Personal Finance: Freud And Your portfolio

PERSONAL FINANCE
Freud And Your Portfolio

Put Freud over Mammon, understand the investing psychology that makes you go wrong, and you could sing those blues away.

By Shilpa Nayak

It's difficult finding a blame-figure when carefully planned out investments-every word printed in the best investment guides is followed faithfully-go wrong. Now, an emerging field of study, investment-psychology, takes a leaf out of a certain Mr Freud's writings and suggests that the fault could lie within, not without. Put simply, it wasn't the weather, it wasn't rogue traders, and it certainly wasn't a global stockmarket downturn that busted your portfolio; it was you. Rather, it was your mind.

As some wise man-his investment-record, alas, remains unknown-is supposed to have said, the mind sometimes plays curious tricks on the man. Some of these have little relevance to the art (or science, depends which way you lean) of investing; others, do. And it is only by understanding these mind-traps that the archetypal investor can rise above psychological pitfalls that often hurt investment portfolios.

Who Framed Mr Poor Investor?

What do you think doctors will pick? A revolutionary new treatment with a fatality rate of 7 per cent, or one with a survival rate of 93 per cent. In studies, doctors picked the second, a continuing twist to the half-full, half-empty tale. The doctors-instance is a manifestation of framing, the presentation of facts anchored in a certain context.

Framing is common in the investment domain. A mutual fund claims it outperformed a certain index, in a certain time-period. Both the index, and the time-period, have been chosen to reflect outstanding performance. Indeed, the same fund could have performed miserably when compared against another benchmark, in a different time period. Investors make decisions not just on the basis of the information at their disposal, but also on that of how this information has been presented. Simply rearranging the information should do the trick, but most investors don't do it.

An Imperfect Anchor

Psychologists call it anchoring, the inability of the mind to analyse information beyond first impressions. For instance, a generation of investors hit hard by a prolonged recession may have strong views towards investing in the stockmarket.

Americans who bore the brunt of the great depression, didn't look too favourably at playing the market; they managed to convince themselves, based on their experience during the depression, that all businesses were vulnerable; ergo, their money went into government securities.

Anchoring has its flip-side too. Investors who've seen only the better side of the economic- and business-cycle may continue to plough money into a falling market, hoping, futilely, that it will rebound soon. Investors who've fallen prey to the anchoring malaise tend to form a view early, and then view all data in its light.

And as anyone with the least bit of investing common sense will tell you, the inability to analyse new data and information, and modify earlier positions, could hurt. Even if you think you know everything there is to be known about your favourite stock, listen to what a disinterested analyst has to say about it.

The 'Kind Of Money' Trap

Is there such a thing as money that investors can afford to lose? History suggests there is. The typical investor tends to distinguish money depending on its source.

They are conservative when it comes to money earned through sheer dint of industry. Investments made with this kind of money are done after adequate analysis of all available options. And the usual decision concerns a low-risk investment vehicle that promised not outstanding, but modest returns.

But money that comes from a sudden windfall-inheritance from an uncle the investor didn't know existed-is treated differently. Even the most orthodox investor classifies this as money that can be risked. Unfortunately, money that investors think they can afford to lose is invariably lost. Our recommendation: all money is the same; invest your inheritance carefully, or give it away to charity.

The Acquisition-Price Snare

There may be no logical link between the two, but most people make the mistake of linking the way the market moves to the cost at which they acquired a particular stock. It won't be too hard, at a time when the market is trading way off its peak, to find investors obstinately holding on to a stock despite it having fallen 70-80 per cent off its acquisition-price.

Most such investors admit that their initial decision was wrong, and they express their willingness to get rid of the stock. Only, they say, they would prefer to wait till the scrip moves up, and reaches the price at which it was acquired by them.

That could never happen. The price at which an investor buys a stock is one of thousands registered in trades immediately before, or after. Scrips with weak fundamentals that soared to exaggerated highs riding on irrational exuberance, are unlikely to ever reach those highs again. Investors holding on to such stocks, hoping for them to climb just that bit more, could end up waiting a long time. And by the time they decide to trade, the company itself could be long gone.

Are You Loss-Averse Or Risk-Averse

The human mind dreads losses more than risks. And to avoid losses, however minor they be, investors sometimes take huge risks. Picture this: Investor A has Rs 1,000. He can invest it either in option B that gives him an assured profit of Rs 500, or in option C that can give him a profit of Rs 1,000, or no profit at all. What should he pick? That's a no-brainer; he'll pick option B.

Now, picture the same scenario with a twist. The amount of money at A's disposal remains the same. Only, now he has to choose between option C that involves a sure loss of Rs 500, and option D that involves no profit, or a loss of the entire amount (Rs 1,000). Easy as the correct choice is, most investors-and this includes those who chose the correct option in the first scenario-end up choosing option D.

The reason? People like to avoid a 'sure loss', and don't mind taking a larger risk to do so. Is this decision based on an objective evaluation of the risks involved and the returns promised? Not quite; it is driven purely by the desire to avoid a certain loss.

It is easy to fall prey to investing mind-traps. They are, after all, part of the cognitive process of thinking. But unless you grow beyond them, chances are, your performance as an investor won't be anything to write home about (that is, if you still have a home).

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