FINANCIAL BEHAVIOR OF A RETAIL INVESTOR

When we talk of an investor, we relate him to only money and finances and tend to overlook the fact that first, he is a human being and thereafter an investor. Investor behaviour is characterized by his feelings, moods and sentiments, personality traits, perception, attitude and emotions. Therefore, like all other humans, his actions and decisions are affected by various biases. Investor psychology (the science dealing with the mind and mental processes, especially in relation to investor behaviour) classifies these into heuristic biases and cognitive biases. Simply put, a heuristic is a ‘Rule of Thumb’ mental shortcut used to solve a problem. It is a quick, informal, and intuitive algorithm that the brain uses to generate an approximate answer to a reasoning question. When investor heuristics fail to produce a correct judgment, it can sometimes result in a cognitive bias, wherein the processes information by filtering it through his experience, thoughts, likes, and dislikes. Psychologically, these biases lead an investor to a judgmental error when it comes to investing, which includes both buying and selling of the financial instruments. In this article, we will explain how some of these or other biases play up to influence the investor’s decision making. Some of these biases are listed in the chart below, and explained and exemplified through Mr Anil, a retail investor residing in a Tier II city of India, in the succeeding paragraphs. He represents the common salaried man who has two children and strives to make his ends meet within his salary.

Present Bias:  This is the tendency to overvalue immediate rewards at the expense of long-term goals. This bias propels Anil to live in the present without thinking too much about how the future unfolds. This gives rise to the tendency of overspending or anticipating a future windfall, which creates barriers to current saving and hampers long-term investment. Therefore, he indulges in buying consumer durables and enjoying lavish vacations and parties and postpones saving for his retirement to a later date. This proves disastrous in the long run since Anil does not start investing early. Thereby, he loses the advantage of the exponential growth of his early investment into a sizeable retirement corpus achieved through the power of compounding, which requires time.

Representativeness: This refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion that a person is rich if you see him alighting from a luxury car, even when he does not own it but has merely travelled in it as a guest of the owner. This results in investors labelling an investment as good or bad based on its recent performance. As per Chandra Prasanna (2016), Behavioral Finance, McGraw Hill Education, investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance. Investors may become overly optimistic about past winners and overly pessimistic about past losers. Investors generally assume that good companies are good stocks, although the opposite holds true most of the time. Consequently, Anil may buy stocks after prices have risen expecting those increases to continue and ignore stocks when their prices are below their intrinsic values.

Availability Bias: It is a bias where most relevant, recent, or traumatic events strongly influence the perceptions of investors that may be far from economic reality. The danger of basing investment decisions on market perception, rather than facts, is that Anil may pull his money out at the wrong time and miss some of the best days as the market recovers. In the stock trading area, this bias manifests itself for Anil through his preference to invest in local companies, which he is familiar with or about which he can easily obtain information, rather than relying on deeper market research.

Anchoring: It is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control his cognitive decision-making process. As per Chandra Prasanna (2016), Behavioral Finance, McGraw Hill Education, there are two plausible explanations for anchoring. The first is based on uncertainty relating to true value. When there is uncertainty, the decision maker adjusts his answer away from anchoring value until he enters a plausible range. This explanation works best for relevant anchors.  The second explanation is based on cognitive laziness. Since it requires effort to move away from the anchor and people are cognitively lazy, they tend to stop too early. This explanation works best for irrelevant anchors. Therefore, anchoring will lead Anil to invest in the stocks of companies that have dropped considerably over a short span of time. He is likely anchoring on a recent high point for the stock’s value, likely believing in some way that the fall in price suggests that there is an opportunity to buy the stock at a discounted rate. As far as Anil is concerned, the overall market has caused some stocks to drop significantly in value, thereby allowing him to capitalize on short-term volatility. However, what is perhaps more likely is that a stock which has dropped in value in this way has seen a change in its underlying fundamentals.

