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Home > Business > Special


Why smart people make dumb money mistakes

Monika Halan and Rajesh Kumar, Outlook Money | August 07, 2007

  • 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 [Get Quote]). 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
seriously than money earned, although both can
build savings equally well.
Situation One You've paid Rs 150 to buy a movie ticket. When you get there, you realise you've lost the ticket. Do you buy another? Situation two You are yet to buy a ticket. You get to the theatre and find that you have lost Rs 150 on the way. Do you still buy the ticket?
Answer If you do not buy in Situation 1 and buy in Situation 2, you have fallen prey to Mental Accounting. In the first case, you think you are spending Rs 300 on a movie and refuse to pay that much. In the second case, you treat the loss of Rs 150 as an unfortunate, but unrelated event, and buy the ticket. Your total spend is Rs 300 in both situations.
DUMB SIGNSMART SIGN

  • You don't think you are a reckless spender, but still have trouble saving

  • You tend to spend more when you use a credit card than when you use cash

  • You save carefully, but blow up dividends, tax refunds or money back from an insurance policy

  • You are less than 50, with most savings in FDs

  • You have cash in your savings account and FDs, but unpaid balances on your credit card

  • You value each rupee equally and treat all inflows (even bonuses, dividends, refunds and money back on an insurance) as earned income

  • You make an asset allocation after taking your PF and PPF in the debt part of your portfolio

  • You look at tax-saving investments as asset allocation options and not as standalone decisions

  • You do not use the instalment payment facility on your credit card

Way out. So, do remember to look at your total savings - fixed and unfixed. Take a look at the full asset allocation pie and then divide your funds between debt and equity.

Loss aversion and sunk cost
We hate losses and peg the value of a rupee lost at double that of a rupee gained. We also throw good
 money after bad - keep repairing an old car as we have
spent lots on it already.

Situation ONE You have been given Rs 1 lakh. Now pick between a sure gain of Rs 50,000, and equal chances of gaining Rs 1 lakh or nothing. Situation TWO You have been given Rs 2 lakh. Now pick between a sure loss of Rs 50,000, and equal chances of losing Rs 1 lakh or nothing.
Answer If you choose a sure gain in Situation 1 and take the gamble in Situation 2, you show Loss Aversion. The first options in both get you a certain Rs 1.5 lakh. In the second options of both, you can net either Rs 1 lakh or Rs 2 lakh. But as the value of loss is double that of gain, rather than take a hit of Rs 50,000, we take a chance that could even double the loss.
DUMB SIGNSMART SIGN
  •  You make your spending decisions based on how much you have already spent

  • You prefer fixed income instruments to stocks

  • You sell winning, rather than losing stocks

  • You take all your money out of the market when the market index falls

  • You keep paying premiums on useless life covers just because you have already paid the first few premiums

  •  You diversify your investment in non-correlated products

  • You don't carry the past and believe stock selling should not be based on buying price, but company fundamentals

  • You understand your risk capacity and then choose products

  • You look at investment returns in relation to a current benchmark rate

 

We hate to lose. The distress that each lost rupee causes is twice as high as the pleasure we get from each rupee gained. This is actually good because it prevents us from gambling away our retirement funds or the money we save for our kids' education. But there is a big flipside to this. We tend to hold on to the wrong consumer and financial products. Why?

Because the act of throwing the rotten thing out would bring home the loss and make us 'feel' dumb. To prevent that feeling, we stuff new but tight shoes at the bottom of the shoe rack, and a new but useless mixer-juicer at the back of the kitchen cupboard.

Similarly, you hold on to losing shares and funds. People who invested Rs 10,000 in Bajaj Hindustan [Get Quote], a sugar stock, in May 2006, would be left with just Rs 2,943 today. If, on the other hand, they had cut losses and moved the money to the Sensex even after losing 25 per cent at the end of May 2006, their investment would be at Rs 11,000 today.

Use the loss aversion argument carefully, for it does not work for fundamentally sound stocks. Sometimes an overall fall in the market brings down the price of strong stocks. That, in fact, is the time to buy more rather than book losses.

Linked to this is the sunk cost trait. We go on putting good money after bad in, say, car or washing machine repair. Aren't we all familiar with spending recurrent amounts on 'fixing it' when a new appliance would have cost less? Loss aversion looks nasty when we see what it does to our investment behaviour.

Take, for example, our fetish for buying a new insurance policy every year. The only life cover one needs is a term plan, but the agent keeps selling you a useless policy every year. But do you discontinue the 4-per-cent-return money-back and endowment polices even when you discover that they are garbage? Most people continue paying premiums and say they are doing so because they have already invested for a few years.

Way out. The first mantra is to learn to cut losses and move on, but it should be used selectively for investments and products that are genuine losers. The second strategy is to have a well-diversified portfolio. It would be less subject to such mental traps as it would be more stable than individual stocks or funds.

