! Wrong investment decision!
These, and many such instances, clearly prove that humans are not an intelligent species (as they so believe). 'Emotional fools' would describe them better than 'rational beings'.
Remember how companies are shaping your behaviour — Flipkart ya Amazon pe khareed. OLX ya Quikr pe bech de. — to make "more and more" profits for themselves?
Given the way our brains are wired, it is almost impossible not to let your 'emotions overpower reason'. As such, it is almost impossible not to make the most obvious mistakes.
And, this reflects in many of our day-to-day money matters too.
End Result: Wrong investment decisions.
In the academic circle, this is known as Behavioural Economics or Behavioural Finance.
You will often come across these terms: Anchoring, Mental Accounting, Confirmation Bias, Hindsight Bias, Gambler's Fallacy, Herd Mentality, Prospects Theory, Availability Bias and much more.
However, for simplicity sake, I have excluded all these high-sounding terms from my discussion.
As I have often advised... Keep Things Simple.
So let's look at some of the common examples, of (mis)guided actions in our personal finances and investments.
Example 1
Deepak has Rs.4 lakhs @9% p.a. in a fixed deposit. He is also servicing a 3-year personal loan of Rs.4 lakhs @15% p.a. taken for his sister’s marriage.
His one pocket is earning Rs.36,000 per year. But the other pocket is losing Rs.60,000 per year.
'Logically' it makes ample sense to prepay the loan using the FD amount.
Let's look at it differently.
If Deepak continues with his FD and Loan running simultaneously, after 3 years his loan would be fully repaid and his FD would be worth around Rs.5.20 lakhs.
Alternatively, let's say he immediately prepays the Loan. And, the amount equivalent to the EMI every month (i.e. Rs.13,866), is invested in a Recurring Deposit @9%. Thus, after 3 years his RD would be worth around Rs.5.70 lakhs.
So, by behaving 'illogically', Deepak stands to lose Rs.50,000.
However, having money in a fixed deposit is of great psychological comfort. Hence, this irrational behaviour. I am sure you too will feel jittery if you had to zero your FD. It is a herculean task to overpower the emotions and take decisions based purely on reason. [By the way, I know many Deepaks who are sailing in the same (illogical) boat.]
Wrong comfort zone! Wrong investment decision!
 |
| Are you destroying your wealth through irrational and emotional behaviour? |
Example 2
Mr. Tandon is a so-called 'intelligent investor'. As common sense dictates, he always buys low and sells high. He has got his investment basics right.
Therefore, he tracks the stocks that have hit the 52-week low or the 52-week high. Accordingly, he buys the stocks that have hit the lows; and sells those that have hit the highs.
Contrary to his expectations, Mr. Tandon has not made any money. The buy-low sell-high strategy is not working for him.
Problem?
Choice of an "arbitrary" reference point, which has no relation whatsoever to how the stocks are likely to perform going forward!
Like many others, he wrongly presumes the 52-week high price to be some sort of "ceiling"; and the 52-week low price as some sort of "floor".
And this is where Mr. Tandon has got his logic wrong... he has chosen a wrong fact.
It is quite possible that the stock has soared to its 52-week high, as the company has made an important discovery. This is likely to add super-normal profits to its bottom-line. As such, its stock may hit many new peaks over the next few years. So, it is wrong to sell the stock even at 52-week high.
Or, the stock has dropped to its 52-week low, because it has lost an important customer. This is likely to further erode its customer-base. As such, its stock may make many new lows going forward. So, it is wrong to buy the stock at its 52-week low.
In short, there is no reason whatsoever that share prices should adhere to calendars. Therefore, our fixation with 52-week prices as a reference point, is totally illogical. Rather, we should be focusing on the company's business prospects.
Wrong reference point! Wrong investment decision!
Example 3
Ajay is extremely happy with his investment in 'Mutual Fund ABC'. In last 5 years, it has given him average 19% p.a. returns. He had started this investment to accumulate the down-payment required to buy a house. He has successfully met this target. In fact, he has some extra money left over, with which he can also buy a new car.
Moreover, his fund has beaten the index by around 5%, which has gone up by 14% p.a. only during the same period.
But his excitement is short-lived. He discovers that his friend Rahul has made 22% p.a. in 'Mutual Fund XYZ'.
Beware!
It is impossible to predict the top performing funds. Moreover, (unless we are a fund manager) becoming the "best investor" in town is not our objective. Instead, we have to invest, keeping our needs and desires in the mind.
Ajay has not only made good returns, but also comfortably met his objective. Therefore, he should remain happy with his investment. If he gets disheartened by other peoples' returns, he is likely to end up making wrong investment choices.
Wrong comparison! Wrong investment decision!
Example 4
If you analyze the stocks' portfolio of a large number of investors, you will notice two clear trends:
a) There are very few multi-baggers
b) There are quite a few failed stocks.
Why?
Because, people hate losing money. Therefore, if the stocks they buy depreciate, they prefer to hold on rather than taking a hit. They fondly hope and fervently pray for the price to recover. Even a break-even price would satisfy them. There is a clear aversion to book losses.
Instead, if they booked losses "early" and moved to better stocks, they would probably end up with far better results.
Similarly, when the stocks appreciate, they become extremely anxious to book profits. A fear always lurks at the back of the mind, that the markets might correct and they may lose the gains they are presently sitting on. This tendency to sell early, leaves little opportunity to own stocks, that may go on to become say ten-baggers.
Wrong timing! Wrong investment decision!
These, and many such instances, clearly prove that humans are not an intelligent species (as they so believe). 'Emotional fools' would describe them better than 'rational beings'.
Remember how companies are shaping your behaviour — Flipkart ya Amazon pe khareed. OLX ya Quikr pe bech de. — to make "more and more" profits for themselves?
