The tendency to only invest in familiar investment instruments or sticking to losses in the belief that they will get recovered can harm your financial plan
People know that they should start saving and investing early on in their life, but often don’t because of inertia
Nawin Chandra, 43, is a Mumbai-based HR professional who steered clear of equity investment for the first decade after he started earning. Instead, he invested in what he considered tried and tested ‘safe’ investments like PPF and fixed deposits. “I had seen my parents rely on these options, so I followed suit. I thought mutual funds were riskier, so I stayed away from them," he said.
Chandra is not alone is his aversion to step out of his comfort zone and try new investment products. Many investors have the same hesitation about new or ‘risky’ investments, even though they might know better, but what drives this behaviour?
“A rational decision is made by taking all available information into account and weighing benefits and costs. But people often deviate from rational behaviour due to behavioural biases. These biases are associated with simple, intuitive ‘heuristics’," said Brishti Guha, associate professor of economics, Jawaharlal Nehru University, New Delhi. Heuristics are mental shortcuts we take to make decisions. For instance, we might trust our intuition when making certain choices as it makes the job quicker and easier.
It’s easy to believe that bad things happen only to other people. Even though we know that we’re not immune to losses, it’s much more comforting to believe otherwise, and this tendency is known as optimism bias.
“People typically underestimate the probability of experiencing anything bad. Most people think others in general—but not they themselves—are at risk of facing a tough financial situation. Of course, people are unlikely to save money for something that they don’t believe will happen to them, which prevents them from saving for a rainy day," said Aditya Jagati, behavioural economist and South Asia manager at ideas42, a non-profit firm that uses insights from behavioural sciences to address social problems.
In sharp contrast, people tend to overestimate the probability of “good" events. “We may overestimate our chances of winning a lottery as we only hear about the successes of lottery winners and not about all the other people who didn’t win," said Guha. This also falls into the category of heuristic behaviour, wherein your mind takes the shortcut to convince you that your chances of winning a lottery is high.
By underestimating the chances of making a loss and overestimating the possibility of a windfall or great returns, you might end up being underprepared for difficult financial situations.
Short-sightedness does a lot of damage when it comes to financial goals, but many are guilty of focusing much more on short-term gains than long-term ones. “Present bias refers to the tendency to favour immediate rewards. In other words, one tends to give stronger weight to payoffs that are closer to the present when considering trade-offs between two future moments," said Jagati. So, if you have a choice between an equity instrument which promises a payout of over ₹50,000 after 15 years with an investment of ₹10,000, and an FD which promises a payout of just over ₹20,000 after 10 years, you might be inclined to pick the latter.
“Too much focus on short-term gains creates constant anxiety regarding investments particularly about equity investments. Also, the bias comes with the myopic view on long-term goals. For instance, retirement corpus is often compromised for children’s education, though the latter can be paid for using an education loan," said Shilpi Johri, certified financial planner and founder of Arthashastra Consulting.
Status quo bias
One bias most of us are guilty of is status quo bias, what we otherwise just term as inertia or laziness. People know that they should start saving and investing, but don’t because of inertia. While we know that the earlier we start, the better our returns will be over the long term, we keep putting it off for later. “If effort is required to change the status quo, we tend to avoid it," said Guha, adding that the bias is magnified if there is a lot of paperwork involved. “This kind of procrastination compromises the compounding effect of investments. Lesser time of investment means lesser returns," said Johri.
However, this bias doesn’t impact only those who are yet to start off. Even those who actively invest might find themselves reluctant to switch over to other investment options. “People like to be internally consistent. Since making a switch would imply that previous decisions weren’t the right choice, we’ll avoid the change to avoid facing that inconsistency," said Jagati.
But staying put in an investment irrespective of how it performs can end up doing you just as much damage as not investing at all. It is crucial to periodically review your portfolio.
Loss aversion bias
Most people attach much more weight to losses than to equivalent gains. While they might not look at a 10% gain in equity as anything extraordinary, the same amount of loss will have them rushing to make an exit. “This is typical as money lost is always considered that hard earned money. On the other hand, gains are considered as ‘easy money’," said Amol Joshi, founder, PlanRupee Investment Services. This tendency to steer clear of the possibility of losing money is caused by loss aversion bias. “Loss aversion causes people to make less than optimal choices. We might wait too long to sell a poorly performing investment as it gives us great displeasure to make a loss," said Jagati.
“As a consequence of this bias, people do not want to take any risk on their investments, like not considering equity investments at all and confining themselves to FDs," said Johri. This was the case with Chandra. What finally made him take the plunge was the need for higher returns to secure his retirement and children’s education.
The comfort zone can be a dangerous place sometimes. As management gurus all over the world have said over and over again, if you only stick to what you know, you will miss out on a multitude of opportunities. Investors stick to well-known investments even though they see the seemingly obvious gains that diversification offers. This might result in them losing out on returns. “The way we are open to new technologies, new destinations, and new of almost anything, we should be open to new investment vehicles too," said Joshi. After Priyanka Roy, a 22-year-old software developer, started earning, she entrusted her investments to her father, but observed that he stuck to conservative products. She felt the need for a course correction, and found a financial planner. “Now I invest in mutual funds via SIPs and have learnt to tune out market noise," said Roy.
Disposition effect bias
When a stock soars, people scramble to sell and make the most of it, whereas when it plummets, people hold on, hoping to recover their losses. This stems from a tendency to label investments as good or bad, or disposition effect bias. “We tend to sell investments whose value has gone up recently even though their value is expected to go up further, while holding on to investments which have recently experienced a loss, even though this loss, too, will usually persist making us lose more," said Guha. Apart from the losses you could make, this can also make your capital gains tax add up quickly.
“Few people like to admit they are wrong. Nothing says wrong more than when you sell investment at a loss. We should just do the math, or re-visit the investment thesis. If it holds good, one may stay invested, but if it doesn’t, it’s best to exit the investment," said Joshi.
Following your gut might spell disaster when it comes to finances. “Some customers require a strategy of forced commitment to avoid any cognitive biases. Systematic investments help achieve this," said Rajiv Guha, partner, K&R Planners LLP. Doing your research, strategising and enlisting the help of an expert can help you avoid succumbing to a bias.