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"Emotizing" is yet another word that cannot be found in English dictionaries so let me explain the term. I have coined the term "Emotizing" to describe the process of using emotions to make decisions on investments. Of course, our behavioral biases and emotions are one of the aspects of decision-making nevertheless they play an important role. In an ideal world, all investors should go about the business of investing very logically and unemotionally as prescribed by the modern portfolio theory. However, humans are irrational in many ways. We have our preferences, likes, dislikes and biases in everything we do. Investment activities are not immune to this behavior. This article captures some very common but universally exhibited "Behavioral Biases". The order in which the biases are listed does not imply any importance or priority. While it is difficult and probably not desirable to eliminate the emotional aspect completely, one can try to minimize it.
A loss in investment creates more sorrow than a gain in investment brings joy. Invariably, we end up holding loss-making investments in the hope of recouping our losses. In the process, an investor increasingly takes greater risk. This can lead to a gambling kind of behavior where a gambler keeps increasing the bets in order to recover the losses. "Losing your shirt" is the term that comes to my mind. Investors also tend to believe that liquidating a loser amounts to accepting that they made a mistake. So, the natural reaction is to delay that acceptance. Investors should remember that the ultimate goal of any portfolio is to generate returns with an acceptable level of risk. For example, an investment bought at Rs. 100 and currently at Rs. 50 may take forever to recover the loss whereas a fundamentally better investment will definitely reach the Rs. 100 mark from Rs. 50 (assuming the loss-making investment is sold off and the proceeds are reinvested) in much lesser time with much higher probability. The investor's goal is still met without taking higher risk. Initially, it can be a gut wrenching exercise but all investors should have a hard look at negative investments and go through the fundamental analysis. If the conclusions determine "Sell" call then take the bitter pill in order to maintain your financial health.
Fear of Regret
Fear of regret can lead investors to being in their "comfort" zone. Investments in bank Fixed Deposits, Recurring Deposits, Insurance money-back products are some examples of "comfortable" investments. By deliberately excluding stocks, bonds and other asset classes, investors want to avoid being in the position of possible regret. If an investor has lost money or made wrong calls in the past then it is likely that he/she will become unnecessarily risk averse. Thus, the investor will fail to hold investments that could improve the return/risk characteristics of the portfolio.
Maintaining Status Quo and Inertia
If it does not hurt then maintain the status quo is a mantra followed by many individuals. But there is an associated opportunity cost. Since it is difficult to quantify the opportunity cost, investors do not feel a sense of urgency in taking actions. This is akin to not taking preventive health measures until an individual encounters a health issue. While we don't have to squeeze every penny out of our investments, it is prudent to consider the available options and exercise those so that money is not left on the table. For example, money in a savings bank account can be put in liquid funds to earn extra returns without adding any risk to the portfolio. There are many such instances of portfolio enhancements that can be done rather than being inert and maintaining the current allocation. Opportunity cost in itself is an interesting topic so I will write more about it in a future article.
How many times we may have heard someone say that they will sell the investment at a particular price or return. Investors have a tendency to be anchored to a value (price, return) which hinders them from taking timely decisions. While investors can set return targets based on fundamental analysis but they should keep reevaluating as and when new information becomes available. The adjustment to the targets and any required actions should be taken promptly.
In this Internet age, information is available at finger tips. With the onslaught of television programs, news media, internet sites dedicated to investments advice and related material, investors increasingly feel empowered to make the right investment decisions. This is a very healthy trend however this also tends to make individuals feel over-confident in their abilities. During the dot com boom in the year 2000, anyone who would have invested in the US market in a dot com company would have made handsome returns and believed in his/her superior investment picking skills. Similarly until the crash of 2008, investments made during 2003-2008 period in the Indian market would have fetched excellent returns and made most people feel like "Investment Gurus" for a very long time. Each individual also likes to believe that he/she has access to better information and he/she is better at interpreting information than others.
Lack of Discipline
The lack of discipline comes from the need for instant gratification. The long-term goals are not balanced with the short-term financial needs which lead to fewer savings and more consumption. Further, if an individual borrows to meet the short term needs then it he/she throws fiscal prudence to winds. "Cut your coat according to your cloth". One of the ways to achieve the discipline is by enrolling for Systematic Investment Plan every month. Many people also avoid credit cards so that they don't put unnecessary purchases on the card and end up with higher debt.
Mental accounting is "Bucketizing" investments to meet each goal. My previous article explained this behavioral bias in detail and how it leads to sub-optimal allocation of investments. The alternate approach of two "buckets" - Short-Term and Long-Term Assets - helps investments allocation in the context of overall portfolio, its return, its risks and correlation amongst the underlying asset classes.
How to overcome the biases?
The first step in overcoming the biases is the recognition and the realization. Next, individuals can begin with writing down their financial goals, return expectations, risk-appetite, investments entry criteria, investments exit criteria. Developing a comprehensive plan, monitoring its status on a regular basis, updating the plan based on changed parameters and implementing the plan takes out the subjectivity from the decision-making. It is always helpful to take professional advice because the emotional aspect will then be certainly minimized.
Mitraz Financial with its dynamic asset allocation approach has well-defined entry and exit criteria for asset classes and investments to capitalize on the available opportunities and protect investor returns. With the proprietary model developed in-house, the investments are advised to be bought and sold based on market parameters like Price to Earnings Ratio, Interest Rates etc. Mitraz advice based on this model helps investors minimize the impact of their behavioral biases and lets them achieve better risk-adjusted returns.
The writer is the Managing Director of Mitraz Financial Services Pvt. Ltd and can be contacted at firstname.lastname@example.org