Think you are managing your finances very well? Think again
Posted by: Uma Shashikant on Apr 23, 2018, 09.46 AM IST
Many of us think we know how to handle our finances. We go by past experiences and lessons we deem valuable.
We want to be in charge of our money decisions. When someone tries to influence us with their recommendations and advice, we stay sceptical. How well do we actually do?
The perils of overconfidence are so widely prevalent that we are most likely to see ourselves as doing well. For a variety of psychological reasons, we are unlikely to find fault with our decisions.
A longtime friend, who is also an avid investor in stocks, is usually my representative subject when I think about our investment decisions. Let us call him Raman for simplicity. Raman buys stocks because believes that if he bought a few stocks that did well over the long term, he would do much better than most. He does invest in mutual funds too, but thinks that his own stock portfolio has the potential to do well, or even better, since he is under no compulsion for performance unlike the professional fund managers.
Raman’s idea is fine in theory, but I argue with him that he might not be able to find the stocks he thinks would do well. We argue quite often about his choice of stocks.
While I think that he is just trying to get lucky, depending heavily on information gathered from newspapers, social media, and television, Raman thinks that he is an excellent investment analyst. He would come up with his theories about how and why a stock he has picked will do well. When one hears him talking, he would be describing what might happen in the future with such detail, you would think he can see how things would unravel for the stock he has chosen.
Psychologists will call this the illusion of control, where Raman fails to see that the stock may take on a trajectory that is not amenable to precise prediction. This tendency to assign subjective probabilities for future events is a classic case of overconfidence. Many of us suffer from this limitation, though we may be loath to admit it. We make several sweeping generalisations: Good companies will ultimately do well; in the long run everything will be fine; if there is profit, the investment is good; if we book profits we will prevent a loss; a market that goes down will come up; we have to buy when others sell; and so on. For each one of these “rules”, there are enough “exceptions” to negate the very idea. Making such thumb rules enable us to navigate the unknown when it comes to investing.
However, we fail to see that these are not sound scientific principles that have stood the test of time or have been validated consistently by numbers. These “rules” are but products of another behavioural limitation: the hindsight bias. See how everyone is now telling us that they knew all along about the Indian banks that are now in trouble. Or that tiring analysis after an election result about how the signs of the unexpected outcome were there for everyone to see. We have the ability to reconstruct the past in a way that offers a plausible explanation for what has happened in the present. This is the hindsight bias. We behave as if we knew it was coming, while we did not.
Raman uses the hindsight bias to explain away many of his investment decisions. When his investments do not behave as expected, he offers some plausible explanation for what is happening, making it all look like he had predicted and expected all of it and that it was only playing out as predicted. Like him, we all have the acute need to make ourselves look good. It is a coping mechanism.
If there was a glaring case of something going wrong, Raman would change tack. Like the time he bought a new business that was into renewable energy and it came crashing down in debt when the markets turned. Raman had no place to hide. He took recourse to the other well documented behaviour—attributing failures to others. It was common for Raman to attribute success to himself, but failures were all a simple stroke of bad luck.
We refuse to let our failures and its burden stick to us, and thus remain overconfident about our abilities. That was not all. If I insisted that we discuss each investment decision he made, and make himself accountable for each one of them, almost allowing no escape, Raman had another trick in his bag. He would find information that confirmed his own position, and emphasise that over all else. Consider how good the management is, he would argue; or he would tell me how the business will sell its goods at a discounted price; or that there would be a turnaround in the offing given the new diversification; and so on. If we want to believe our version of the reality, we will actively gather selective evidence that supports our view.
Did Raman do well? He was below average in my assessment. The trouble he was putting himself through was not showing in the results of his portfolio. But Raman only spoke about his successes. He thought he was a smart investor based on a few picks that did great, and never failed to tell those stories. He also told me how he was doing better than so many others, and how he was beating even some of the fund managers. In his mind, he was above average at all times. People had money lying in the savings bank, he would smirk. Here he was actively investing and making money.
Many of us are like Raman, but we do not want to admit to it. We do not want to subject our investment habits to an objective analysis of numbers and stare at our actual performance. We worry about the guilt, shame and regret that may ensue if we found out that we could have actually done better. The easier and more comforting option is to remain overconfident about our abilities and behave as if everything will be fine.
There is a need to be optimistic say the evolution theorists. We would not have made the strides we did as the human race, if we weren’t overconfident and if we did not take risks. Is our money worth that experiment? That is a question we have to honestly answer.