Emotion-proof your investment decisions4 min read . Updated: 24 Oct 2017, 07:31 AM IST
A good saving and investment plan and the intent to see it through may come undone if you let emotions dictate investment decisions
Personal biases may cloud your judgement when choosing the type of investments you make, how you select them, your response to market movements and your reactions to gains and losses and other important aspects of managing your portfolio. Here are some common biases that affect the decision-making process and financial security.
When you exhibit a willingness to act on investment advice—from your tax consultant, friends or others—without evaluating their credentials to give advice on markets and investments, you are exhibiting the halo effect or bias. This could lead you to prefer the mutual fund arm of a successful bank or insurance company—without evaluating its competence in the new business—over a proven mutual fund. This effect also comes into play when you make an investment decision based on news or recent events. This means, projecting your positive impression or perceptions of a person, company or product to all activities related to them, whether or not it is justified. This bias may translate into selecting wrong investment products and services that have no place in your plans, incorrect asset allocation that is not aligned to your goals and buying and selling decisions that are not dictated by your needs, such as: increasing your allocation to equity on the back of a bull run, or pulling out completely when markets crash, without reference to your own portfolio holdings and the demands of your goals.
The optimism bias in financial matters manifests itself as a positive and upbeat outlook of how your future money matters are going to pan out. When such optimism is not supported by actions such as disciplined saving and investing for the goals or the performance of the investment portfolio, then it can be detrimental to your financial security, as it makes you underestimate the risks. For example, if you underestimate the expenses in retirement and believe that a small pension will be adequate, then by the time you accept the reality, it may be too late to rectify the situation.
Optimism may also beget over-confidence in how you manage your finances and you may believe that you have the Midas touch and anything that goes wrong is sheer bad luck and not a reflection on your skills or efficiency. Overconfidence leads you to take on higher levels of risks in your investment decisions. You may hold on to losing investments because you cannot accept that you made an error in selection. This impacts the long-term returns from your portfolio and consequently your ability to meet your goals.
While loss aversion is ingrained in all of us, when the primary driving force in making decisions related to money matters is the desire to avoid loss, even more that the potential gains possible, then you are exhibiting a behavioural bias of loss aversion. You may pay a steep price for this desire to protect yourself. The most common manifestation of this bias is holding your investible surpluses in low-return products that protect the absolute value of the capital invested and ignore the loss in real value over time with inflation and the risk to your goals. You may be jeopardizing your long-term goals as your portfolio’s returns are sub-par because of your actions.
Another erroneous investment behaviour is to ignore flashing signs that an investment is a loser and needs to be cut out of your portfolio. On the other hand, you sell winning investments and book profits because you don’t want a situation of the price going down and incurring losses. Over time, your portfolio may have more of losers as you sell off the winners.
Other detrimental emotional reaction is to hold on to an investment even when rational analysis tells you that you need to cut your losses. This bias may be exacerbated by over-confidence in your ability to forecast performance. Or, you only seek and use information that confirms your investment decisions and ignore any red flags. The most common of all biases that inhibit investment action is inertia. You take the easy way out and maintain status quo when decisions need to be taken on making investments, rebalancing, and others.
Decisions based on instincts can inhibit your investment success. Take a step back and ask yourself the basis for the decision. Unless it is backed by research-based facts and the move is aligned to your goals and their investment horizon, or for managing the risks in your portfolio, it is unwarranted and should be avoided.
Make annual goal check-ups an integral part of your financial plan. Look at hard numbers and then decide whether goals are on track and not merely on the basis of an optimistic outlook.
There are three steps to overcome this. First, acknowledge and recognise that these biases exist and how they may affect your decision-making process. Second, stop and ask yourself if an investment decision was an objective one based on factual data or an emotional response. And third, adopt disciplined strategies to emotion-proof your investment decisions.
Saving, investing and rebalancing the portfolio become objective when you have an asset allocation aligned to your investment horizon and risk and return preference. Other tools that will help keep emotional responses at bay include using systematic investment processes, rebalancing the portfolio to a schedule, having stop-loss rules to help initiate exit decisions, and quality control checks to review the performance of the portfolio. Taking professional advice is another way to keep your personal biases from impinging on your financial success.