Money Disorders & You
The investments we make are often ‘coloured’ by the bias that we have in our mind. And there are various kinds of biases that often work as stumbling blocks to taking the right decisions. The article explains each such bias in order to help you work on your investments with clarity of sense and purpose
Consider this case study: Ranbir Desai stays with his wife, Alia, and their three children in Mumbai. He always felt that his house was too small for his family. So he went to a priest and asked for advice. The priest advised him to invite his distant relatives. Although the advice seemed absurd and annoying, yet since it had been given by a sage, he followed it and did what was suggested. A week later Ranbir again approached the priest and complained how the suggestion had made the situation worse for him and was now intolerable. Ask them to leave, instructed the priest. Once again he followed the instruction religiously, and suddenly the house felt big. Nothing had materially changed but he was now relieved and happier. Why do we behave in such a way? The priest explained to him the decision-making process and how it can be improved if it is flawed.
Understanding Human Behaviour
The easy answer to this question is that forces of evolution have designed us to behave this way. Through years of evolution, our brain has learned some tasks to perform without much effort such as recognition of facial expression, which helps us to understand if someone is happy, sad or angry. This capability of the human brain is hardwired as it helps us to make decision quickly. But not everything that is hardwired or seems natural is useful. Our brain has failed to evolve with the same speed with which our environment has changed.
And therefore, sometimes the way we behave might hurt us and we are subject to cognitive biases. Our brain then fails to perform in a perfect way. This often leads to drawing incorrect conclusions, based on an ill-conceived heuristic to make bad decisions. Such disorders occur in money management also and are common enough among investors. In the following paragraphs, we will list them and try to clear the air around them so that you make informed decisions.
Hindsight Bias
Hindsight bias in most simple terms can be explained in five words, ‘I knew it all along’. It is a bias which leads investors to overestimate their predictive abilities. After an event has taken place, people suffering from hindsight bias tend to think that the event was perfectly predictable even if it would not have been so. One of the recent examples is the great financial crash (GFC) of the year 2008. Many economists and market participants thought it was bound to happen given the excess built in the system. Nonetheless, very few could avoid the losses that they suffered during the GFC. The reason behind such bias is the lack of a perfect memory of humans. Instead, they tend to ‘fill in the gaps’ with what they prefer to believe.
At a particular point of time, there could have been many possibilities or outcome of any event; however, the actual outcome is more freely and easily imbibed by the human mind and hence people suffer from such bias. For example, in case of the GFC, some of the economists had been predicting a fall in the market as early as 2005 but the actual outcome happened only three years later, which was accentuated by a fall of the Lehman Brothers in September 2008. This was only one of the outcomes that were possible at that time. Another possibility was that the US Fed might have given the required liquidity to the company to survive and there would have been no contagion effect or investors would have had more faith in the system so that the GFC could have been avoided.
Those who had predicted the fall in the market never knew that the market would crash for this reason. But since they suffered from hindsight bias, they knew it was coming and had predicted it so. The problem with such bias is that investors fail to learn a lesson from the past and become overconfident of their predictive ability. This seriously impacts their investment decision and its outcome. You may invest in risky assets that may not be suitable to your risk appetite. To get out of this trap, you need to first admit your susceptibility to such bias. Take note of each event and subject your predictive ability against various situations that would have taken place. This will help you to deal with hindsight bias and take the right lesson from the past.
Confirmation Bias
Sometimes you start with a set of beliefs and look for information that confirms your belief. This is known as confirmation bias. For example, you believe that the earth is flat and you walk on your lawn and see no curve, which confirms your belief. Confirmation bias leads you to take wrong investment decisions. You are always exposed to a slew of information and very conveniently ignore the facts that do not match with your belief. This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being caught unaware and unprepared when something does go wrong.
The best way to tackle such bias is to challenge the status quo and seek information that causes us to question our investment thesis. One of the ways of doing this is to turn your belief upside down so that now you can ask yourself why you might be wrong. We need to continually revisit our investment assumption and understand where you can go wrong in your investment assumption. In the current scenario, when the equity market in India is trading at its lifetime high despite being faced by one of the worst economic growth patterns since independence, most of the investors might be thinking that the equity market may fall drastically.
Such investors should look at the situation from another angle and check the reasons why it should go further up. For example, lower interest rate and higher liquidity might lead the equity market to scale new highs, ignoring the historical PE ratio which measures its attractiveness. Most successful investors such as George Soros and others keep on questioning their investment assumptions continuously, which is the mantra of their successful investment journey. The point is that you should not take your investments for granted. Periodically, co-relate your investments with present trends to see how they are faring and take decisions accordingly.
Mental Accounting
In the olden days, many people used to keep money aside for rent, furniture, groceries, and so on, in separate jars. Some practice this even today. We have the same mental accounting approach towards our various pools of assets and streams of income. An investor tends to compartmentalise the assets he uses for downside protection from the assets he may use for upside potential. For example, many investors use small-cap funds to grow their capital or mentally set aside this investment for upside potential. Similarly, an investment in government securities is considered as a safe investment and is used for downward protection as well as for financial needs that we cannot defer.
This phenomenon of investors to make decisions based purely on mental categories is known as ‘mental accounting’. Although, many a time they look rational, sometimes they may be misleading and lead to sub-optimal utilisation. For example, tax refunds or any unexpected money such as a lottery win is often used for impulsive buying because they are not being accounted for in your financial plans. Nevertheless, there is no colour of money and before spending it, you should consciously compare where the money could alternatively be spent on. If all your goals are well-funded and do not require extra funding, feel free to spend such unexpected inflows for your extravagances. From the perspective of inflows, all-cash can be used for investments. As a matter of fact, you should not care whether this cash is coming from salary, incentive or lottery.
