Ask yourself these questions to avoid emotional investing

Despite access to more information and better financial literacy, investors still exhibit the same emotional tendencies: fear, greed, overconfidence, herd behaviour, and loss aversion.

Basic instincts

Emotions override logic. Else investors would not be asking about continuing SIPs (systematic investment plans) or switching from equity to gold. These questions often stem from a desire to feel in control during uncertainty. Gold may be a hedge in uncertain times, but switching purely due to short-term fear ignores the long-term growth potential of equities. SIPs are designed to average out market volatility and work best when continued during downturns. Yet investors forget these simple mantras; they’ve continued to display loss aversion over the last few months. 

Products are still chosen on gross returns. Are gross returns the right way to assess a product? Take the case of low-rated, high-yielding corporate bonds, where investor interest has been rising. Individuals believe that they are at lower risk in corporate bonds than in equities, as they give similar returns but without the volatility. However, low-rated bonds carry a huge default risk, and even though they may be secured, it is well-known how tough it is to get back money in the case of a default. Just relying on high gross returns, in most cases, is fatal.

The vast amount of financial information can overwhelm investors. Social media and real-time news amplify this effect today. This leads to overconfidence and an illusion of control. Take the case of the NPS Tier 2 account. Investors often boast about using these accounts to park short-term funds. However, given that there is an equity component in the national pension system (NPS), can the Tier 2 account be used like a liquid fund? It is like investing in a balanced fund for five years, when the funds are actually required in the next few months.

Investors’ short-term focus is one of the most common and damaging behavioural tendencies in investing. Despite long-term goals like retirement or building wealth, many investors behave like day traders, reacting to weekly market swings and news headlines. Long-term products like the NPS Tier 1 are shunned due to the inability to withdraw funds as needed. Long-term goals are basically being left to God’s mercy.

Finally, the infatuation with exotic products, which in most cases are not regulated, is baffling. At one end, individuals panic at the slightest volatility in equities and at the other end, they go ahead and invest in things like managed farmlands or renewable energy assets. These farmlands or renewable assets are spread across the country, typically in remote areas. It is surprising, then, to hear investors asking about the safety of gold exchange-traded funds, just because they aren’t tangible like jewellery.

All of these cognitive biases, such as confirmation bias, recency bias, and anchoring, lead investors to not use logic in financial decisions. 

Take a step back and question

Whatever the situation, investors must ask themselves the following questions:

Is the product regulated? No regulation means no grievance redressal or regulatory oversight, which can prevent misdoings. A majority of Ponzi schemes that went bust were unregulated, and investors couldn’t recover their money.

Does the product align with the individual’s financial goals? What purpose can this product be used for? If the financial product is not mapped to the right purpose, it doesn’t really serve a need. One of the reasons investor returns lag the fund returns in equity mutual funds is that the investments are exited in short timeframes, thus not achieving the expected returns.

What is the worst that can happen with the product? Can one lose the entire investment? How easy would it be to exit if the product doesn’t work out? Remember how AT1 bonds of banks sold as safe bank bonds didn’t pay back investors? Investors got into these bonds without understanding the minute clauses and lost their funds. An add-on question would be: Have the goals or time horizon changed? In times of market stress or on the upswing, when there is a strong temptation to make impulsive changes, this is the most grounding question an investor can ask.

What’s the real cost of the investment? Are the returns compensating for the risk being taken? Most high-returning guaranteed investments seem to give great returns but carry 10x more risk. Thus, the question arises whether the returns are justified. 

Finally, what is the investor’s ability to handle the investment? Stock trading, managed farmlands, and cryptocurrencies may sound great, but they require deep understanding and monitoring. Do investors have the time and capability to do so?

In investing, your greatest edge isn’t superior knowledge, it’s superior self-control.

Mrin Agarwal is the founder-director of Finsafe India.