Tuesday, July 9, 2024
HomeMutual Fund5 Emotional Mistakes That Lead to Common Financial Mistakes

5 Emotional Mistakes That Lead to Common Financial Mistakes

Believe it or not, five emotional missteps can lead most individuals to commit common financial errors. It may sound unbelievable, but let’s delve into these mistakes individually. If you are susceptible to these mistakes, I urge you to read on until the end. Despite how trivial it may seem, there is a solution to these challenges.

About the author: Ajay Pruthi is a fee-only SEBI registered investment advisor. He can be contacted via his website plnr.in. Ajay is part of the freefincal list of fee-only advisors and fee-only India.

The five mistakes are:

  1. Greed
  2. Fear
  3. Guilt and Gratification
  4. Social Strata
  5. Ignorance

1 Greed

Who among us doesn’t aspire to be wealthy? Whether it’s you, me, or anyone else, the desire for financial prosperity is universal. Yet, setting aside a few exceptions, is it realistic to expect to become rich within a mere 2-3 years? Achieving substantial wealth requires a significant amount of hard work and strategic planning. Consider Warren Buffet, for instance, who dedicated 75 years to attain his current status. Yet, it’s curious how some of us aim to outpace him in a mere 75 days. This is where the impulse of greed begins to take root.

Stocks – My acquaintance, Rohit, lacked knowledge about stock investments and tended to be a conservative investor. However, one of his friends boasted about doubling his money through a particular stock within just six months. This friend advised Rohit, suggesting that if he aimed for rapid wealth accumulation, he should consider investing in stocks. Caught in a dilemma, Rohit pondered whether to opt for safer options like debt mutual funds, which would potentially double his money in 8-9 years, or take the riskier route of investing in stocks, promising a doubling within 6 months.

He plunged into stocks. Result- Within the following six months, the stock’s value halved. Two years later, it dropped to just one-tenth of the initial investment.

Reason – Greed. Investing in stocks is perfectly acceptable, provided you know how the market operates. However, if you’re venturing blindly into the market, you will likely yield no returns.

Mutual Funds– Ajay, known for his moderate risk tolerance, typically invests in large-cap mutual funds, yield 12% per annum returns. However, when a friend suggested investing in small-cap mutual funds promising returns of up to 20%, Ajay couldn’t resist the temptation of the extra 8% returns. Consequently, he shifted half of his investments into small-cap funds. Unfortunately, with upcoming elections resulting in a change in government, the stock market plummeted. Small-cap funds suffered a staggering 60% decline, compared to the more modest 25% drop in large-cap funds. 

Despite his aspirations for higher returns, Ajay’s attempt to earn extra money ultimately failed. Another common financial mistake.

Reason – Greed. Now, there are many examples like investing in

  • Non-Convertible Debentures
  • Investing in some ad-based instruments where returns are promised as high as 20% per annum.

Let’s move on to the 2nd point.

2 Fear

In a true-life situation, my wife was persuaded to purchase a money-back policy in 2008 amidst a market crash when portfolio returns were negative and people were seeking safer investment options. Seizing the opportunity, one of her distant relatives sold her a traditional policy with an annual premium of Rs. 40,000. Despite my advice against it, she was convinced of the wisdom of investing during the market downturn.

Although she lacked knowledge about investments at the time, her decision was influenced by a fear of loss that had been instilled in her.

Reason – Fear

After 4-5 years, I was compelled to surrender the policy, incurring a loss of Rs. 90,000.

Let me explain how fear operates. Many individuals, despite being conservative investors, enter the stock market or mutual funds when the market is at its peak due to a sense of greed. However, when the market suddenly crashes, it may take another 2-3 years to recover the initial capital. Subsequently, fearing another market downturn, they withdraw their principal amount as soon as the market begins to rebound. Consequently, they shift all their investments into debt instruments.

In this scenario, two financial mistakes have been made:

  1. Investing in the stock market or mutual funds when too fearful.
  2. Failing to allow sufficient time for investments to mature after taking the initial plunge.

Do you now realize why traditional insurance policies like LIC Jeevan Anand, Jeevan Labh, etc., are often sold? It’s primarily due to the fear of avoiding financial losses.

3 Guilt and Gratification

Guilt. Let me illustrate an example involving my friend, Suresh. Suresh recently relocated to Mumbai for work, while his family remains in Delhi due to his wife’s job. Consequently, Suresh travels to Delhi every fortnight for a weekend visit. Previously, Suresh and his family would dine out at a restaurant once a month or every two months. However, since Suresh’s visits have become less frequent, they now opt for dinner outings whenever he returns to Delhi. Additionally, Suresh’s son requests expensive toys during these visits, which Suresh obliges, despite knowing they will hold his son’s interest for just a few days.

