Most of us think we are rational beings who act emotionally sometimes. That’s not so true – we are rather emotional beings who act rationally sometimes. When you see your friend, relative or your colleague doubling an investment in an IPO; your rational mind most likely will go for a toss and you might dump your diversified equity mutual fund.
Greed is an emotion. The number of trading accounts opened during the lockdown has grown manifold. Boredom is also an emotion. Money flows into funds or asset classes that have the best recent performance; the fear of missing out is an emotion. At times, many investors sell their portfolios at huge losses and never return to the equity market. Fear and Regret are emotions.
Even financial goals are emotional in nature. For someone saving every penny and making many sacrifices to save to see their children get higher education is an emotional journey.
Personal finance is more personal, and less of finance. It’s not a study of mean frontier method or discounted cash flow or macroeconomics. Personal finance is a study of how humans interact with money daily.
What helps us learn?
When it comes to personal finance, experience and mistakes are the best teacher. For someone who lost his job will understand the importance of an emergency fund. Or someone who has a medical emergency will understand the importance of an adequate health insurance. But life is short, and the stakes are high. All mistakes in personal finance have already been made. So the better way is to learn from them.
Most investors make the most common mistake of jumping into an asset class without defining the objective and purpose of the investment. Retirement, which should ideally be the number one goal, is always the least important one for most. Human beings find it difficult to think beyond 10 years. That’s why most people realise about retirement planning only at the age of 50.
Here’s an analogy: If you put a frog into boiling water, it will immediately jump out. But if you place it in room temperature water and slowly heat it to boiling, the frog won’t notice it and will slowly be boiled to death. Inflation is the silent enemy and most people forget inflation when they plan for their financial goals.
So what’s the way out?
Economics is a study of how to maximise output with limited amount of resources. Most people don’t know how to spend. The best way to achieve more from your money is to be frugal about things that do not matter in life and be lavish on things that matter the most.
If travel gives pleasure to live, then one can be generous with travel plans, but then be frugal on things that do not matter to them, like a car. Financial formulas can show how much to save but they cannot teach ‘how to save’. It’s human to procrastinate.
Try a simple experiment at home. Ask your child – one ice cream now or two icecreams next week, which option will he choose. Most likely, your child will prefer to have one icecream now. We think we have grown up, but we act and behave like children. Our brain constantly struggles between instant gratification and saving for the long term. It’s important to remind oneself – “everyone year of delay in investment means working two years extra later on in life.”
What’s interesting about us? Human brain is not designed to think compounding. It thinks linearly. It can calculate 6+6+6+6+6, but it cannot calculate 6x6x6x6x6; and that’s why most investors play a short-term game. Re 1 compounded over 100 years @12 per cent can become Rs 83,522. If one understands this concept, she would like to start their journey as soon as possible and hold such investments for as long as possible. The best way to win in a casino is not play any game. The house always wins because the odds are in their favour.
One should always play a game where the odds are in their favour. In a stock market, there is a 50 per cent chance of Sensex either going up or down. As the time horizon increases the odds of winning increases. Diversification reduces the chances of going wrong. A well-diversified portfolio with long tenure increases the overall odds for success.
It’s all a mystery: There are more unknowns in the world that we know; hence, prediction is a futile activity. In the beginning of 2020, there was not a single research report talking about the risk of a global pandemic. And the same is true with the India-China conflict. The risk, which everyone is talking about, is already factored in by the market. So it’s not a Risk. Risk is what nobody is talking about and what markets react to when it emerges. Preparation, and not prediction, should be part of a personal finance plan.
Markets don’t care about your financial goals. That’s why one should build a portfolio where one can achieve their financial goals in all market conditions. One should be pessimistic and think about the worst case scenarios to deal with risk. This will force them to save more, buy term and health insurance and have sufficient fixed income in their portfolio.
At the same time, one should be optimistic about the future too, which will motivate them to invest in equity with long term horizons.
Why be skilled? To be a surgeon, a good chess player, or fighter pilot, one needs skill. Without skill, it’s impossible to achieve the task. But in investing, one can get good returns without any understanding of the underlying investment. One can make money by throwing random darts, but when luck stops favouring one, he is out of the game. Investment plans should not be based on luck, but process.
Being practical helps!
One can understand the motions of electrons because electrons don’t have emotions. Markets are not governed by the law of physics. Investors in the markets have emotions and it is hard to predict when these emotions would turn greedy or fearful.
Warren Buffet says if one cannot see his stock fall more than 50%, he should not invest in the equity market. Having enough fixed income in the portfolio can help an investor stomach this fall and not have sleepless night. You can’t tell your child that you can’t pay his school fee this year because the markets have corrected, nor can you tell your spouse you don’t have sufficient money for retirement, because you played safe by investing only in fixed deposits.
To conclude, personal finance is about risk management and about being able to achieve all your financial goals with the least amount of stress.
Amit Grover is AVP for Learning & Development at DSP Investment Managers. Views are his own)