Do Not Let Emotions Dictate Investment Decisions

Making an investment decision should ideally be a quantitative exercise; however, in practice, many a time emotions take the driver's seat. DSIJ explains some of the most common emotions and biases that come into play while taking investment decisions and how to avoid them.

- 

Puja (aged 34) and Abhishek (39) are someone with whom most of us can associate. They are well-settled with rewarding careers, but they are still facing various financial challenges. They are not good at taking financial decisions. Their savings rate does not match up to the required rate, they do not have proper insurance coverage, they are yet to start investing for their various goals, and worst, they do not hesitate in accumulating debt. It is not that they do not understand the pitfalls of making such erroneous financial decision. Nonetheless, our brain is hardwired in a way that we do take decisions purely on quantitative factors, but various behavioural biases and heuristic factors enter into decisionmaking, thereby leading to sub-optimal decisions. Heuristics are mental shortcuts that involve only one aspect of a complex programme or phenomenon, leading to errors in judgement or biases.

According to a study done by Dalbar Inc, in 20 years from 1993-2012, the average mutual fund investor in the US underperformed the broader equity indices, S&P 500 by 3.96 per cent. S&P 500 index on an average gained by 8.21 per cent compared to only 4.25 per cent of annual gain by retail investors. Besides the expense ratio, what led to such underperformance were investors themselves and their irrational behaviour.

Puja and Abhishek’s perception about their finance and investment is shaped by their cognitive biases, financial attitude and their prior experiences with money and wealth. In the following paragraphs, we will discuss some of the important emotions and behavioural biases and how these lead us to irrational financial decisions. Understanding these techniques can be useful in improving the quality of financial decisions you take.

Recency Bias