Status quo bias and regret aversion

The desire not to change the current status due to the fear of becoming worse off.
This is partly to avoid regret and take responsibility
for a painful action.

Situation One You invested Rs 10 lakh in Stock X. You are told to sell as it is losing steam. You don't. Your holding's value falls to Rs 8 lakh. Situation two You invested Rs 10 lakh in Stock Y. A friend suggests that you buy Stock X. You do. Your holding's value falls to Rs 8 lakh. 
Answer If you feel worse in Situation 2, you suffer from a Status Quo Bias or the desire not to suffer regret over a decision that may cause you to lose money. Most of us want to avoid the responsibility and pain of negative outcomes and, hence, do not take any action to change the status quo.
DUMB SIGNSMART SIGN
  •  You allow a very wide range of choices to confuse you

  • You do not monitor your portfolio each year

  •  You keep very old investments alive even if they are non-viable

  •  You continue to pay premiums for useless life insurance polices

  •  You do not use the cool-off period in products like insurance to get out of wrong choices

  •  You understand that maintaining status quo is a decision

  •  You monitor your investments each year

  •  You weed out non-performing investments from your portfolio

  •  You discontinue useless insurance polices that do not fetch inflation-plus returns

  •  You do not wait for the end of the year to do your tax-saving investments

Since we hate to lose, we go to great lengths to avoid the feeling of regret and don't want to take on the responsibility of a wrong financial decision. This is called regret aversion. In the 'Status Quo Bias and Regret Aversion' test (on the left), the two people are in the same situation, but the second person feels worse because he blames himself for a wrong financial decision.

Having been through many situations where our financial decisions were proven wrong (selling a stock just before it became a kite, buying a house at the tail end of a property bubble, buying a gadget to see its price halving a week later), we fall into the status quo bias trap, or the desire not to change anything much with our financial lives so that we don't get to a position where we regret taking faulty financial decision.

Several cash-poor but asset-rich senior citizens fall into this category. Some of them are 100 per cent invested in debt instruments and real estate. They see real estate and stock prices zooming, but are unable to take the call of selling some of the real estate they are holding selectively to get more cash and invest the rest in stocks. They feel that real estate prices may go higher and stockmarket investments may go wrong anytime.

Way out. An overall asset allocation and portfolio diversification approach makes us look at portfolio return rather than individual product returns.

 'It's the dopamine!'

Philippa Huckle, founder and chief executive of Hong Kong-based The Philippa Huckle Group, an investment advisory firm, is a behavioural finance expert. Outlook Money spoke to Huckle over telephone on applying the understanding of behavioural finance in investment decisions. Excerpts from the interview:

Despite having knowledge of emotions that cause mistakes, why do people repeat the mistakes?

This is due to the illusion of control. Typically, it's at work when we gamble, as well as when we invest. It gives us the feeling of having control over something that we know is random. When we gamble and win, a chemical called Dopamine is released in our brain that gives us a pleasant feeling that we try to prolong with more success. In the case of investments, too, if you win, you start taking more risk.

How can we avoid the illusion of control while investing?

This is possible by rebalancing of portfolio. Once you set the risk level for the portfolio across uncorrelated cycles, after some time, an economic condition that affects one kind of investment doesn't impact another and helps the former perform better. As a consequence, the asset allocation of the portfolio changes. Here's an illustration.

Say, your portfolio has 50 per cent in equity and the rest in non-equity. If the environment is more favourable for equity, these investments could grow in value and constitute a larger part of the portfolio's total value than non-equity. The new equity-to-non-equity ratio could become 60:40. Now, you bring the portfolio back to the original risk level (50:50) by investing 10 per cent in non-equity. This is called rebalancing, which helps you curb the illusion of control.

Philippa Huckle

Anchoring

This is when we hang on to a number, fact or return figure that has no bearing on the overall investment or spending decision. When property prices began zooming up in 2003, some of us postponed our purchase decision till they 'settled down'. We watched prices rise more than 100 per cent without doing anything, for we were 'anchored' to the earlier prices.

While this sort of anchoring can really break a family's wealth creation stride, a smaller, but more insidious hurt comes in the monthly grocery bill. You may have seen this sale gimmick: 'Cheap Basmati Rice: 5-kg bag now selling at Rs 210, down from Rs 350'. But this is

Rs 42 a kg on sale, down from Rs 70 a kg. You anyway get basmati rice at Rs 40-42 a kg. When we buy more or unnecessary products and services because they are 'cheaper' or 'free', we use up money that could have been used for wealth creation. A simple way out it to use the calculator to break 'sale' prices down to per kg or per gram or per litre to skip the anchoring trap.

