Emotion & Investments. Do Not Let Emotions Dictate Investment Decisions
Making an investment decision should ideally be a quantitative exercise; however, in practice, many a time emotions take the driver's seat. DSIJ explains some of the most common emotions and biases that come into play while taking investment decisions and how to avoid them.
Puja (aged 34) and Abhishek (39) are someone with whom most of us can associate. They are well-settled with rewarding careers, but they are still facing various financial challenges. They are not good at taking financial decisions. Their savings rate does not match up to the required rate, they do not have proper insurance coverage, they are yet to start investing for their various goals, and worst, they do not hesitate in accumulating debt. It is not that they do not understand the pitfalls of making such erroneous financial decision. Nonetheless, our brain is hardwired in a way that we do take decisions purely on quantitative factors, but various behavioural biases and heuristic factors enter into decisionmaking, thereby leading to sub-optimal decisions. Heuristics are mental shortcuts that involve only one aspect of a complex programme or phenomenon, leading to errors in judgement or biases.
According to a study done by Dalbar Inc, in 20 years from 1993-2012, the average mutual fund investor in the US underperformed the 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 retail investors. Besides the expense ratio, what led to such underperformance were investors themselves and their irrational behaviour.
Puja and Abhishek’s perception about their finance and investment is shaped by their cognitive biases, financial attitude and their prior experiences with money and wealth. In the following paragraphs, we will discuss some of the important emotions and behavioural biases and how these lead us to irrational financial decisions. Understanding these techniques can be useful in improving the quality of financial decisions you take.
One of the most common behavioural biases is the ‘recency’ bias. In this case, events that have occurred recently or information which we have received recently impacts our decisions to a greater extent and investment decisions are also no different. Therefore, if I ask your opinion about the chances of equity investment, your answer will depend upon the current performance of your equity portfolio. Hence, if it is doing well, you will say every good thing about investment in equity market. On the other hand, if you are one of those unfortunate ones who started investment somewhere in 2017 and your portfolio is still in the red, you would advise against investing in equity and explain how it destroys your wealth.
The recency bias leads an investor to invest in an instrument which has recently done well. And this is the reason why you see that maximum investment in the stock market comes in when the market is at its peak. Assuming inflows into equity mutual fund as proxy to equity investment by investors, we see that as the equity market, represented by BSE Sensex, goes up, equity investment also goes up.
The graph clearly shows how the inflows into equity MF are following the movement in Sensex. For example, in January 2008, when the market was at its peak, the inflow was around Rs.21250 crore, compared to average of Rs.9000 crore for the previous one year. This was again repeated in January 2018, when again the market touched its peak and the inflows were around Rs.48,000 crore compared to an average of Rs.19000 crore in year 2019.
The opposite happens when the market falls. During November 2008, just after the collapse of Lehman Brothers, the inflows into equity MFs dropped below 10 per cent of inflows received in January 2008.
This clearly shows how the recency bias impacts the investors' investment decision and ultimately their returns. Those who had invested in January 2018 might have been still sitting on losses, while those who refrained from investing during February 2019, which has witnessed recent lowest inflows, might have lost the recent gain in the market. Investors act in just the opposite way. When the market was at its peak, they should have moderated their inflows, while when the market was at its lowest, they should have invested. You can avoid the recency bias by reading history of the stock market that will help you in understanding the cycles and how you can avoid investing at the top and missing investment at the bottom.
When you invest in any fund and its performance exceeds some benchmark or any other return through which you measure the performance, you get overconfident. The reason for this outperformance might be your sheer luck. Overconfidence makes you confident on predicting the returns on your investment and hence you want to time the market. However, hardly anyone can do this on a consistent basis.
Overconfidence bias particularly becomes detrimental when you are doing your long term financial planning such as retirement planning. Individual investors frequently overestimate the amount of wealth they can accumulate across time because they overestimate their investment selection and their returns. This might seriously jeopardise their retirement planning.
The advent of social media and the internet have only accentuated this bias. Research have found that increased access and availability of very large amount of financial data have resulted in the increased overconfidence of investors that has resulted in substantial loss of wealth for investors who attempt to time the market. It is not only they overestimate investment returns, they even underestimate the potential loss. Hence, requisite care to prevent loss from very low probability, but financially burdensome adverse events, which can otherwise be mitigated through insurance coverage, is never taken.
