How To Avoid Making Bad Decisions

investment tips Apr 22, 2021

Depending upon which internet survey you believe, a consensus says young children make about 3,000 conscious decisions per day, and adults 35,000 per day – mostly simple, some more complex. It is the complex decisions that fall in the good or bad basket for they materially impact our lives. So, one may wonder, why do we make bad decisions. According to neuroscience, all our decisions are affected by our emotions. Let us see some of the more common decisions that people regret making at some point in their lives, especially in their wealth and finances.  

Have a thorough understanding of the investment

Many times investors do not understand why their investments are under water because they did not understand the investment itself in the first place. Yes, say no to confusing proposals. If the basics of the product cannot be explained to a 12-year old in plain English, you need to get a professional to explain it to you.  Mutual Funds, REITs, Annuities, Private Equity Funds, Structured Products, Retirement Plans etc. inherently carry varying levels of sophistication compared with trading direct investment in stocks, bonds, real estate or gold.

Get professional guidance

We all often face difficult situations in different spheres of our lives. Little or no knowledge of the solution to the problem and/or lack of tools to tackle the issue at hand, prompts us to seek professional assistance. Guidance or professional service from an expert becomes the most sensible option then – be it the doctor, lawyer, electrician, accountant or the financial consultant. While we repose our trust in these experts who give us supposedly valid information, sometimes, we should be confident enough to challenge the advice to ensure it is a sound one. The expert should be a qualified and trusted entity. Remember, a clear understanding of the investment product or service helps you make an informed decision.

Prioritise the most important decisions to avoid “decision fatigue”

In the fast-moving world today, multi-tasking and juggling numerous roles are the new norm. In the race against the clock we tend to attend to the easiest task first. The ease of making the decision puts the importance of the decision on the back burner.  For instance, as an investor, you should focus on your financial objectives and asset allocation, ahead of selection of specific names and construction of the portfolio.   

Learn the difference between choice and preference

Choice and preference are different and influence the outcomes differently too. A choice is what you would like to do, irrespective of what others think of it. Preference is generally forced on you for it is popular, not necessarily to your liking though. In the case of individual decision-making, your choice should be the choice (after weighing the possible outcome), not the preference.

Impulsive move can accelerate your pulse rate

Decisions based on emotions such as anger or impulsive moves can invite undue risks, especially in the case of investments. Wealth creation is built on a solid base of carefully analysed goals, solutions, planning and execution. Ad hoc plunge into seemingly like an opportunity might turn out to be an opportunity or even real loss. Calmer heads always prevail in the long-term as they make decisions after optimizing the risk versus reward scenario.

Do not rely on past performance alone

Have you noticed the disclaimer stating “past performance is no guarantee of future results” in the marketing material of mutual funds across a variety of platforms – online and offline alike.  A lot of investors simply look at the returns over the recent past, which, by the way, is different from performance, and buy the product with the expectation that the money manager will be able to replicate the past performance in the future. There are a variety of reasons why past performance should not be a deciding factor for you to invest. For instance, an stellar performance in a particular debt mutual fund might have come on the back of easy monetary policy, making debt an attractive investment. But, at the time of your investing, if the monetary policy is tightening, all bets are off for debt as a category of choice. Or, an equity mutual fund could be at the tail end of its category cycle, where you should be exiting, not entering.

Coming back to the difference between return and performance. Returns are just a figure representing the gain/loss in an investment. Performance, on the other hand, is a broader term. It includes the data of gain/loss, standard deviation (volatility), upside/downside capture ratios, beta etc. among other technical indicators. For example, Fund A with return of 15% might be better than Fund B with return of 20% if the former registered much lower standard deviation, making it a more stable performer.

Never pile up on the losing position

Emotions and stubbornness are common traits among human beings, especially when it comes to investing. Many inexperienced or less-informed investors tend to keep buying a losing position with the hope of making windfall. Little do they know that the stock, originally acquired at 100, currently trading at 90 might actually be poised to tumble to 65. A mere drop in the market price does not necessarily make a stock cheap. Stock A and stock B – both purchased at the same time @100 – are reviewed after 6 months. Stock A trading @110 might still be a good value versus stock B @90. There could be change in the fundamental factors behind their respective movement. One of the most common preaching “cut your losses short and let your profits run” is narrowly practiced.

It is naive taking more than you can chew  

The world lives and thrives on borrowed money – be it governments, corporations, individuals or investment funds. And, just like when a corporation is unable to repay the debt, it is forced to file for bankruptcy, an individual also has to face the music of the lender. We often hear of individual bankruptcy cases, wherein the borrower had taken a loan he could never repay (in full). Just like in the case of an investor, a borrower must weigh the odds of being able to repay the loan before signing on the dotted line. Loans arising out of a feasible business expansion plan or a personal emergency can be viewed viable. A cruise around the world on credit or expensive shopping on notoriously high interest rate-binding credit cards is a bad decision. It is best you take the loan that you can easily service without affecting your lifestyle too much.

Additionally, it is not just the overdraft, all sorts of personal or business loans that need careful examination of interest costs and other terms of the borrowing. Even leveraged financial transactions involving margin loans drawn from financial institutions are also a serious debt trap. Adverse market conditions can easily wipe out a major chunk of your own equity, while the loan stands with your broker/banker issuing margin calls (based on mark-to-market) that need to be paid almost immediately. So “take only what you can chew.”

Not reviewing your portfolio

At least a periodic, if not regular review of your investment portfolio is the only way to ensure the consistency of your asset allocation, investment mandate, tracking the performance, and above all detection of any anomalies that need urgent attention and appropriate action.  

Summary

Avoiding bad decisions is just as important as making good ones.   


- Ramesh Sadhwani

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