DO YOU MAKE THESE INVESTMENT MISTAKES?

“An investment in knowledge pays the best interest.” – Benjamin Franklin

We all make mistakes in life, but our mistakes in investment literally cost us dearly. Prussian leader Otto von Bismarck had famously remarked, “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.” Therefore, fiscal prudence demands that an investor learns from investment mistakes of others rather than his own. Various feelings, moods and sentiments, personality traits, perception, attitude, and emotions characterize investor behaviour. Therefore, like all other humans, various biases affect his actions and decisions. These biases are heuristic, a mental shortcut that allows people to solve problems and make judgments quickly and efficiently. Such a ‘thumb rule approach’ reduces decision-making time because the person does not have to stop and think about his future course of action. Heuristics are helpful in many situations, but they also lead to cognitive bias, a limitation in objective thinking caused by the tendency of the human brain to perceive information through a filter of personal experience and preferences. Often people say that ‘forewarned is forearmed’ and with that thinking, we put across to the reader some common mistakes that investors make during their lifetime and would do well to avoid.

Not Starting Early – Normally a person should start investment within the first six months of his career start to gradually build the corpus for his post-retirement income. However, young people delay or procrastinate about their investments on some pretext until about 30 years of age.

Thereafter, family and other domestic responsibilities catch up with them to reduce their investment capability. This pushes them into a time trap that precludes them to save enough to build up their retirement corpus. The accompanying chart clearly indicates the advantage of starting early when retirement corpus is approximately rupees 10.6 crores at the retirement age of 60 years.

Irregularity or Trying to Time the Market – Continuous and regular investment through systematic investment plans (SIP) is the most disciplined and convenient option that averages the rupee cost of investment and uses the power of compounding for wealth creation. It is ideal to invest more when the markets are falling to take advantage of buying more units as the NAVs are low. However, the investors do just the opposite due to fear psychosis of falling markets and apprehension of losing money. Stopping the SIP even for a few months could impact the investor’s goal and your future wealth.

Some investors try and time the market and wait for the markets to go down, whereas the purpose of SIP is bringing regularity and discipline in investment to avoid the trap of timing the markets. The picture posted by Matthew A. Young highlights the dangers of market timing and he explains it as follows, “If a buy-and-hold investor put $1 in the S&P 500 at the end of January 1970, he would have $141 today. If that same investor tried to time the market but missed the best 10 months, he would have $44 today. If he missed the best 20 months, that $1 would be worth a mere $9 today. Market timing not only risks losing out on significant gains, but it also risks missing vital dividend payments.”

Only Saving/Investing Surplus Money – A retail investor usually invests his surplus money. By this we mean, the money that he feels is surplus and left balance after meeting his expenses and wants. Warren Buffet had famously remarked. “Do not save what is left after spending, but spend what is left after saving.” This is quite simple as Paula Pant[1] discusses in her blog that the core of money management is to create the gap between earning and spending, invest the gap, and repeat until the gap can perpetuate itself. To widen this gap, one must either earn more or spend less. Earning more may not necessarily be in the hands of the investor, but spending less is certainly for him to implement. Human desire is endless and the more one has, the more he craves for more. For this, he must identify his ‘wants’ and ‘needs’ and then deliberately choose to spend only on his needs rather than wants. He must avoid debit financing i.e. planning to spend the money that is not available in his bank account. Usually, this leads a person into an EMI trap from which he seldom recovers or finds it convenient not to recover.

Ignoring Financial Goals and Risk Appetite – Financial goals based on individual’s risk appetite is the crux of all investing. It varies from person to person and no particular investment fits all. Risk profiling is a factor of age and liabilities that helps one to invest judiciously to meet his financial goal. A very common mistake that investors make is to start investing without a specific financial goal or target figure. This invariably leads to bleeding of the investment through premature withdrawal for the flimsiest of reasons. In turn, it reduces the corpus and creates a deficit for the goal. Herd mentality and market buzz often drive investors to take impulsive decisions and invest in well-advertised schemes or financial instruments. The risk profile is an evaluation of an individual’s willingness and ability to take risks. Through correct risk profiling, an investor can decide his risk-taking capacity and risk tolerance, then decide on suitable asset classes meant for him to invest, and finally be prepared to manage surprises, if any, in the returns from his investment.

Misunderstanding Risk-Return Relationship– Another point that they miss is the risk-return relationship. Risk is the investor’s probability of earning an inadequate return[1]. In fact, it is not just the potential loss of return, it is the potential loss of the entire principal and interest. Any scheme that promises abnormally high returns is fraught with the market and default risk. The trade-off between risk and return is essentially the trade-off between earning a higher return or having a lower chance of losing money in a portfolio. The investment code is higher the risk; higher the potential of return. While considering trade-off on individual investment or across portfolios, an investor must deliberate on factors like his overall risk tolerance and capability to replace lost money.

Putting All Eggs in One Basket – A very serious mistake that an investor can make is to invest all his money in very few financial instruments or companies. On the other hand, diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Diversification reduces portfolio risk, hedges against market volatility, and offers higher long-term returns. Though, it limits short-term gains, makes portfolio management more time consuming and incurs more transaction fees. An investor should possibly diversify across various asset classes, financial instruments, geographically different economies, industrial sectors, and companies.

Avoiding Financial Literacy – Investment is both; an art and science. It is an art because the investor must overcome his emotions greed and fear, overreliance on previous experience, and psychology to follow the herd to make rational and logical decisions. It is scientific because the investor must base his decisions on a lot of technical and statistical data, mathematical probability, arithmetic algorithms, and above all financial principles. The money is yours, so the final decision should be yours. With this logic, it is imperative that the investor possesses thorough professional knowledge, a bedrock of decision making. In the case of investment, professional Investment knowledge implies sound financial knowledge. One must seek professional advice from financial advisors but filter it through the prism of one’s own financial wisdom to take well-considered decisions. This personal financial wisdom does not come up overnight and requires years of theoretical and practical indulgence in the financial markets.

Letting a Bad Experience Impede Future Investment – A very common phenomenon noticed in investors is that they develop loss and risk aversion after making a bad investment or after a wily person or scheme defrauds them. The expression “losses loom larger than gains” (Kahneman & Tversky, 1979) encapsulates this and suggests that psychologically the pain of losing is twice more painful than the pleasure of gaining. This inhibits the investor to stay away from the equity markets thereby reducing their wealth creation capability. One bad investment experience should never keep you away from future investment in the true spirit of the quote of renowned golfer Tiger Woods, “You hit a bad shot, you have to get over it right there and then, so you can get focused on the next one.” Therefore, an investor must learn to move on and put the bad experience behind him.

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Welcome to Maloo Investwise

Disclaimer: Dear Investor, By clicking on the submit button you will be redirected to our secured website. This link is provided only for the convenience of our visitors. The site has the necessary tools to help you understand your risk profile, asset allocation, and goal calculations. You will also be able to open a folio and transact online in mutual funds.