Tuesday, 6 December 2011

Common Financial Mistakes

We all are social animals and we remain the same social animals while thinking about money and investments. Let me discuss today the common investment mistakes which we human beings make as social animals and to understand that we have to branch out to “Behavior Economics” which combines the twin disciplines of psychology and economics to explain why and how rational people make totally irrational decisions when they spend, invest, save and borrow money.

Sunk Cost fallacy - Throwing Good money after bad
Imagine that somebody has given you a play ticket “free” in which your favourite star in acting. Now, hours before the play is going to commence you come to know that your favorite star may not be able to act that day and there is big weather problem and going to the theatre and coming back might be risky. Now, imagine that you had actually “paid” and purchased that ticket. The likely answer is that in the first instance you might not go for the play while in the second instance you might go for the play even though your favourite star is not acting in it and risk traveling in the dangerous weather. This is called “sunk cost” fallacy – in the first instance since you have not paid for the ticket you don’t mind skipping the event but in the second instance since you paid hard cash for the ticket you don’t want to “waste” the money which is actually already wasted or sunk. The same way in investments many a times because we buy a certain stock of a bad company at a certain price and then it halves then in the name of “averaging” we invest more in it throwing good money after bad. The lesson we learned from this behavior is that we should not sell winning investments more readily than loosing ones and not take money out of the stock market just because markets have fallen.

Loss Aversion
One of the main tenants of behavior economics is that people are loss averse. The pain people feel from loosing Rs.100 is more than the pleasure they get from gaining Rs.100. This explains why people behave inconsistently while taking risks. For example, the same person can act conservatively when protecting gains (by selling successful investments to guarantee the profits) but recklessly when seeking to avoid losses (by holding on to loosing investments in the hope that they’ll become profitable). Loss aversion causes investors to sell all their investments during periods of unusual market turmoil. If you had sold most of your equities during the bottom in the year 2008 or contemplating of selling your “good quality” banking or infrastructure stocks currently, then probably you are suffering from “loss aversion”.  

Mental Accounting
This term “mental accounting” refers to describe people who treat money differently depending from where it has been received. For example, a person may treat salary (earned money) as sacred and be over cautious with it while the same person might treat gifts, unexpected bonus, written off tax refunds, huge inheritance as “free money” and be careless with it. The sacredness may lead the person to let the money just remain idle in savings account and thus getting beaten down by inflation and the carelessness may lead the person to just spend the money or invest in risky ventures and eventually loosing the funds. The lesson is that money is money from whatever source it is received – deposit any windfall gains first in your savings account and mentally count is as part of your wealth and then there is less likelihood of you squandering away that money. 

Bigness Bias
Most of us try to think big as far as money is concerned but easily forget the small things which when compounded over a period of time result into much bigger losses. This is because of our ignorance to the basic principles of mathematics. For example, the tendency to dismiss or discount small numbers as insignificant can lead us to pay more that we have to pay for brokerage, commissions, mutual fund expenses, income taxes which has a surprisingly deleterious effect on our investment decisions over time.

Decision Paralysis
Whether it is investments, insurance, spending or any other money matter, many a times we are not able to make a decision and just maintain status quo. However, we don’t realize that not making a decision is also a decision in itself that we have voted in confidence for the way we are doing things. The lesson we learned from this behavior is that by not taking the right decisions many a times we continue to promote the wrong decisions, the opportunity cost of which may prove to be very costly over the long term.      

Money Illusion
Most of us have illusion with money – the more the money the more we think we have earned and vice versa. But, this may not always be the case. I explain this with a simple example. Suppose, an employee got a 10% salary increment when the inflation is 12% while in another case the same employee got 5% increment when the inflation is 3% - which one would he prefer. There are chances that he will prefer the first case of 10% increment although in the case the employee is getting negative real increment since inflation is more than the increment while in the second case he is getting positive real increment since inflation is less than the increment. This is called money illusion and one of the main reasons why people prefer investment in fixed deposit at negative real interest rates after tax than long term tax free gains through stocks.  

Cash Fallacy
Suppose, we go to buy an expensive gift item for say Rs.1 lac. If we have to actually remove cash from our bank account and then pay for it we will feel the “pain” of loosing cash and therefore we would think twice before buying it. In the same instance, if we just pay through our credit card then we may be very comfortable and have the illusionary thought of not seeing the pain of loosing cash. This is called “cash fallacy” and is the main cause of lot of unwanted and avoidable expenses in the modern plastic word. Remember, if you buy things you don’t need, soon you will have to sell things which you need.

Over or under confidence
These are the other two enemies of investors. If you are over confident on your abilities then you would only look at your successes and boost about it while trying to “explain away” your losses. On the other hand if you are under confident then you would not be able to take control of your finances, make investment and spending decisions based solely on the opinions of friends, colleagues or worst than that the so called “investment advisors” (including myself). Both these psychological characters are not good for your money and hence beware of it. The lesson form this is that “either you act on your own judgment or entirely on the judgment of another” and that another should be a family member with equal stake in the outcome of the decision and not just a friend or worse than that a financial advisor (including myself).

Certain simple steps to take in order to avoid big financial mistakes over time are:

Ø       Take proper insurance and let it be pure insurance (term policy).
Ø       Make proper retirement plans.
Ø       Pay off credit card bills with so called “emergency” funds lying idle in your savings account.
Ø       Make proper asset allocation and diversify your investments.
Ø       Put maximum of your equity allocation in index funds – it will save you a lot in fund management expenses and avoid the randomness bias of Fund Managers.
Ø       Review your assets and take stock of your entire portfolio including real estate, art, retirement plans etc.
Ø       Set up a “direct payroll deduction” to some kind of recurring savings / SIP.
Ø       Keep reviewing your plan.

1 comment:

  1. nice article thanks for sharing. i just readout article on financial mistakes if you guys want to read more detail about financial mistake then you should read this article