We all are social animals and we remain the same social animals while thinking about money and investments. Let me discuss the common financial mistakes that we, human beings, make as social animals; to understand that, we have to turn to Behavioural Economics. This combines twin disciplines of psychology and economics to explain why and how rational people make totally irrational decisions when they spend, invest, save and borrow money.
1. Sunk Cost Fallacy
Imagine that somebody has given you a ‘free’ ticket for a play in which your favourite star is acting. Now, hours before the play is going to commence, you come to know that your favourite star may not be able to act that day; also, there is weather problem and going to the theatre and coming back might be risky. Now, imagine that you had actually ‘paid’ and purchased that ticket. It is likely that, in the first instance, you might not go for the play while, in the second instance, you might go for the play even though your favourite star is not acting in it and risk travelling in inclement weather. This is called ‘sunk cost’ fallacy. In the first instance, since you have not paid for the ticket, you don’t mind skipping the event. But, in the second instance, since you paid hard cash for the ticket, you don’t want to ‘waste’ the money which is actually already sunk.
The same way in investments, many a times, because we buy a stock of a bad company at a certain price and then it value declines to half, then, in the name of ‘averaging’, we invest more in it; throwing good money after bad. The lesson we learned from this example is that we should not sell winning investments more readily than losing ones and not take money out of the stock market just because markets have fallen.
2. Loss Aversion
One of the main tenets of behavioural economics is that people are loss-averse. The pain people feel from losing Rs100 is more than the pleasure they get from gaining Rs100. This explains why people behave inconsistently while taking risks. For example, the same person can act conservatively when protecting gains (by selling successful investments to guarantee the profits) but recklessly when seeking to avoid losses (by holding on to losing investments in the hope that they’ll become profitable). Loss-aversion causes investors to sell all their investments during periods of unusual market turmoil. If you had sold most of your equities during the bottom of any market cycle, then, probably, you are suffering from ‘loss aversion’.
3. Mental Accounting
This term ‘mental accounting’ refers to people who treat money differently depending on from where it has been received. For example, a person may treat salary (earned money) as sacred and be over-cautious with it, while the same person might treat gifts, unexpected bonus, written off tax refunds, huge inheritance as ‘free money’ and be careless with it. The sacredness may lead the person to let the money remain idle in savings account and, thus, getting beaten down by inflation and the carelessness may lead the person to just spend the money or invest in risky ventures and, eventually, losing it. The lesson is that money is money irrespective of the source from which it is received. Deposit any windfall gains first in your savings account and mentally count them as part of your wealth. Then, there is less likelihood of your squandering away that money.
4. Bigness Bias
Most of us try to think big as far as money is concerned but easily forget the small things which, when compounded over a period of time, result in much bigger losses. This is because of our ignorance of the basic principles of mathematics. For example, the tendency to dismiss or discount small numbers as insignificant can lead us to pay more than we have to pay for brokerage, commissions, mutual fund expenses, income-taxes; all of these have a surprisingly deleterious effect on our investment decisions over time.
5. Decision Paralysis
Whether it is investments, insurance, spending or any other money matter, many a times, we are not able to make a decision and just maintain status quo. However, we don’t realise that not making a decision is also a decision in itself that we have voted in confidence for the way we are doing things. The lesson to learn from this behaviour is that by not taking the right decisions, often, we continue to, invariably, promote the wrong decisions, the opportunity cost of which may prove to be high over the long term.
6. Money Illusion
Most of us have illusions about money—the more the money, the more we think we have earned and vice versa. But this may not always be the case. I explain this with a simple example. Suppose, an employee got a 10% salary increment when the inflation is 12% while, in another case, the same employee got 5% increment when the inflation is 3%—which one would he prefer? There are chances that he will prefer the first case of 10% increment, although in this case, the employee is getting negative real increment since inflation is more than the increment, while, in the second case, he is getting positive real increment since inflation is less than the increment.
This is called money illusion and one of the main reasons why people prefer investment in fixed deposits (FDs) at negative real interest rates after tax than long-term tax-free gains and dividends through stocks.
7. Cash Fallacy
Suppose we go to buy an expensive gift item for, say, Rs1 lakh. If we have to actually withdraw cash from our bank account and then pay for it, we will feel the ‘pain’ of losing cash and, therefore, we would think twice before buying it. In the same instance, if we just pay through our credit card, then we may be very comfortable and have the illusion of not experience the pain of losing cash. This is called ‘cash fallacy’ and is the main cause of a lot of unwanted and avoidable expenses in the modern plastic world. Remember, if you buy things you don’t need, soon you will have to sell things which you actually need.
8. Over- or Under-confidence
These are the other two enemies of investors. If you are over-confident about your abilities, then you would only look at your successes and boast about them while trying to ‘explain away’ your losses. On the other hand, if you are under-confident, then you would not be able to take control of your finances, make investment and spending decisions based solely on the opinions of friends, colleagues or worse than that, the so-called ‘investment advisers’. Both these psychological features are not good for your money and, hence, beware of them. The lesson from this is: “either you act on your own judgement or entirely on the judgement of another” and that another should be a family member with equal stake in the outcome of the decision and not just a friend or worse than a financial adviser having vested interest.
Certain simple steps to avoid big financial mistakes, over time, are:
- Take proper insurance and let it be pure insurance (term policy).
- Make proper retirement plans.
- Pay off credit card bills with so-called ‘emergency’ funds lying idle in your savings account.
- Make proper asset allocation and diversify your investments.
- Put maximum of your equity allocation in index funds; it will save you a lot in fund management expenses and avoid the randomness bias of fund managers.
- Review your assets and take stock of your entire portfolio including investments in securities, real estate, art, retirement plans, etc.
- Set up a ‘direct payroll deduction’ to some kind of recurring savings / SIP.
- Keep reviewing your plan.
Achieving financial freedom is a simple, boring and mechanical process. Avoid the common financial mistakes and you would be fine.