Behavioural economics and your investment decision
Common wisdom suggests that people make rational decisions on their investments to maximize their benefits. Although it is true for a shorter period, in a longer duration they fail to stand true. Most of the times, you invest based on your emotions and then try to justify it, logically. The two most strong emotions on which investors work are greed and fear. It has been well-researched and documented that these two emotions have led investors to make inefficient investing decisions that have proved to be detrimental in the long run. According to a study done by Dalbar Inc, in 20 years from 1993-2012, the average mutual fund investor in the US underperformed their broader equity indices, S&P 500 by 3.96 per cent. S&P 500 index on an average gained by 8.21 per cent compared to only 4.25 per cent of annual gain by the retail investors.
Besides the expense ratio, what led to such underperformance is investor’s themselves and their irrational behaviour. Investors chase performance (greed) and buy when the market is up, and they panic and sell when the market is down (fear).
How can you overcome your emotional traps!
Recency bias: The most recent results dominate our decisions. Therefore, if a fund is outperforming its category or market, it looks more attractive to us for investment. Nevertheless, in this everchanging world, past returns do go in predicting future returns.
Overconfidence: Many of you might be confident about predicting the short-term market movements and hence want to time the market. However, predicting short-term market movement consistently cannot be done even by professionals.
Loss aversion: Experiments have shown that the loss of Rs. 100 inflicts a pain that is twice the enjoyment that we get if we gain Rs. 100. Hence, many investors are fast enough to lock their profits but avoid booking loss. It's better to book your losses early and let your winning position gain some more.
Mental accounting: Most of us treat money based on their source. So, if you get an IT refund you will treat it differently from the money you get in the form of salary. Similarly, in some of the cases, you spend more to recover your sunk cost. Whatever the source of money, you should invest wisely, and sunk cost should not form part of your future decision.
Anchoring: Sometimes investors cling to their old beliefs and facts without taking much efforts to re-check them as they may have changed. For example, you invest in a fund and wait for it to reach a certain level to sell. Hence, it is always better to take a second opinion and take necessary action regarding your investments.