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This article is more than 3 year old.

The role psychology plays in personal finance

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Every person who is investing, tends to think that they are rational investors. They say that they carefully evaluate options, weigh the pros and cons and then take a decision. But reality is vastly different. Suresh Sadagopan, a certified financial planner, discusses some of the emotional and psychological aspects that affect investor’s decisions. Have a read..

The role psychology plays in personal finance
Every person who is investing, tends to think that they are rational investors. They say that they carefully evaluate options, weigh the pros and cons and then take a decision. But reality is vastly different. Most of the decisions that investors make are hardly rational. Decisions are arrived at with a significant dollop of emotion and leaps of faith. To lend respectability to the decision making process, we rationalise to ourselves and others, about the centrality of data and how we logically evaluate them and arrive at the final decision.
That is as far from the truth as Mumbai is from Minneapolis!  Let us look at some of the emotional and psychological aspects that affect investor’s decisions.
  • Decision making:
  • We all tend to believe that loads of data is good - more the merrier is the refrain. Thanks to the internet, information is available in abundance on virtually every subject under that sun. There is a massive information overload today. When they start sifting through the information, they find all kinds of information - some for, some against, which leaves them confused, instead of enlightening them. Most times, it results in decisions paralysis.
    This is where their human nature takes over. They just ask their friends about it, fall back on heuristics and rely on their agent to provide them the information/logic to go for the product. Decisions are taken like this, though most still continue to believe that they are very rational in their decision making!
    Wisdom of the crowd: Probably, the largest percentage of investors is affected by this. For instance, when the equity markets are booming everyone around will be investing in it. There would be a mass hysteria and frenzied conversations, with everyone falling over each other to invest in the hot and happening product. The problem in this is that most people wait in the sidelines for too long, till they are convinced that the boom is well underway. This way, a lot more join at the fag end, before the correction. When the trend corrects, there is a steep fall. People are left licking their wounds. They wait until they see the next trending product to invest to switch their money. Ironically, this cycle continues ad infinitum.
    • Investments should be exciting: Many people look at their investments as not just a way to meet their goals...they want a load of excitement from it too! People speculate with their money - do tip based investing in equity, which is gambling, investing in crypto-currencies without the least knowledge about them, taking positions in commodity markets, currency markets, buying property with the idea of flipping it in the near future...
    • Let’s put this in perspective… We work hard to earn money - giving our best years to work. Yet, we are willing to gamble it away looking for excitement with the money that has come to us after so much hard-work.  If excitement is what one is looking for, then there are multiple options - horse races, casino, bungee jumping, para-sailing, trekking etc. However, investing should be a staid, solemn affair. Even if it is as exciting as watching paint dry, it should do.
      • Show me more: We need to invest in a few chosen products to achieve the diversification and asset allocation needs. Beyond that, adding more and more products thinking that it will add in some way to better diversification, is a major fallacy. More and more products makes one’s portfolio bloated and makes managing the portfolio far more difficult. We should go for a focussed set of products, which help to achieve the investment objectives. Also, it pays to go for simple products that are easy to understand and execute.
      • Overconfidence effect: Some people have invested in specific asset classes like equity, real estate and have tasted success. Such people swear by that one asset class and would continue to invest only there, in spite of any information to the contrary. They put that down to confidence, domain knowledge and a superior understanding of that asset. There may be some truth there. But, it is most likely overconfidence, stemming from a few early successes. Such people seek out information which confirms their line of thinking. This is called confirmation bias. In investments, it makes sense to stay sensible and avoid hardline positions with respect to asset classes. The focus of the investments after all is to achieve the goals. We need to focus on that and invest accordingly, taking acceptable levels of risk.
        • Investments to prop social standing: Looking good in the eyes of the friends, extended family and others alters even the way people invest - not just the way they spend. For instance, buying a second home confers one with bragging rights, much more than thousands of shares in a few bluechip stocks. A holiday home/ farm house shows the world at large that one has arrived. Even crores of rupees in the bank, in mutual funds or other investments can never ever convey their sense of accomplishment. You can hardly show someone a mutual fund statement to claim one’s place under the sun. Inviting friends and family to the farm house and they going gaga over the “sound investment” evokes an entirely different level of satisfaction and smugness.
        • Investment decisions are more emotional than rational. There are many, many more such emotional decisions we take in life, as we go along. To counter that, it pays to have an external advisor, who acts as a sounding board. The advisor would be able to stand aside and be able to offer advice dispassionately. Also, a good advisor would lend his/her knowledge and expertise to evolve a good strategy and choose appropriate products, which may be able achieve the desired outcomes in life.
          Suresh Sadagopan is a Certified Financial Planner and runs Ladder7 Financial Advisories, a fee-only financial planning firm.
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