Another example is a stock going at, say, Rs 1,500 that someone recommends. You consider buying it, but don't. When it reaches Rs 1,800, and you see that the company is going great guns, you say, "I should have bought it at Rs 1,500". That you didn't is one mistake, another would be to not buy it at Rs 1,800. You could fall into this trap while renting out your house. You may want the older, higher rent for your property even when overall rents have gone down. As a result, you may forego rent while still paying tax on the imputed rental on the second home.

Way out. To beat this mental trap, you can look for a current benchmark and not the one that is implicitly suggested, or even better, look at a realistic lifetime return that will make you happy. This is specially useful while evaluating the performance of your portfolio, fund and, even, unit-linked insurance policy.

Money Illusion  

Anchoring

A fact or figure with no bearing on a decision ends up influencing it. Many FD investors still
look for a 12 per cent return, forgetting these are linked to inflation.

Situation One Convention is you should spend at least two months' pay on an engagement ring. You start calculating two months' pay.

Situation two Convention is you should spend at least two months' pay on an engagement ring. You ignore it and decide what to spend. 
Answer If you choose Situation 1, you are suffering from Anchoring bias. Actually, the ring should not cost more than what you can afford, irrespective of how many months' pay that amounts to. By fixing unrealistic benchmarks that may not be accurate, we get trapped into financial decisions that are harmful.
DUMB SIGNSMART SIGN
  • You wait for a stock to come back up to its buying price before selling it

  • You still pine for the 12% interest rate regime

  • You want as much as your neighbour who sold when the real estate market was at its peak

  • You want the same bumper return as last year from your mutual fund

  • You buy at a 'discount', but the price is equal to the normal price due to smart packaging 

  • You value each stock purchase according to the fundamentals of the stock

  • You are happy with an average index return of 15% a year

  • You break down prices to per unit to see through sharp sales pitches

  • You look at the average annual rate of return on your investment rather than absolute return to judge performance

 

We have a tendency to ignore the effect of inflation on our money choices. Take, for example, the way an average insurance agent sells you a policy. His pitch to you is: Put in Rs 100,000 every year for 15 years and get back Rs 25 lakh. Sounds great, till you remove the money illusion. The annual return here is a nominal 6.9 per cent. Factor in inflation at 6 per cent and you are left with a return of just 0.9 per cent.

Other fixed return instruments like fixed deposits and bonds also fall prey to this trap. We think FDs are giving us 9 per cent return nowadays. But, at 6 per cent inflation, the real return is just 3 per cent. Allow taxes in and the return is even lower.

Money illusion

People mistake nominal variables for real variables. Investors evaluate 
the return from debt instruments without taking
into account inflation.
 

Situation One Gave 30% returns on his funds in a year in which the benchmark rate was 40%. Will you choose him as your fund manager? Situation two Limited losses to 5% in a year in which the benchmark rate was minus 20%. Will you choose him as your fund manager? 
Answer If you chose the guy in Situation 1, you suffer from Money Illusion. In the first case, the fund manager underperformed the average market rate and the investor would have been better off in an index fund. In the second case, when the market fell by 20 per cent, this investor would have just lost 5 per cent.
DUMB SIGNSMART SIGN
  • You look at the nominal return without looking at post-inflation earnings

  • You do not use equity during retirement to stay ahead of inflation

  • You promise to save more tomorrow rather than today

  • You do not look at other costs of investments, typically in insurance

  • You use absolute return to judge performance

  • You look at real return after accounting for cost, inflation and tax

  • You use structured equity products like ETFs to ensure long-term wealth creation

  • You understand the benchmarks in floating rate loan products

  • You start investing today rather than wait for a large amount to begin with

  • You see returns as benchmark-plus or -minus

Way out. Look at returns after taking into account inflation and taxes. To get the real returns, consider all the costs and taxes that apply to an investment, then reduce the return rate by the expected inflation number - about 6 per cent in India. You will find then that the stockmarket index gives the best long-term, low-cost real return. If you had invested Rs 10,000 in the Sensex in 1979, it would be worth over Rs 12.6 lakh today; a bank FD would have fetched Rs 1.58 lakh on the same amount.

Another way money illusion hurts is when inflation keeps eroding the real value of a life or non-life cover. If we assume an inflation rate of 5 per cent, a 25-year life cover of Rs 10 lakh (Rs 1 million) would be half as effective after 15 years since Rs 10 lakh then would be able to buy only what Rs 5 lakh does today. This is one reason why our insurance covers need periodic reviews.

You can be more in control of your financial life if you know the traps that you are programmed to fall into. The real challenge is to use these five behaviour traits as two-way weapons. Wherever possible, use their good points to your advantage, while being careful about their stings. Let not your financial journey be one of remorse and regrets, but of hope and conquests.

With reports from Anagh PAL, Kayezad E. Adajania, Pankaj Anup Toppo and Sunil Dhawan


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