Regret or Loss Aversion: This refers to an important concept encapsulated in the expression “losses loom larger than gains” as the pain of losing is psychologically about twice as powerful as the pleasure of gaining. Typically, this is noticeable in the game of golf where the golfer avoids a water hazard by going around it or taking a layup shot. In the bargain, he loses a stroke or is required to play an excellent shot thereafter to make up the loss. Similarly, Anil will prefer to avoid the loss because the associated pain is more intense than the reward that he will feel from a gain. To avoid this pain of loss, he will try to play safe and resultantly move his investments to a place he perceives as safe-haven i.e. cash, cash equivalents or fixed income instruments. Another step he may undertake is to discontinue his ongoing SIP/SEP. All this will cost him when the inflation eats into his savings and erodes his purchasing power. Regret aversion can explain investor reluctance to sell losing investments because it gives them feedback that they have made bad decisions. Anticipated regret influences Anil’s decision making to take less risk because this lessens the potential of poor outcomes.

Overconfidence: This bias leads to the false assumption that someone is better than others, due to their own false sense of skill, talent, or self-belief. Investors often exhibit overconfident behaviour resulting in severe consequences. Research documents that overconfident behaviour is connected to excessive trading and results in poor investment returns. It can also lead to investors failing to appropriately diversify their portfolios. Overconfidence plays out in the real world and creates biases, viz. over ranking, illusion of control, desirability effect and timing optimism. Therefore, Anil having performed well in recent past may conclude that he is truly skilled and take more risks and trade more. To him his overconfidence will make future trades look less risky, but, when things go wrong his potential losses will be higher as they are directly proportional to his degree of overconfidence. Barber and Odean (2001) studied the role of trading behaviour and gender bias for a sample of 35,000 individual accounts over a six-year period. Their findings reveal that males are not only more overconfident about their investing abilities but also trade more often than females. Compared to women, men also tend to sell their stocks at the incorrect time resulting in higher trading costs. Women generally trade less and apply a “buy and hold” approach resulting in lower trading costs. Other studies have found that the relatively young are more overconfident than the relatively old and that highly overconfident people tend to have a higher risk tolerance.

mutual funds in jaipur
mutual funds in jaipur

Herd Effect: It happens when people feel most comfortable following the crowd and tend to assume the consensus view to be the correct one. It is also referred to as the bandwagon effect where the phenomenon of a popular trend attracts even greater popularity. This is the single most important bias in financial markets that create economic bubbles, which burst later to erode capital of the investors. History is replete with example of such bubbles, where during the run-up, investors bid up the prices to unsustainable levels. Then, even more quickly than they expanded, these markets burst and contracted to leave the herd scrambling. It is because of this bias that Anil will invest into a scrip or financial instrument that forms part of the rising bubble without due diligence and personal research, only to lose his capital when the bubble bursts.

INVESTMENT NUANCES

An investor is someone who commits capital in order to gain financial returns. Warren Buffett, the investment legend, defines investing as “… the process of laying out money now to receive more money in the future.”  An investor differs from a trader. An investor puts capital to use for long-term gain, while a trader seeks to generate short-term profits by buying and selling securities repeatedly. Therefore, the frequently asked question is whether investment is an art or science? Investment is neither an art or nor science; instead it is common sense based on three important tenets – discipline, patience, and knowledge. An investor must be wary of the market cycle and understand that when he invests, for all the gains that he will make, he will also incur some losses. It is impossible to only gain from the markets and not undergo some loss. However, a seasoned investor will mitigate his losses and increase his gains to ultimately improve his financial position. In this article we discuss some important facets that an investor must consider while he undertakes his investment journey.

Know
Yourself

There are no set piece solutions for investing or template that fits many or
all investors. Each investor is different and before you embark on your
investment journey, make sure that you know and understand yourself as an
investor. There are some important financial aspects that you must understand
and then devise your investment strategy. If you are unable to do it yourself,
then seek help from a financial advisor who can help you to do it. First, is to
establish your cash flow. If you are a salaried person then financial planning
is relatively easier due to fixed cash flow. For a businessperson, it is
trickier due to cash flow and business cycle uncertainties. Second, is setting
your life’s financial goals that include children education and marriage, house
purchase, retirement, dream vacations, and consumer durable among others. In so
doing, also decide on the time horizon for each of these goals to then classify
them into short, medium, and long-term financial goals. Third, is the aspect of
your risk-taking ability that is function of your age, cash flow and liabilities?
This will help you to decide whether you are an aggressive, moderate, or
conservative investor. Fourth, beware of venturing into investment options that
you do not understand merely because your friend does it or your advisor has
asked your to do it for higher returns. Invest only in what you understand and
are comfortable to deal. Fifth, invest in yourself and purchase health/life
insurance early in life to keep the premiums low. Normally, one should consider
separate family floater policy for health and critical illness coverage and a
term insurance policy for life coverage. Ideally, your life coverage should be
10 times of your annual salary.

