Tripped by guilt

BEHAVIOURAL FINANCE

Throwing good money after bad money is not a great idea when investing in stocks and mutual funds.

I don't want to book losses on this investment. I will wait till I recover my principal and then exit this stock," said an indignant Sagar Arora, a businessman in his late fifties. Touché! I thought.

While planning for Arora, I came across this stock which was trading at Rs 8, which he had bought at Rs 20. And it looked quite an aberration, if one were to look at his entire portfolio. On enquiring I was informed that the tip had come from well-intentioned club friends.

However, his reluctance to exit was more to do with his inability to accept the fact that he had made a wrong judgement. And in his mind the only penance for this was to at least recover the principal. This phenomenon is popularly referred to as Loss Aversion.

This behaviour simply refers to the concept of how we feel about our losses and make unwise choices such as waiting too long to exit a losing investment or as they say, throw good money after bad money to average our costs. And this impacts us adversely in all kinds of investments.

But you should consider that if today you have a certain amount of money, would you still invest in the same stock? The case for it looks even better today because it is available at a much lower price. If the answer is no, then you know what needs to be done. Dump this dud stock and opt for something which is more likely to give you better returns. You might be afflicted with loss aversion if you:

Don't sell a dud stock or mutual fund for a loss

Tend to sell a winning investment more than a losing investment

Prefer fixed deposits over stocks or equity mutual funds

Make decisions based on how much you have invested or spent already. Averaging dud investments on the way down or keeping your old car going just because you have already spent a lot on it, or even keeping a failing project or business going just because you have already pumped in lot of money

Want to lock a gain and not take slight risk for additional gains but the moment you see a loss, you do not mind taking excessive risk to avoid it

It is not that loss aversion as an overall policy is bad. But too much of it can rock your financial boat. One must certainly manage risks well but one of the key elements in managing risk is to really understand risk and importantly, what a loss means. For most of us, a loss just means loss of principal but it does not mean loss of opportunity or loss of purchasing power. It is this myopic view that causes one to take irrational decisions.

Always ask yourself an additional set of questions. For instance, if you have two types of investments "� gainers and losers.

How many times have you sold or are tempted to sell the gainers just because you have made a gain and you want to lock in the profits?

How many times have you held on to losers because you believe that you will recover the principal?

If you have been looking at investments in this manner, then you are basically trying to say that your losers will do better than the gainers. And it is simply because the gainers have gained and the losers have lost. Flawed thinking indeed.

To address this problem, start with forgetting what you have already done and take a fresh look at the situation. In other words, if you have made a mistake, admit it and move on for the better.

Remember that there is no place for emotions in the equity markets. What matters is your future economic interest and that should supersede any emotional pain that you might temporarily have to go through. Much like life, isn't it?

The writer is director, My Financial Advisor

Test Yourself

Tick your choices in (a) or (b) in Part I and Part II. Suppose you are in a game where the probability that

Part I

You win Rs 80,000

You also have an 80 per cent chance of winning Rs 1 lakh (otherwise a 20 per cent chance of winning nothing)

Part II
(a)You lose Rs 80,000

(b)You have an 80 per cent chance of losing Rs 1 lakh (or a 20 per cent chance of losing nothing)

If the answer is (a) for Part I and (b) for Part II, then you are afflicted with Loss Aversion.