Behavioural traits shaping our financial decision making

21 Jan 2022 , 09:27 AM

The meager mention of ‘finance’ and imageries of calculations, statistics, figures, rush as a flashback in our minds. Eventually, emotions, feelings and any other aspects take a backseat. However, what often goes unnoticed is that our behavioural trait has an important implication on our decision making in our financial endeavours. The envy and angst generated due to external situations can impact our financial decisions significantly.

The impact of behavioural traits on our financial decisions

Consider this thought experiment as an example. Mr. A and his family invested in a PMS (Portfolio Management Services) with an expectation of earning a 15% CAGR.  The fund manager surpassed their expectations and delivered a 17% CAGR over a 3-year period. Mr. A and his family were ecstatic with the results until they came across an advertisement by another PMS provider indicating it successfully delivered a 22% CAGR over the same period. This made Mr. A envious, regretful and even furious at their fund manager. The sole reason for this is that our minds have been wired in such a way that we always want to be in the top position in all our endeavours. Hence, we want the best of the deals and the highest ROI especially when it comes to finance management and investing our savings. Due to this very reason, A pulled the money out and invested in the fund they saw in the advertisement.

This behaviour is especially visible when we allocate funds to a Mutual fund or a PMS. We easily start second-guessing our decisions when the fund manager is going through a lean patch or is not acing the performance charts. On the other hand, the funds that we allocate ourselves especially to illiquid assets like real estate or gold do not undergo such levels of scrutiny. Even if our fund managers underperform all other asset classes, we tend to hang on to those. We do not give a long enough rope to the fund managers we select even after a thorough research.

The outperformance of funds and their effective management by Fund Managers: The key elements in investments

It usually happens that the funds that have outperformed in the past few years end up attracting a lot of capital. The outperformance happens due to the equities/sectors/securities that the funds were invested in, performed well due to margin improvement and valuation rerating. Higher valuations of these securities are detrimental to future performance. With a huge fund inflow, the fund manager must allocate a lot more funds. But they should keep in mind not to overdo in the lure of attractive valuations as this could lead to underperformance in the next few years!

Furthermore, the Net Asset Value of the fund may look promising even after a few years but the new capital that was put in might not get similar returns. In the example quoted above, when Mr. A is lured to switch to the outperforming PMS nudged by his envy, he is not only risking underperformance in new PMS but is also foregoing the outperformance that could have happened in his original PMS due to the market's cyclical nature. These cycles play out inevitably and there are numerous such anecdotes in the market.

Summing up

However, this does not imply that one should stick to their fund managers even if they are underperforming. But whenever and wherever you plan to invest, it is advisable that you first understand the investment philosophy as well as the mandate of the fund manager. Apart from looking at the performance outcomes, one should keep a sharp eye on the process of the fund manager as well. You should monitor their progress to check if they are sticking to the mandate. If your fund manager deviates from the mandate due to the latest fad in the market or other external factors that could affect your investment; then it might be a good time to consider a new fund.

However, in case, the fund manager is sticking to the mandate and performing well but is not in the prime position, then, the next logical step would be to give this manager a longer rope and consider associating with another expert. The bottom line is that our behavioural biases might pose a hindrance and we should be conscious as well as cautious of these while deciding to investing in or switching to a new fund. In financial matters, patience can be a good behavioural antidote to envy!

The author of this article is Mr Viraj Mehta Managing Director - PMS, Equirus

The views and opinions expressed are not of IIFL Securities, indiainfoline.com