Science behind the Bad Investment… Part I

 

While the numbers and the statistics play an important role in any financial investing, finally it’s the human beings who are doing the actual execution! Human psychology is an interesting science, but at the same time it’s a dangerous thing. Many of the investors and even advisors are not aware about the common psychological behaviors that can wreak havoc on your hard-earned money invested into different instruments. (In fact, a few investment advisors use this knowledge to their advantage by getting people to invest in not ethically correct decisions but rather more convenient ones for themselves.) How dangerous it could turn out to be for the financial future of you and your families… Just Imagine!!

So today, our attempt is to educate you and share some important pointers on science behind the investments and most essentially how to avoid the bad investments. So here we go. The first part of this blog is going to talk about few basic concepts and biases.

Let’s start with the most common one and what people think is the best decision in the circumstances. The “Loss Antipathy Bias”!  People believe that there are more bad things in the world for us than the good things happening and thus it’s better to capitalize on anything positive at any given point in time. Simple example is of investment that you have done in a couple of funds at the same time. One was say: 1 Lac because of a “hot tip” given by your friends and another one was a 15000 only in an investment which was well researched by you. Imagine the 1Lac has gone down to 50000 only whereas a well-researched one you did is now 50000 too. Which one are you likely to sell in a need? “The Loss Aversion” mindset kicks in and says, sell the profitable one first, else you may lose that one too!  It’s the natural psychological barrier which says you may lose this profit.  

Well, we all should see that it’s not a simple answer! That profitable 50000 may be only just tip of the iceberg and the rally is expected to take it to 1Lac… But, psychology doesn’t let you think like that.

A wonderful analogy is shared in one of our earlier blogs with a story of Tamarind Tree.  (Link: Why an Investor should never let a crisis go waste) The tree which was feasted upon regularly and daily without letting it grow, dies soon after. And the one where you let it flourish will continue to give prosperous returns.

On similar lines, we can think of another pitfall called “Lost Cost” pitfall. This is as dangerous as the previous one we talked about, if not more. Psychologically, we start protecting and justifying certain decisions taken earlier (but not realistically), and its catastrophic for the investment. It’s very difficult to accept that you made a mistake or made a wrong choice of investment earlier! You continue to stay vested into this loss making instrument, even though the best idea would be to get out of it as soon as possible. This delay can prove to be fatal for any positive returns. Emotional commitment to the bad investment makes things worse.

An ideal analogy here can come from Mahabharata and the character “Karn”. He is actually the son of Kunti, Pandava’s mother. He knows that he has sided with the wrong side during the war and Duryodhana is the side of “Adharma”; but unfortunately to keep his commitment to Duryodhana, was killed in the war along with other Kauravas.

Next one to talk about is a “Relativity and Comparison” pitfall. Each and every individual is different psychologically. Each and every situation is different worldly. And each and every opportunity looks different from an individual’s goggle or a lens. This is a true reality! Not every investment and opportunity can be compared and related to what others are doing. Especially, your closest friends and relatives… Imagine there is a huge opportunity in the market because of a certain global situation, whereas your best friend wants to put in additional 50Lacs investment to benefit from this opportunity, you may not be in a position to do same thing! Multiple factors to be considered like family responsibilities, financial liabilities, ongoing commitment to certain investments already done (e.g. property loans or some electronic White Goods purchased on EMI plan). Well, these are still simple but how about your mental or psychological make-up??!! Every individual is different and so is the risk-taking or risk-aversion ability. If investing these 50Lacs is going to lose you a good night’s sleep, is it really worth it??!!

But people do get into this, comparison and relativity trap and thus losing a lot on investments in future (if they don’t stay invested) or even on their comfort and mental well-being.

The analogy here can be of a copycat syndrome in business scenarios. What the market leaders do, some businesses blindly copy. They may not have the sustainability say in terms of marketing dollars spend and thus eventually lose out on the entire business.

Irrational Exuberance Pitfall (Term popularized by US Fed Chairman Alan Greenspan): So, what does it mean? Irrational exuberance is unsupported and unfounded market optimism that lacks a real foundation of fundamentals, but instead rests on psychological factors such as past performance. When investors start believing that the past equals the future, they are acting as if there is no uncertainty in the market and market will only continue to go up. Unfortunately, in real world the uncertainty never vanishes. Just relate it to the COVID19 scare we have been living through for past 6 months. It was never expected and is a kind of Black Swan event that has crippled economies all over the world. Irrational exuberance is actually synonymous with the creation of inflated asset prices associated with bubbles based out of just sentiments and emotions, which ultimately pop out.

Well, the stories and examples are galore and we can learn from many of those… But, these are only a few pitfalls being talked about. In the second part of this blog let’s talk about few other psychological barriers. Are you ready?