Behavioral Finance – Herd Behaviour

Mental Accounting

Human Beings are unique individually but more often than not they behave in similar fashion when it concerns their personal finance decisions. There are some subtle observations that we have observed during our practice which is worth discussing and may have good learning points for our readers.

behavior finance

a)           Treating money differently based on source of earning

The source of income often allows people to differentiate their money spending habits e.g. if you got some money from lottery or tax refund (may be for which you have not toiled hard) you are likely to value that money less than your salary or business income. Whatever might be the source, it is after all currency notes having the same purchasing power. We tend to spend our directly earned income more preciously than from those which are earned from other sources mentioned above. The same feeling is applicable for income tax amount about which everyone is aware of but not the indirect taxes they pay throughout the year in the form of service tax, entertainment tax, VAT etc. If calculated that may also add up to substantial percentage.

b)         Holding on to loss making portfolios

It has been a common experience for us to find the client portfolios comprising of laggards while the transaction history displays that multibaggers have been sold off. This is a mental bias of notional profit/loss that treats the consistent underperformance and consequent loss in the portfolio as notional (as they have not been booked) but will boast of the profits in the portfolio even when they also are on paper only and not profit transferred to the bank a/c. Also there is another notion that when a client has seen a certain level of profit in the portfolio but currently it has breached to lower levels or has been underperforming for a few quarters or years then the client refuses to redeem the same because they have the previous profits etched in their minds and hopes that it will go back to those levels in future. The client ideally should set triggers which will remind them of their risk taking levels and make them cautious if the holdings return adversely. Holding on to laggards may prevent him from making fresh equity investments as the portfolio will bear a negative impact at the back of his mind.

c)                Quantum of money concerned    

We often try to bargain hard for lumpsum deals or purchases but try to avoid the same even if the amount involved on an annual basis or regular basis is substantially higher. We try to go to Shopping malls or Electronics stores when some special offers are running but don’t act similarly for the purchase of grocery items which can add to substantially higher amounts. Moreover, the habit can lead to higher annual savings as you are not going to purchase a big sofa set or a LED TV every year but will definitely have to shop monthly, weekly or bi weekly for food items. Ideally, we should try to calculate the savings in percentage terms instead of the amount involved as that will give the actual benefit earned and project the true picture.

d)               Earning less interest but paying more interest

The idea of safety of the investments made in government bonds, PPF, savings bank a/cs or FDs (even though interest is low) does not allow the investors to repay higher interest paying personal loans or credit cards as they are more bothered with the security of the holdings in the portfolio but not with the overall performance of the portfolio. We have to look at the complete picture, instead of compartmentalizing the portfolio into safe and risky. This attitude can endanger the overall financials of the family in real terms and imbalance the financial future to a great extent. Investments need to beat inflation and loans need to be refinanced or paid off with lesser interest bearing instruments than the interest payable.

e)               Treatment of cash in non currency format

Nowadays, many corporate issue food coupons for their employees in lieu of cash. These are often treated in a loose manner by the employees as they often have a tendency to use it more casually than if they had to shell out cash for the same. This is a tendency similar to using Credit cards because there is no cash outflow on an immediate basis. However, the fact is food coupons are as good as cash and carry the same purchasing power like cash. Similar is the treatment with gift cards which are also as good as cash. Credit cards have to be used very judiciously because of the high rate of interest while the prudent usage of coupons/gift cards is also desirable as these amounts are either part of your CTC or linked with your performance.

From the above points we can understand that there is a perception among people that anything not purchased through hard cash or debit card i.e. which results in an immediate fall in the cash position have a different effect on the mindset of the client. Therefore, the client has to understand the bottomline that money in whatever format is money with the same purchasing power as cash in the purse or the bank balance. When we are calculating the networth we are considering all cash, bank, gift cards and food coupons as cash only and so we have to reframe our thoughts accordingly. The compartmentalization of the mind needs to be construed in a prudent manner so that we can manage our finances in a rational manner rather than on whims or hearsay of friends and relatives. A lot of thought have to be put in to get one’s act together in effectively managing the finances.