What is Suresh doing in this scenario? Suresh is alleviating his guilt by spending more money during his visits.

However, how is Suresh breaking financial rules here? Instead of maintaining his previous spending routine and investing the surplus for his child’s future needs, Suresh is spending extra solely to assuage his guilt. 

Even if he maintained the same routine, his son would still miss him when he returned to work. Reason – Guilt

Gratification. Consider this: Have you noticed how many insurance agents who sell policies are acquaintances of your parents? They often come, persuade your parents, and sell you an insurance policy.

But why do you end up purchasing the policy? It’s often a matter of gratifying your parents. Despite knowing that the product may not suit you and yield poor returns, you buy it because your parents requested it. A blend of guilt and gratification drives this decision. The aspect of gratification doesn’t need further elaboration.

Similarly, you might comply if you have a childhood friend who recently launched a mutual funds agency and urges you to invest in regular plans through him. Even though you’re aware that direct plans offer better returns than regular plans, you still opt to invest through your friend. Reason – Gratification

Let us move on to 4th Point.

4 Social Strata

Three years ago, my friend relocated to Mumbai and secured an Assistant Vice President (AVP) position in a prominent corporate entity. Initially content with residing in a rented 1 BHK apartment, his perspective changed following a gathering at his home. During a casual conversation the following day, a friend questioned why he, as an AVP with a lucrative salary, was living in a 1 BHK.

Influenced by societal pressure, he purchased a flat worth 100 Lakhs with a home loan within six months. Unfortunately, the flat is situated 60 kilometres away from his office, necessitating a gruelling three-hour commute daily. Furthermore, he harbours doubts about settling in this location in the long term.

As a result, his financial stability, as well as his overall happiness, has been jeopardized.

Log Kya Kahenge (What will people say?)

Car Loan – The situation is similar with car loans. My neighbour owns a Honda City, while I drive a Santro. Even the manager working under me has an i20.

Despite lacking the funds, I feel compelled to purchase a larger car.

Child`s Marriage– I fail to comprehend why many individuals prioritize spending more on their child’s wedding rather than their education. I’m not suggesting they neglect investing in academics, but it begs the question: why the disparity in spending?

Could it be a concern about societal perceptions? Consider this: Your child is 25 years old, and you’re planning to allocate 25 Lakhs for their wedding. But what if you allocated only 5 Lakhs for the wedding and invested the remaining 20 Lakhs in equity mutual funds?

Imagine the potential outcome if your child works until 60 and refrains from touching the invested amount until retirement. With an assumed return of 12% per annum, that 20 Lakhs could potentially grow to 10.5 Crores. This significant sum could afford your child an early retirement around the age of 40-50, allowing them to enjoy a peaceful and fulfilling life, something you may have desired for them.

Yet, despite the potential benefits of such an investment, would you still prioritize spending on the wedding? It’s something worth pondering.

5 Ignorance

I understand that no one can excel in every aspect of life. If you’re a software engineer, your expertise lies in coding, whereas I, as a financial planner, specialize in personal finance.

Consider this: When you purchase a mobile phone, don’t you conduct research? Don’t you seek advice from friends? While you may lack knowledge initially, you likely conduct some background checks before making the purchase. You wouldn’t remain ignorant about the mobile phone you intend to buy. However, the same level of diligence often doesn’t apply when purchasing financial products. Many individuals research financial products only after making the purchase, leaving them with limited recourse.

Being ignorant is not a crime, but remaining ignorant when purchasing financial products can have significant consequences.

Solution to Common Financial Mistakes

If you find yourself making emotional mistakes, it’s advisable to consider hiring a fee-only financial planner. These professionals can assist you in making informed and unbiased decisions, helping you avoid common financial pitfalls.

That’s all I have to share for now. I would be pleased to include any additional points you may have by sharing your experiences in the comments section.

*Disclaimer- Nothing in the article is my solicitation, recommendation, endorsement, or offer. If you have any doubts as to the merits of the article, you should seek advice from an independent financial advisor. Registration granted by SEBI, BASL membership, and NISM certification does not guarantee the intermediary’s performance or provide any assurance of returns to investors. Investment in the securities market is subject to market risks. Read all the related documents carefully before investing.

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