However, most people do care about the source of these inflows. To get rid of this, you need to get financially organised. You should be aware of all your income and expenses and track them accordingly. This will help you to avoid the trap of mental accounting. The second step is to keep a track of all your financial goals. You can write them down and know which goals are on track and which ones need extra funding. This will help you to follow something tangible and avoid mental accounting. Finally, if you can get the help of a professional financial planner, it will not only help you to get rid of mental accounting but also other behavioural bias as well.
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Anchoring and Adjustment Bias
Investors most often use a default number or ‘anchor’ or past reference or piece of information while making an investment decision. They do not adjust these anchor points adequately to reflect new information. The problem is that these anchor points become statistically arbitrary and irrelevant to make any sensible investment decision. In case of financial planning, investors tend to base their future returns on the recent returns, which acts as an anchor point for them. This may be hazardous as this might not be true in case of your investment and the duration for which you are investing. This may lead to either under-investing for your goal or over-investing.
For someone who looked at the investment returns of equity mutual funds in 2017 for the past three years and considered that as his future return expectation, he might be overestimating the return expectation and hence might be investing lower for his goals. The opposite could happen too if someone would have anchored the return expectation based on historical returns of three years sometime in the mid of the year 2020. Investors who want to make decisions in a rush are more prone to such bias. Hence, to avoid such a risk you need to first acknowledge that you are susceptible to such weaknesses of your mind and anticipate prejudiced judgement.
The second step involves slowing your decision-making process and seeking additional information. In case of the above example you can take historical rolling returns of your investment horizon instead of point-to-point returns to figure out your expected investment returns in the future. Once you are aware of the powerful effect that strategic anchors can have on our judgement, you can use this knowledge for your personal benefit. In the above case, it will help you to save and invest according to your needs.
Recency Bias
If I ask you to recall the names of 10 people you met this month, whom would you recall? Chances are you will recall the names of people whom you met most recently. This is called the recency effect.
Recency bias is one of the most common biases affecting our investment and other decisions in life. Here, events which have happened recently or information which we have received recently impacts our decisions to a greater extent. When it comes to investing, people invest in an instrument which has recently done well. Particularly, you will see that in mutual funds and especially so in equity-dedicated funds where maximum investment comes in when the markets are peaking. So, most of the times, people invest when the equity market is very high and stay away when the markets have fallen sharply.
This behaviour is universal and the reason behind it is the recency effect. When markets go up and the returns of equity mutual funds are very good in the recent past, investors look at the recent past and start investing. Here, the subconscious mind starts believing that this behaviour of the markets will continue and they will make good returns and so investment at these levels will increase. Similarly, when the markets fall and the recent past is not so good, people start believing that the markets will fall further and therefore avoid investing more money in equity.
In January 2008, when the Sensex touched the 21,000 level for the first time, it was an all-time high. In the preceding year (from January 2007 to January 2008), the Sensex had moved up from 14,000 to 21,000, a rise of around 50 per cent. In January 2008, equity mutual funds had the highest net inflow of Rs 13,678 crore from the investors. At this point, the Sensex had gone up by around 50 per cent in one year but the economy (corporate profitability) had not grown by even 20 per cent. The markets were extremely overvalued and the risk-reward ratio was unfavourable. But due to the recency effect, investors started feeling very comfortable and forgot to consider the risk of the overvalued market.
On the other side, when the markets started falling immediately after this and touched the bottom, the Sensex level in March 2009 was around 8,344 and the net investment in equity mutual funds was around Rs 544 crore only, which was not even 10 per cent of what was recorded in January 2008. Both of these behaviours are examples of recency bias. Ideally, they should have behaved exactly opposite to their actual behaviour. But the recency effect did not allow this. You can get out of this bias if your investment decisions (whether buying or selling) are not based on the current market events or news. Instead, they should be based on long-term strategies like asset allocation and portfolio rebalancing. Those who don’t adopt strategies are actually following tactical money managers.
Loss Aversion or Endowment Effect
The desire to avoid loss or loss aversion is the tendency of investors to strongly avoid losses. Closely related to loss aversion is the endowment effect, which occurs when people place higher importance on shares or funds that they own than on similar funds or shares that they do not own. For example, if you have invested in a large-cap fund that is not doing well, an investor will try not to sell that fund, book loss and invest in another large-cap fund that is doing well. The loss-aversion or endowment effect can lead to poor and irrational investment decisions.
In such a case investors refuse to sell loss-making investments in the hope of making their money back. It can be seen as the underweighting of opportunity cost. If you want to be a successful investor you need to fully grasp the importance of opportunity cost and not stick to any past investment decision and avoid booking losses. In doing so you might be losing some of the most lucrative opportunities. Hence, all your future investment decisions should be measured against the opportunity cost and past decisions are sunk cost that should not form part of your decision making.
Know Your Own Behavioural Biases
Asked for his three golden rules of investment success, Fidelity’s Anthony Bolton started his list with “know your own behavioural biases.” “Investors need to understand themselves,” Bolton said, in order to see how emotions affect their investing. Hence, investing is not only about researching and making the best of the financial models; it is also about looking inward and understanding your own emotional and cognitive pitfall in decision-making. Knowing your own biases would help you to avoid them and you can make investment decisions that are skill-driven and not cognitively flawed. Channelize your emotions effectively so that you make the right investment decisions.