Behavioural Mistakes To Avoid While Investing

It’s often said that an investor’s worst enemy is he himself. If our house is on fire, we listen to our intuition and run for safety. This helps us survive. However, in the case of investment decisions, this behaviour can land us in trouble. The moment we see signs of panic in the stock market, we run to sell all our stocks; when we see euphoria, we jump into the market. We tend to behave irrationally and in a biased manner in many investment situations. 

Our long-term investment success is determined by our ability to control our‘inner demons’ and ‘psychological traps’. The good news is that human behaviour is irrational in a predictive manner, as examined by Professor Dan Ariely in his book ‘Predictably Irrational’. Once we recognise these ‘inner demons’, we can develop approaches to tackle them. A thoughtful investor can leverage this predictable irrationality by remaining un-swayed by the noise and making rational decisions, thereby taking advantage of others’ ‘behavioural biases’. One of the inner demons is ‘over-confidence’. Time and again we tend to overrate our ability, knowledge and skill. Watching 24-hours news channels and listening to ‘experts’ we tend to believe that we are experts and make investment decisions that are not thought through. We think we can predict and time every up and down of daily price movements and invest accordingly. Overconfidence can lead to excessive trading and poor investment decisions. To be a successful investor, one needs to follow a zero-based approach towards decision-making. Investors need to be prudent to not sell their winners too soon and nor hold on to their losers too long.

Another important psychological trap we need to avoid is ‘herding’. People tend to follow the actions of a larger group, independent of their own knowledge. Large-scale social imitation can lead to significant gaps between actual value and price. This herd-like behaviour phenomenon can create profitable opportunities for an individual stock. But taking advantages of collective irrationality, either for a specific stock or for the market as a whole, is difficult. Since most of us have a strong urge to be part of the crowd, acting independently is not an easy feat.  However, if we’re able to control this behaviour, it can result in significant investment gain for us. Warren Buffet sums this up by saying: 

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful”.

 It requires significant control over one’s emotions to practice in real life.  Focus on avoiding silly behavioural mistakes. Research has shown that behavioural mistakes can reduce the return on investments by 10% to 75%. So what do you need to do avoid this? It can be summarized in one word: discipline. One need not always focus on becoming smart. Avoiding silly behavioural mistakes can help one become a successful investor in the long-term. Warren Buffet once said, “You only have to do a very few things right in your life, so long as you don’t do too many things wrong”. If we can avoid making a big mistake, the right decisions would take care of themselves.  As the central theme of the Mahabharata, the battle for investment success is about systematic adherence to dharma – financial dharma. As stated in the epic, “The road to heaven is paved with bad intentions.” Our journey towards financial heaven is filled with inner demons, which need to be identified and tamed for long-term superior returns. Just as mental discipline and willingness are required to forego short-term pleasure to wake up every day and jog for good health, a similar discipline and willpower are required to follow the simple but powerful mantras of enhancing long-term financial health. 

 Key Takeaway Points • Always use a ‘checklist ‘approach towards entry/exit of stock. Keep it short and reasonable.  

• It is better to do your due diligence before investing. Keep a safety margin while ; never invest to lose.

• Adopt a ‘buy and hold’ strategy with periodic review.

• The less frequently you track the market and check your portfolio, the less likely you will be to react emotionally to the natural ups and downs of the stock market.

• Be more thoughtful while taking a long-term investment decision. Losing one day’s return will not matter if you want to keep the stock for 10 years. When you see a sign of panic or euphoria, the best advice would be to wait for another day. If the investment is meaningful from a long-term perspective, the opportunity will continue to remain a good one, even in the future.

• Have appropriate asset allocation, and rebalance your portfolio periodically.

• Be humble, and learn from your mistake. When you succeed, evaluate which of your actions contributed to the success, and which ones did not. Don’t claim the credit for successes that have occurred by chance. Avoid rationalisation when you fail.

• Don’t exaggerate the role of bad luck in your failures

Happy Investing!

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Volatile Markets ? What to do? Read on

Volatility is a part of investing. There is no need to get afraid of it. Volatility acts as small bumps in our investment journey.

  • Control your emotions. Don’t Panic.
  • Call your financial advisor and understand the reason behind the volatility.
  • Don’t listen to the noise in the market. Stay focused on your goals.
  • Look at the big picture:

The most common mistake which an investor does is to think about exiting current investments. Remember that you have invested for fulfilling the dreams of your loved ones and exiting current investments will compromise that objective.

  • Use volatility as the opportunity:

Don’t stop your SIPs or STPs. This is an opportunity to accumulate more units through SIPs or STPs. So, let your SIP or STP run.

  • This is the time to be greedy:

Remember the quote by Warren Buffet – As an investor, it is wise to be “Fearful when others are greedy and greedy when others are fearful.” So, this is the right time to top-up your investments through lumpsum and SIP mode.

And lastly, don’t forget that in the long term, market rewards disciplined and patient investors.

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Various Investment Options

When you first start out to plan your finances, it is likely that you are overwhelmed with the options there are. There are a number of instruments that will help you grow your money, but how do you choose which ones are appropriate for your needs? We’ll give you a brief on the popular investment avenues and tips on how you can make your decision.

To understand this, the following will help you put investments in perspective. Investments are all split into “asset classes” – primarily these are equity, debt, gold, and real estate.

Equity refers to the stock markets. Debt refers to an investment that is linked to fixed returns for a particular maturity period.

Now, on to the main investment product options available and what they are:

PPF

Public Provident Fund (PPF) comes with a fixed interest rate for each year, which is pegged to prevailing government bond yields. With an upper limit of Rs.1,50,000 per year, it is meant to inculcate small saving habits. The investment amount is locked-in for 15 years and is eligible for tax saving deduction under 80C. Current rate of interest on PPF is 8% per annum. EPF is similar to PPF.

The positives: With a long lock-in period, PPF ensures that you put aside some money for the long term. Apart from being eligible for tax deductions, the interest on PPF is also tax-free.

The negatives: Being a debt product, its returns are limited and even investing the maximum amount each year may not be enough for your retirement corpus.2.

Fixed Deposits

FDs issued by banks are more common, but corporates issue FDs as well and often with higher interest rates. FDs have fixed maturity and can range from 7 days to even 10 years. A few bank FDs have become more flexible with premature exit options but largely they are locked in for the maturity period. Prevailing interest rates in popular banks is around 6.5%-7% per annum while the higher risk counterpart corporate deposits offer around 8.5%-9%.

The positives: FDs are low-risk, offering a guaranteed return. Setting up recurring deposits and using your bank’s sweep facilities are a great way to build up investments. FDs ensure that your money is not idling in savings account earning minimal interest.

The negatives: For longer time periods, FDs aren’t great. Historically, they haven’t given inflation beating returns. Interest income is also taxed at your tax slab. Depending on FDs alone for all your needs means you need to save up a high sum or you may miss your target.

Insurance

Insurance in its true sense is a risk cover. But some life insurance policies like endowment and money-back policies place themselves as investments. This is because they offer some benefits on maturity even on survival. ULIP is a hybrid product where a part of the amount gets invested and a part goes for the insurance cover. ULIPs have different schemes which invests in equity and debt market.

The positives: Insurance provides a protection. Premium payments qualify for tax deductions.

The negatives: They are not investments. Variants which give lumpsum amounts at the time of maturity may look attractive, but the returns are poor given the time you stayed invested. ULIPs give you a life cover and returns from your investment. Unfortunately, the life cover you get for the premium paid is minimal, when compared to plain term insurance. In a ULIP, you get neither adequate insurance nor investment. Liquidity, transparency, and comparisons of ULIPs are also poor.

National Pension Scheme (NPS)

NPS is a pension scheme which invests in a combination of equity, corporate bonds and government securities. You can decide the allocation between each yourself, or you can allow the system to choose it for you. The scheme matures when you turn 60 or 10 years from the time of account opening, whichever is earlier. At that time, up to 60% of the amount can be withdrawn and the rest is compulsorily invested in annuity. Even though premature withdrawal is possible for a certain amount, it comes with a lot of rigid clauses.

The positives: NPS gives an additional tax deduction of Rs.50,000 under 80CCD. Similar to PPF, the long lock-in period ensures that there is a retirement fund is in place. The addition of equity helps improve returns compared to PPF or EPF.

The negatives: For disciplined investors who don’t need such constraints, NPS is a bit too rigid. Compulsory conversion of a large portion of the end corpus into an annuity is not tax efficient nor attractive in terms of returns.  

Gold

Gold has traditionally been used as a savings avenue. But physical gold is not an investment because of challenges arising in purity, storage costs, wastage costs, and liquidity. Financial gold is more effective in capturing movement in gold prices without having to deal with physical gold. These include Gold ETF and gold mutual funds. Gold sovereign bonds issued by the government are also another way of investing in gold, and comes additionally with a small interest component and taxation benefits.

The positives: Its low correlation with stock prices and its counter to inflation makes it a good hedge against market risk.

The negatives: Gold as an investment does little to your overall portfolio. Their prices move solely based on global equity market sentiments and the exchange rate. Gold prices can and have stayed stagnant for long periods of times.

Stocks

By investing in shares (equity) of a company, you become a shareholder. The returns you reap will come from the growth of the company which will reflect in the price of the stock. There is no cap to these returns and stock prices can rise multi-fold. A small amount, therefore, can grow in very large sums. You need a trading and demat account to transact in stocks.

The positives: Equity has historically been the highest returning asset class. Higher returns mean you can invest lower amounts – so a large corpus target can be achievable even if your savings capacity is lower.   

The negatives: Picking stocks comes with high risk. It requires market expertise. Stocks can be very volatile and therefore require both risk appetite to stomach rapid change in values as well as conviction to hold on to the stock. While volatility evens out over the long term, it still needs time. It can be safely said that equity investing is not for all and you should refrain from investing directly in stocks if you don’t understand the equity market well.

Mutual funds

A mutual fund is a pooled investment vehicle which invests in equity, debt, or gold and is managed by investment professionals. Choice of investments and their management is made by fund managers. Mutual funds charge a fee for such management. Eventual returns will be decided by which asset class you invested in. Broadly, returns from equity mutual funds will be market linked whereas debt oriented mutual funds will be a notch or two higher than that of fixed deposits.

The positives: Mutual funds give you professional management of both equity and debt markets without you having to make choices yourself. The variety of mutual funds means that you can find a fund that matches all your requirements. Open-ended funds can be exited anytime, giving you flexibility to structure your investments around your needs. Debt mutual funds have lower taxes than bank or corporate FDs.     

The negatives: The same flexibility can turn harmful if not used prudently. Easy-exit and no lock-in feature of mutual funds can hamper long term wealth building if not used for the right purpose. You will also need to track your mutual funds from time to time to ensure that they continue to be good performers. 

What you should consider

Now that you understood features of different products, you need to see which ones suit you. For that, you need to consider two important things – your needs and your risk appetite.

First, let’s understand what risk here means. It is the uncertainty in returns and probability of losses. For example, returns from any equity product is volatile and cannot be predicted beforehand. Whereas debt-oriented products, like PPF and fixed deposits, are more predictable and low risk. The more you’re able to withstand volatility in returns and losses, the more risk you can take and vice versa. But why should you take higher risk? The trade-off here is higher returns. So, while equity (stocks and equity mutual funds) is risky, returns over time compensate for this. While debt (FDs, PPF, debt mutual funds) is low-risk, so are its returns.

Second, your needs. You can think of your needs as the purpose for which you need money. Split this into what you would need in the short term versus money that you can put away for your future. To keep it simple, call anything longer than 7 years as long term. If you don’t have a well-defined goal and you just want to save up your surplus, consider it to be long-term as you have no definite use for it.

How to make the choice

Two simple rules. One – longer the timeframe, higher the risk you can take and vice versa. Two – the more risk you can take, the more equity investments you can make and vice versa.

Here are a few pointers. For short term needs and contingency (emergency) funds, you’d need a stable source of returns, easy conversion into money, and low risk. You can consider bank FDs or debt mutual funds for that purpose. PPF is unsuitable because of its long lock-in. Don’t use equity-oriented products for short-term goals, no matter how attractive the 1-year or 3-year returns may look.

For long term wealth building or a timeframe of 5 years and longer, include equity as it delivers superior return and you can build more wealth. Be it through NPS or mutual funds or direct stocks, up your equity exposure longer the time frame and the more comfortable with the market. You can include an exposure of 60%-80% in equity for a period more than 5 years, depending on your risk level. Put the remaining in debt-oriented products like FDs or debt funds. Don’t put all your investments into equity – that’s just exposing your entire portfolio to high risk with no means to limit volatility.

Insurance products for the purpose of investment can be written off the list. Simply hold adequate term insurance (thumb rule is your sum assured should be 10 times your annual income) and medical insurance.

If you get confused by the array of products out there and whether you should invest in those, just do this – look at how it gets its returns, the risk level it involves, how long you can give that investment the time to perform, and how easily to can liquidate it either to meet your needs or if it is not performing well. Then blend these products to create a portfolio that suits different aspects of your needs.

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