June 11, 2015
As financial analysts and investors, there’s a lot of focus on the technical or analytical aspects of the investment related decision making, which you may term as the logical perspective. But there is also an alternative perspective – the emotional one.
So, what exactly do these two perspectives mean? And what roles do they play in our investment decisions? That is something we will explore below.
Since this piece is about emotions, we will quickly try to understand the technical aspects/ logical perspective of investment decisions before moving on to the ‘emotional’ side.
Normally, whenever an investment decision is to be made, one needs to analyze the investment decision in terms of:
• Investment time horizon
• Potential returns
• Potential risks
For example, if an investor is looking to invest in a land parcel, she/ he should consider:
• Investment time horizon: How long is the investor willing to hold the land to obtain the desired returns? E.g. a delay in execution of certain infrastructure projects near the land parcel can delay the increase in land prices, forcing the investor to hold the asset for a longer time.
• Potential returns: How much return is the investor expecting from the investment? Whether there are some factors which can drive up the returns on the land parcel e.g. a booming urban economy leading to job creation leading to strong urbanization leading to mass migration from villages to cities leading to higher demand for land (assuming this land parcel is located near a city
• Potential risks: Whether there are potential risks because of which the anticipated returns may not be realized at all e.g. possibility of the demand drivers not materializing – say, a change in locations for key infrastructure projects, etc.
Similarly, if an investor is evaluating investment in equity stocks, she/ he may take a look at the financial performance, strategy, quality of management, performance vis-à-vis competition and overall industry potential. They may also build a financial model for fundamental valuation of the stock or look at comparators for relative valuation. All of the above constitute the afore-mentioned logical perspective.
However, there are numerous scenarios in which an investment decision is taken not based on these factors alone. Let’s take a look at some such examples.
• One may have some experience of working in a particular industry and may consider oneself as an industry expert and also develop an inclination to invest in stocks of companies from the same industry
• As a customer one may have a liking towards the products of a certain company and may invest in the equity of that company purely because she/ he is a satisfied customer
• One may have invested in some companies which may have performed well over a period of time. However, as time passes, those investments may not be worth holding on to. Still the person continues to hold on to those stocks due to emotional attachment
• One may have made some loss making investments. However, the person continues to be over-optimistic and waits for a bounce back, for too long, driven solely by emotions
• At times, investors tend to ignore the information which is indicative of an adverse change and continue with a biased mindset. It may also not be easy for investors to assess the investments objectively over changing time horizons. Hence, they may continue to hold on to certain investments for far too long, in turn missing out on alternative investment opportunities (even more profitable ones)
• When a position held in a portfolio is profitable, investors may themselves take the credit for success. But when a position in a portfolio is in the ‘red’ (making losses), they tend to blame it on luck or other uncontrollable factors. Hence, the key is not to get engrossed in the ‘self-praise’ mode and let emotions subvert logic.
Now, I will cite a personal example of one of my relatives. She had taken a home loan of around INR 2.5 million with an interest rate 10% p.a., repayment period of 30 years, on which she could also avail the income tax benefits on the interest payments. Over a period of 10 years after the loan disbursements and paying EMIs, she also built a well performing portfolio of mutual funds from her savings which consistently generated returns of 12-15% p.a. At that point, the size of the mutual fund portfolio exceeded the home loan amount repayable and she wanted to liquidate the mutual fund portfolio to repay the home loan completely. Her argument was that by doing this, she would be relieved from a huge liability at a very young age. She would also get a sense of ‘complete’ ownership of the purchased home.
Assuming the marginal income tax rate of 30%, the net interest payable on home loan = 10% * (1-30%) = 7%
The net annual returns expected to be generated by mutual fund portfolio (assuming lower limit of range of returns, 12-15%) = 12%* (1-30%) = 8.4%
Excess returns generated by mutual funds = 8.4% – 7% = 1.4% per annum
Considering that tenure of 20 years home loan is still pending, over 20 years, 1.4% per annum for a sum of INR 2 million (assuming the amount of principal to be repaid) translates to:
2000000 * (1+1.4%) ^20 – 2000000 = 2000000 * 0.321 = INR 642,000
The net annual returns expected to be generated by mutual fund portfolio (assuming lower limit of range of returns, 12-15%) = 15%* (1-30%) = 10.5%
Excess returns generated by mutual funds = 10.5% – 7% = 3.5% per annum
Over a period of 20 years, 3.5% per annum for a sum of INR 2 million (assuming the amount of principal to be repaid) translates to:
2000000 * (1+3.5%) ^20 – 2000000 = 2000000 * 0.990 = INR 1,980,000 (approximately)
Based on this quick and not so accurate (for the sake of simplicity) analysis, it seems more logical to desist from repaying the home loan and to keep on building the portfolio of mutual funds as over a period of time because seemingly minor differences of 1-2% p.a. can compound to huge amounts over a long time. Therefore, the benefit of emotional ‘freedom’ of repaying the complete loan at once, by liquidating the mutual fund portfolio, will be earned at a substantial opportunity cost (i.e. forgone excess returns on mutual funds).
1. Equity mutual funds may have bad years and in extreme cases, may also lead to erosion of capital
2. This scenario (discussed above) is for an Indian investor and the numbers will probably change depending on the country of investment and relevant local factors
3. This scenario (discussed above) is an over-simplified one for ease of understanding and the actual calculations are different and much more complex
While it is almost impossible for human beings to not be emotional, there are a lot of scenarios in which relatively less emotional and more objective thought process helps in generating desired results and/or returns. The emerging field of ‘Behavioral Finance’ is a very interesting area to peep into to understand the various emotional and psychological aspects of investing. While it may be difficult to control all such aspects, an awareness of their existence and possible measures to be taken to minimize their impact on financial decision making, can be very useful.
Investment decision making is a complex process for human beings as it involves logical and emotional aspects. Emotions may lead to logically unjustifiable decisions and may affect the realized returns from any investment. As an investor, one must be aware of the situations in which emotions may over ride logic and take preventive measures accordingly.
Happy Investing! (Logical and Emotional)
Related links you will like: