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Why smart people make dumb money mistakes

Last updated on: August 07, 2007 09:52 IST
  • The house I did not buy at Rs 46 lakh three years back now costs Rs 1.1 crore.
  • The Rs 5,000 I put in a mutual fund three years ago is now worth Rs 15,000. I regret not putting in Rs 5 lakh.
  • The best-performing fund slipped as soon as I bought it.
  • I sell a stock after holding it for years, and it begins to fly like a kite the day I sell it.
  • My neighbour got a super price for his land; I did not for mine.
  • I have the wrong insurance policy, but am holding on to it.
  • The price of my car dropped a week after I bought it.

I feel unlucky with my financial decisions. Here I am, a perfectly normal sort of a person with a good job, a great family, in control of most of my life. Except for one thought that rankles in my overall feeling of well-being. I feel that I constantly take financial decisions that are not so cool.

If you find any of the above even a little bit familiar, take heart, most of us feel exactly the same way. Did you know that the human mind is programmed to fall into some behavioural traps that cost us big money? A relatively new branch of Economics, called Behavioural Finance, lays down a paradigm that is different from traditional Economics, where all people were rational, all economic choices were the best possible, and markets were mostly in equilibrium.

This meant there was a perfect world out there, where men were calculating machines with zero emotions such as fear, greed, regret and anticipation, and with perfect information about all products, services and prices at all points of time. But when psychologist-economist Daniel Kahneman won the 2002 Nobel Prize for his work in Behavioural Finance, this more real branch of Economics came centrestage.

And it is now accepted that the human mind is programmed to make big money mistakes due to habit - and emotion-driven actions. Though the scope of behavioural finance is much wider, we shortlist the five most common behaviour patterns that most often cost you a lot of money. And tell what you can do to sidestep these traps.

We tend to use mental short-cuts to decode everyday life. These rules of thumb make us put money into different mental accounts, preventing us from seeing the overall picture. Sometimes this works to our advantage - putting money in sacrosanct mental buckets like insurance premiums, tax saving instruments, and so on. But sometimes these buckets cause harm.

How do you use the money that a money-back insurance policy throws up periodically? Most people tend to blow up that money instead of treating it as a return on their investment to be used to meet a financial goal, or for further investing.

Similarly, a dividend, or tax refund is often used frivolously by ordinarily responsible people. A good way to get over this is to quickly bank the cheque and wait for some time. This waiting period can allow mental accounting to kick in so that we treat this money as part of our savings and not something to be blown up.

Mental accounting does not snare us only while spending, it traps us into sub-optimal investing decisions as well. While working out overall asset allocation, we forget to include the provident fund, the Public Provident Fund and endowment insurance polices in the process because they are not seen as part of our decision-making process but as something that's pre-decided. We then divide the rest of the surplus money between debt and equity.

No wonder that the average equity in household savings is a mere 5 per cent, the rest going into debt products (Handbook of Statistics on Indian Economy, Reserve Bank of India). Since equity has given an average annual return of over 16 per cent in the last 26 years, such mental blocks bring down our capacity to create wealth by leaving too much in low-return instruments.

Mental Accounting
To compartmentalise a situation and ignore the overall picture. We treat money found or won less Monika Halan and Rajesh Kumar, Outlook Money