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Four behavioural biases that can harm wealth creation… and how to overcome them

Relying too much on elders for financial advice could mean investing more than what’s needed in tax-saving schemes even though they may not suit our financial plan. Such biases could impart a false sense of financial security.

June 22, 2022 / 10:16 AM IST

Kumar is a 30-year-old software engineer who worked in an IT firm in Bengaluru. He moved back to Aligarh, his hometown, to be with his parents after the COVID-19 outbreak. Work-from-home flexibility allowed Kumar to continue working with the IT firm.

Kumar is aware of the financial stress that COVID-19 caused his friends, family and society in general. Most times, he feels he is on the right track. He’s got a decent job, an apartment in Bengaluru, and pays his mortgage loan regularly from his salary income. He has at least another 25 years of working life. However, for financial advice, he relies largely on his parents, elders or peers.

Like others, Kumar too is susceptible to behavioural biases that may prevent him from taking the right decisions. He may think his parents and peers have done well for themselves by investing in certain products, so nothing could go wrong. The point is, contrary to what one thinks or perceives, we all have an intrinsic bias towards certain behaviour that is not always rational, especially for retirement planning.

Let’s examine some of these behavioural traits and explore how we can address them after acknowledging the existence of such biases in us.

Present bias

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Put simply, present bias is the tendency to favour immediate gratification instead of future rewards or returns. Kumar may prefer an instrument that gives good returns in the near future (2-3 years) rather than invest in retirement funds because retirement seems so far away in the future. Present bias is when people focus too much on short-term returns than long-term returns.

Also read: Retiring with Rs 2 crore: How to invest your corpus for regular income so that it lasts for decades

Inertia effect

Kumar has been postponing investment in savings for retirement, thinking he will start “next year.” After all, he has at least 25 years before retirement, so it seems a long way off. This inertia or status quo bias is fairly common. Even though we are aware of the power of compounding, we keep postponing certain decisions because the process requires too much effort.

Also read: Life-stage financial planning: Time to get serious about money in your 30s

Loss-aversion bias

Sometimes, we need to correct course if our investments are not right. However, many times we carry on with our dud investments. We don’t realise that our investments are either inherently bad or not suited to our risk temperament. We also avoid shifting because it might tacitly imply that we were not right.

This loss-aversion bias prevents us from correcting course and learning from mistakes. So we are averse to selling an investment at a loss and making a course correction.

Bandwagon effect

We all tend to get influenced by what our elders tell us and more frequently, what our peers do. Close to the end of the financial year, we look around for instruments that are tax efficient with little regard to our personal circumstances and what is relevant to us.

Tax regimes may change over 25-30 years of employment and while they are a strong incentive to save, the benefits they offer cannot be the sole guide for our investment planning. The bandwagon effect could also be due to the “fear of missing out” on a good opportunity when others are making use of it.

How to overcome behavioural biases

Do a “financial workout” at least once a year.

Life events mean change of strategy: Changes in personal circumstances (marital status, birth of a child, new job, health status) and the external environment (investment returns, government regulations, tax rules) will impact cash flow. You must look at your investment strategy in light of such changes.

Don’t be emotionally attached: Learn to let go of investments that are loss-making and don’t make sense. The sooner you course correct, the better it is.

Be aware and conscious of your financial decision: Ask yourself why you are investing. How does it align with your goals and circumstances? Don’t invest because everyone else is doing it or it is the “in” thing to do.

Overcome the bandwagon effectBe aware of your biases. They can sometimes be traps, so it is good to avoid them.
Preeti Chandrashekhar is India Business Leader – Health and Wealth at Mercer
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