Compounding – Einstein called “compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.” Compounding is the process of generating more return on an asset’s reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. See the chart below where we have calculated the yearly compounding of rupees 1 lakh that earns 12 percent annual interest. In 30 years, it has grown to almost rupees 30 lakh. However, it has taken nearly 7 years to double and 21 years to grow 10 times. Thereafter, in the next 10 years it grew from 10 to nearly 30 times of the initial investment. As is evident, the exponential growth of the investment is only in the latter half of the investment period when the investment has grown from nearly 5 to 30 times. Therefore, the investor must start investing early to give himself adequate time for the compounding to work and minimise withdrawals or keep reinvesting the returns.

Real
Returns

understanding that real returns are the gains made after offsetting the
inflation and taxation will help an investor to consider and invest for maximum
total returns. Inflation erodes the purchasing power of money e.g. in 30 years,
real value of rupees 100 will become rupees 11.34 at 7 percent annual
inflation. The real rate of return is the return adjusted for inflation or
other factors. Adjusting the rate of return offers a better measure of
investment performance and allows for a more effective risk versus reward
measurement. Nominal rates are usually always higher than the real rate of
return. Even though fixed deposits guarantee returns, after tax and inflation
deduction, the real rate of returns in these varies between 0.45 to 0.75
percent. Investing in equities is one of the ways to beat inflation as they
generate positive real returns over long-term.

Flexibility – an investor must always remain
flexible in his investments by investing in different types of investments and
maintaining cash reserve to take care of emergencies (emergency fund) or take
advantage of investment opportunities. There are many types of investments like
mutual funds (open and close ended), ETFs, individual stocks and bonds, real estate,
and various alternative investments. An investor becomes a shareholder or part
owner by buying the company shares in dematerialized (Demat) form and thus
participates in the company’s growth/decline through rise/fall in share prices.
Besides, you also earn dividends that the company gives to its shareholders.
Before buying shares, the investor must use his power of observation, artful
questioning, and logical deduction to decide on the company. If the investor
buys company bonds, then he is loaning money to the company in exchange for
periodic interest payments plus the return of the bond’s face amount when the
bond matures. Both government and companies issue bonds. Several agencies issue
ratings to these bonds to evaluate the probability of whether a bond issuer
will default. Some of the important rating agencies are Standard and Poor
(S&P), Moody’s, CRISIL, ICRA and CARE. The investor should buy higher rated
bonds, which means the company has less chances of default. Government bonds
come with the sovereign guarantee and are relatively risk-free. Mutual fund
investment is best suited for passive investor who cannot actively track the
market or keep themselves abreast on a day to day basis. These are pooled
investments managed by professional fund managers that allow investors to
invest their money in stocks, bonds or other investment vehicles as stated in
the fund’s prospectus. Mutual funds use the end of trading day Net Asset Value
(NAV) for valuation and make distributions in the form of dividends and capital
gains based on this. They offer you the advantages of professional management,
high liquidity, and more tax efficient returns. Unlike mutual funds, ETFs
(although like mutual funds in many respects) trade constantly, like shares and
stocks, while the markets are open.

Diversification – to diversify means that the
investor must invest in various asset classes to manage his risk and earn
higher returns. This happens because the positive performance of some
investments neutralizes the negative performance of others. After, diversifying
his portfolio into various asset classes like equity, debt, gold, real estate
and fixed income instruments, the investor must also consider diversifying
within some of the these individually. He can consider buying securities of
large, mid, and small market cap companies or let us say mutual funds of
different asset management companies or different fixed income instruments like
PPF, FDs or SCSS and so on.

Keeping
Track
– after
investing, it is equally important to keep a track of your investments.
Ideally, you should review your portfolio on a half-yearly basis and if this is
asking too much then at least once a year is necessary. The portfolio review
will indicate the gainers and losers in the portfolio, the financial instrument’s
performance in relation to its financial goal and the overall growth of the
portfolio. Having reviewed the portfolio, the investor must then rebalance his
portfolio. In so doing, he must shed his losers, switch, or reinvest in other
asset classes to maximise gains and offset losses, and realign his portfolio
with his financial goals.

