Avoiding bad financial decisions is as important as making good ones, but what influences you to make such good or bad financial decisions?
Your decisions are a reflection of your financial habits i.e. a reflection of who you are as an investor and as a person.
In this post, we will look at 5 financial habits that you can affect your financial lives adversely.
1. Think more and Act less
Many of us tend to over-analyze. I am guilty too.
I can easily point out 10 ways where over-analysis has led to indecision in my business choices.
But this blog is about personal finance.
I talked to a young smart lady a couple of weeks back. She wanted to invest in equity mutual funds but would wait because she was skeptical of markets and inflation. She wanted to do more research.
It takes many of us 5 minutes to sign up for a traditional life insurance plan but we want to do unlimited research when we want to invest in equity MFs. Which is the best mutual fund will probably be one of the most popular financial queries on Google in India. Many bloggers like me try to exploit this too.
Well, if we are so skeptical of mutual funds, why can’t we apply same rules to other financial products too? Or this research is only meant for mutual funds?
I am not saying that you shouldn’t research. Of course, you should. But you how much information will you process? By the way, Google search is not research.
My motto for investments is:
Start small, make mistakes and learn from those mistakes. Increase exposure over a period of time. The key is to Make small mistakes (and not big ones).
If you can’t do on your own, seek professional help. It is that simple.
Most of us work in the opposite manner. We continue to invest in high cost and low return insurance plans while trying to figure out a way to eliminate the risk of loss in equity funds.
You will never figure out that way.
Essentially, we continue to make big mistakes while trying to avoid smaller ones.
2. Ignore the risk in Life
Superman is fiction. You are a real person. Shit happens in real life.
You can’t always prevent bad things happening in life. However, you can take measures to mitigate risk to your financial life. And this is where insurance comes into the picture.
I have had a serious discussion with a number of friends about whether they should purchase health insurance and not about which health insurance plan to buy.
If you are a rich man and have enough money to take care of prolonged hospitalization, you don’t need health cover. You may not even need life cover.
The question you need to ask yourself is, do you belong to the category?
If the answer is No, go ahead and purchase a health insurance plan. Unnecessary debates may massage your ego but won’t help in real life.
Have you purchased a life cover? Yes, I have LIC.
This is again a common refrain. It is not about the plan you have. It is about life coverage.
If your annual income is Rs 10 lakh and your life cover is Rs 8 lakh, it is not difficult to see that you need more life cover. You can’t ignore the risk of untimely demise.
3. Ignore the risk in Investments
Risk is not limited to life events. There is a risk in investments too.
In fact, risk and reward go hand in hand.
You can’t lose money if you invest through SIPs. or
Debt mutual funds are like bank fixed deposits. or
Real estate always goes up.
I hear these quite often.
I know a few people who had never invested in equity funds but suddenly broke their fixed deposits to invest most of their wealth in equity funds. Clearly, somebody convinced them that there was no risk in equity funds if you invest through SIP or STP.
Do note capital markets will not reward you just because you want to take more risk (or ignore risk).
If at the age of 50, you suddenly start feeling confident of your skills in futures and options market, you are clearly ignoring risk.
you choose corporate fixed deposits
or NCDs over bank fixed deposits because corporate FDs offer a higher interest rate, you may be ignoring risk. You don’t get better interest rate without taking any credit risk. In fact, this risk keeps materializing quite often.
If you invested in long term debt mutual funds just because such funds gave 16-18 percent p.a. last year, you are ignoring risk.
If you choose to invest in a scheme that doubles your investment in a year, you are taking a risk. Well, the scheme is a scam. It is not a question of IF but WHEN the music will stop. The good part is that such scams are relatively easy to detect. Avoid such schemes.
Great asset bubbles are made when many investors collectively ignore risk.
The flavor of the season approach may work with your taste but does not always work with investments. If there is potential for great reward, there is an inherent risk too. You need to diversify and keep asset allocation in mind. Portfolio rebalancing at regular intervals will also help
When you earn good returns from an investment, you pat yourself on the back. However, that does not mean that there was no risk. There was risk. It is just that the risk didn’t materialize for you. Perhaps, it was sheer luck or you reduced the risk by doing proper research. But, there was risk. You must accept it.
Rolf Dobelli, in his book The Art of Thinking Clearly, describes this at Outcome bias and writes: We tend to evaluate decisions based on the result rather than on the decision process.
When you made the decision, you did not know what the outcome will be.
4. Be too conservative with Investments
The biggest risk is life is not taking a risk.
This is another extreme. From ignoring any risk, you go to taking no risk at all.
Client/Prospect: Can I lose money with equity mutual funds?
Adviser: Yes, anything can happen. You can incur a loss. Empirical evidence suggests that the longer you invest, chances of loss go down. But you can still incur a loss. There is no guarantee of good returns.
Client/Prospect: But there is no risk if I invest through a SIP, right?
Adviser: You still have risk.
Client/Prospect: Is there a chance that the value can go zero?
Adviser: Extremely unlikely but anything can happen. In such a case, your equity investments won’t be the only ones to suffer. Your bank fixed deposits may NOT be safe either.
Client/Prospect: Hmmm. Then, I need to think more before I decide to invest in equity
The responses are acceptable if I were talking to a 65-year old man but not acceptable if the responses came from a 25-year old person.
All of us have aversion to loss. Nobody wants to lose money.
However, there is risk involved in even the most common things that you do in life. Just that you are fine with the risk.
When you take a flight to your favorite destination, there is a low probability that the flight might crash. You are quite fine with this risk.
When you drive to your office, there is a possibility that you might meet an accident. But you still drive to the office, don’t you? You don’t always work from home.
When you spent big money on your MBA, there was a possibility that you may not get a well-paying job. You still went for an MBA, didn’t you?
When you agree for a minor appendicitis operation, there is a chance that the operation may go completely wrong but you still laugh on your way to the hospital, don’t you?
There is risk involved in everything you do.
When you can live with risk in various facets of your life, you can live with some risk of loss in your investments.
You need to take calculated risk with your investments.
5. Not follow simple maths
Many of us do not invest because they do not think they have enough to invest, completely ignoring the power of compounding.
Some of us keep running our recurring deposits while rolling credit card debt at the same time. You rolled Recurring or fixed deposits give 6-8 percent p.a. while credit card debt costs 40-45 percent p.a.
It is foolish to go for a personal loan of Rs 5 lacs at 12% p.a. when you have a fixed deposit of Rs 5 lacs that earns you 8% p.a.
Many times, we do not assess the impact of taking unnecessary debt on our cash flows. Living beyond your means or not knowing how much you need to invest for your goals can also be attributed to ignoring simple maths.
I have encountered cases where investors wanted to take a loan at 15% to invest in stock markets. This is also a case of ignoring risk in equity markets.
The choice shouldn’t be that difficult but somehow we struggle (or tend not to care).
By the way, these are not the only poor financial habits that affect your financial lives. For instance, fixation with tax-saving and reckless borrowing are a few other ones but, in my opinion, these stem from one of the aforementioned habits.