The de-biasing technique is to take an alternative view or an outsider perspective on your estimates. This will help you to overcome the problem of self-centred subjective thinking and reduce your overconfidence. Another way you can overcome this hazard is by considering the opposite of whatever decision you plan to take. For example, if you are thinking of investment in a stock or fund and assume a 10% growth for the next five years, think of what if it does not deliver. Will you still continue investing in the fund? These methods will help you to avoid overconfidence.
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. This shows that people are much more sensitive to losses than to gains of the same magnitude. It is typically known that pain from losses is about twice as steep as pleasure from gains.
Hence, many investors are fast enough to lock their profits, but avoid booking losses. Loss aversion motivates a lot of financial decision-making and can be the dominant rationale for risky decisions. This loss aversion explains why investors holds their savings in a low interest bearing savings account rather than investing in the financial markets. Loss aversion is also to blame for something called the disposition effect. According to this, investors hold onto a losing stock because he does not want to realise the loss. This loss aversion also leads investors to do panic selling when the market falls. Loss aversion is known to be related to important investor attitudes and behaviours such as holding losing stocks and selling winning stocks.
In these situations, it is important to return to the fundamentals and make strategic decisions based on reason rather than emotion. Loss aversion might also be the reason people with the capacity to take risk choose a low-risk profile.
Mental accounting refers to the way investors track and evaluate their financial activities. For example, most of us treat money based on our sources. So, if you get an IT refund, you will treat it differently from money you get in the form of salary. Organising information into groups or categories helps us to take judgement of relevant information faster.
Mental accounting has both positive and negative impacts on the financial decision-making. It influences the type of investment decision that you make as well as timing of those decisions. Investment means trade-off between current consumption and future consumption. So, if you invest now, you sacrifice your current consumption so that you can consume in future. Therefore, it protects you from overconsumption at the present juncture. Nonetheless, if you do a mental accounting as illustrated above and you treat income as non-fungible, that is, it cannot be used interchangeably, it can lead you to sub-optimal behaviour. For example, the IT refund that you got can be used to top up your investment or can be used fill any gap in investing.
Besides investment, such mental accounting also does have implication for your financial planning.
For example, if you have received ESOPs from your employer. you may treat them differently and may not consider as part of your overall portfolio. This might lead to improper asset allocation and sub-par performance of your portfolio.
The mental accounting bias may influence your decisionmaking and your financial well-being. Hence, it becomes important to get yourself financially organised and stop calculating everything in your mind. Instead, you should write everything down. This will help you to avoid such traps. Besides, it is always better to take the help of some financial advisor who can help you in such situation.
Anchoring heuristic is used when making estimates about an unknown value. For example, if you are asked to estimate the population of Gangtok, you will most probably start with the population where you stay, and from thereon, you do some calculation to arrive at the population of Gangtok. So, if you are staying in Mumbai where the population is more than a crore, you may think Gangtok as a small city with one tenth size of Mumbai and being hilly region and hence population of 5 lakh may seem to be the right number for you. The adjustment gets you closer to the right answer, but is likely insufficient. This is what is known as the anchoring and adjustment heuristic. The actual population of Gangtok is one lakh (census 2011). This same bias explains the tendency to base future expectations on past performance. This is even true for finance professionals. There are other biases that arise from anchoring and adjustment. For example, status quo bias and sunk costs bias.
The status quo bias is the path of least resistance. It is simply exhibiting a preference for the current state of affairs. Sometime investors cling to their old beliefs and facts without taking much effort to re-check them as they may have changed. For example, you invest in a fund and wait for a while to reach a certain level to sell, but till that time you might have suffered huge losses.
Hence, it is always better to get new information periodically so that you can take an appropriate decision at the right time. Moreover, your decision making process should me more focused towards future, which can help you to overcome the tendency to place more weight on the immediate rewards and lower weight to future rewards.
If you take decisions based on emotions, it can constrain your ability to make rational financial decisions and hence it can impact your financial well-being. Our impulsive or intuitive decision-making system is based on biases that we have developed from our life experiences, preferences and perceptions. Changing it requires lot of effort and you may also need help from others such as financial planners to overcome such emotions. Hence, never allow your emotions to take the driver's seat while investing. Investment is a quantitative endeavour. There are lot of numbers that you juggle before making investment decision, however, the effort is worth it and if you can take the help of a financial or investor advisor, he will be the one who will be assessing all these numeric values, such as your income, expenses, debt, etc., to make a proper investment plan for you.