Technology – like all other facets of life,
technological advancement also has a significant impact on investors. The
digitization of the bourses and concomitant dematerialization of securities has
eased the investment avenues for investors. It has facilitated research and
analysis by investors by opening the plethora of information and tutorials on
the net, generated options for them to invest in various financial instruments
and significantly reduced paperwork by facilitating investment through the
click of a button. The next big change is the introduction of robo-advisory
services, which use technology for client portfolio management by using
algorithms. All these have eased out investor apprehensions and reduced tariffs
and fees.

Emotions – there is no place for emotions in
investments. An investor should be aware of the fear of loss or regret, greed,
risk aversion and bandwagon effect during his investment. An investor should
hold his stocks or other investments dispassionately and consider their
purchase or sale objectively. He should shed them when they have delivered the
result, stopped giving profit or outlived their utility. One cannot make an
investment for indefinite period; relate it to a financial goal or investment
horizon. Prudent investment is to the use financial assets that are suitable
for your financial goals and objectives by considering the risk/return profile
and the available time horizon. To do this, you must keep the fees and taxation
minimized, and rebalance the portfolio periodically.

Understanding
Markets
– know
that markets are volatile in the short-term. As the investment horizon
increases, probability of loss reduces. Sensex movement in the last 39 years
has proved that the likelihood of losing money for periods of 15 years or more
has been zero. Since 1979 till date, markets have given a CAGR of 17.1%. If
wealth compounds at this rate, then an investment in the stock market doubles
every 4.5 years. Robert Kiyosaki had suggested, “it is not how much money you
make, but how much money you keep, how hard it works for you, and how many
generations you keep it for.” If an investor stays fully invested in the market
then he will earn a lucrative CAGR that beats volatility and inflation.
However, if he tries to time the market, then he runs the risk of missing days
that registered some of the biggest gains and the CAGR will drop drastically.

Discipline – a disciplined approach in
investment by taking the SIP/SEP route help you to beat the market volatility,
achieve rupee cost average and reach your financial goal faster. Since the
early bird catches the worm, prudence lies in starting as early in life as
possible. Elders can inculcate the habit in their children by making them save
small amounts from their pocket money that they give them during school or
college days. Let us exemplify this with the case of two investors – Mr. Wise
and Mr. Unwise. Both investors invest rupees 36 lakh over different time spans
of their life. Mr. Wise invests rupees 10,000/- per month from the age of 25 to
55 years, whereas Mr. Unwise invests rupees 15,000 per month from 35 to 55
years. At the end of their investment period, Mr. Wise’s investment grows to
rupees 7.01 crore, but that of Mr. Unwise grows to only rupees 2.27 crore – a
shortfall of rupees 4.74 crore. There is no dearth of financial calculators or
ready reckoners, available on the internet, which show the exponential growth
of your wealth through the SIP route. Another aspect that an investor must
consider is to increase the SIP amount by 10 or 15 percent every year. Evident
from the table below is the fact that if an investor tops up or increases his
SIP of rupees 10,000 by 10 percent every year, then his corpus at the end of 30
years will be 150 percent more.

Details
SIP
without Annual Increase
SIP
with Annual Increase
Per
month SIP amount
Rupees 10
thousand
Rupees 10
thousand
Rate
of return
12% 12%
Investment
period
30 years 30 years
Total
amount invested
Rupees 36
lakh
Rupees
1.97 crore
Corpus
after 30 years
Rupees
3.53 crore
Rupees
8.83 crore

Taxation – since taxation is a dynamic
process and undergoes changes frequently an investor must keep himself abreast
with the taxation policy of his country. This will help him to invest in tax
efficient financial instruments that will also assist in simultaneous wealth
creation. In our country, government levies tax on your income through stipulated
income tax slabs. Government considers your annual interest income from various
fixed income instruments as part of your income and taxes them as per your IT
slab. Additionally, it also levies varying capital gains tax on your equity and
debt instruments and taxes them based on you holding duration (short-term if
you hold equity for less than one year and debt for less than 3 years, and
long-term if you hold both for periods more than their short-term duration
respectively). Capital gains harvesting or setting off capital losses are some
of the means to reduce taxation legally, provided you reinvest the capital to
maintain the corpus. Equity Linked Savings Scheme (ELSS) investment in mutual
funds with a 3-year lock-in period, provides lowest lock-in period and tax
efficient returns with tax savings under Sec 80C of the IT Act.