Kids & Money-2 : What shall we teach our kids about Money?

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In my last article on kids & Money we saw that it is very important to teach our kids about money.  We also saw that financial education that we need to give our kids can be divided into two parts : 1) Practical Aspect of Money.  2) Philosophical Aspect of Money. Now let us see first Practical Aspects of Money in detail.

Practical Aspects of Money:  This includes practical aspects like Income, expenses, assets, Liabilities, investment, banking, insurance etc. For kids from the age of 2 years start observing money transactions but they don’t understand much. According to my experience I would recommend to start discussion of small money transactions with your kids form the age of 5. The discussion should be very basic and not very complicated and parents should try to simplify the topics. Particularly I have observed that when our kids watch us doing some financial transactions or whenever some discussion on any financial matters is going on and they want to participate in it we generally stop them by saying that “you will not understand this”, this approach should be changed.

 Which practical aspects shall we teach our kids?

While educating kids about money matters we have to be careful about which topics shall we discuss with our kids. So according to my understanding and experience we shall discuss following topics.

a) Income : we shall discuss with kids about – What is Income?, difference between income from different sources like income earned from active efforts like salary income, business income, professional income vs. Income earned from passive sources like rental income, dividend income, interest income. How to built sources of passive income? While discussing these topics kindly remember that your kids may understand hardly 10% to 20% of what we tell them but this will definitely puts some seeds in their minds to think. Also you will have to discuss these topics again and again with your kids to make them understand.

b) Expenses – developing good spending habits: Another most important topic is to discuss about spending habits. Expenses can be classified in four categories Expenses for Basic needs, Comfort needs, Luxury needs & expenses which don’t fall in any of these can be classified in waste of money. We need to develop an approach of being not too conservative or too aggressive in spending within our kids. Also we need to develop an approach to do cost benefit analysis and find value for money while taking their spending decisions. I generally try to involve my son in all minor to major spending decision like starting from buying vegetables to decisions like car & house and try to give him different options and understand which option he prefers with reasoning. Like if I have to buy a car I try to involve my son by giving him different options and prices and ask him his opinion with reasoning. Kindly remember that while kids give their views we need to respect their views and don’t criticize or reject their views straight way. But at the same time we need to give them our views with reasoning and this should be a positive discussion. If we straight way reject or criticize their views they will stop participating. This method will help in developing their analytical skills while taking any financial decisions in life.

c) Savings & Investments: After income & expenses, kids need to understand about savings & investment. Savings is what is left out from income after spending and investment is when you invest that saving in a planned manner for some future goal in an investment instrument. Here we need to develop an understanding about saving money and then investing it. This can be done by first making kids earning small income through some small tasks like car washing or you can also motivate your kids to do small projects like stall in their school funfair to earn profit. Once they have earned some sort of income then help them to manage their expenses. Try to develop a habit to write their income as well as income in some diary or excel sheet if they are comfortable. Now whatever they have saved has to be invested in any instrument. First help them to start a saving account and understand transactions in that and after that explain them different instruments like fixed deposit, shares, mutual funds etc. help them to choose the one. Kindly note that don’t push your decisions on kids, let them take their own decisions and see what happens in future. This entire activity will develop a habit in kids to understand relationship between income, expenses, savings and investment and most importantly plan their money matters when they will grow up and become adults.

d) Assets, Liabilities & Net worth: Another important aspect about money matters is educating kids about Assets & Liabilities. Assets are created from savings & investments. Kids should be educated about different types of financial & Physical assets. They should also be given understanding about depreciating assets like car and appreciating assets like property and investments.

Similarly, basic understanding about liabilities should also be given. Which liabilities are good and which are bad should also be explained to them.

Excess of Assets over Liabilities is Net worth and this is the most important figure in ones financial matters. Whatever financial decisions we take has some impact on our net worth. Increase or decrease in net worth will represent our overall financial health and we should try to give our kids this idea of focussing on effect on net worth while taking any financial decisions.

Above are few basic practical aspects of money which one should teach his kids. Following two aspects should be kept in mind while your discuss money matters with your kids.

Let your kids make some mistakes: with all above understanding it is important to give them small experiences to deal with financial matters and allow them to take few small decisions. Also they will make some mistakes and will suffer some losses due to wrong decisions but allow them to do what they want to do. This will improve their decision making.

Also it is very important that they make mistakes at smaller level so that when they have to take bigger financial decisions in their life they will have experience of small mistakes. Try to develop an approach of analysing and learning from the mistakes.

Develop a reasonable risk taking & loss bearing psychological ability: In practical life we all know that many times we have to take financial decisions in our profession or business which may or may not go the way we want but at those times we need to analyse different aspects and take appropriate decisions and after that if that doesn’t go right we have to be ready to make necessary changes. But from my experience I have observed that many parents don’t involve kids in any financial decisions. Even I have seen that they try to take their decisions even after they start earning. This approach as a parent makes our children poor decision makers and they suffer from the lack of confidence while taking financial decisions with fear of going their decisions wrong. But we if involve them in decisions at early stages and develop proper analytical and decision making skills, they will be able to built reasonable confidence in financial decisions and this will help them throughout their life.

In this article I have discussed all the practical aspects which will be useful in day to day life and in next article I will discuss the philosophical aspect of money which we should consider for our kids.

Kids & Money: Why should you educate your kids about Money?

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While reading the title of the article “Kids & Money” you must have a question that what is the relationship between kids & money? or why kids have to learn money matters ? It’s we adults who have to deal with money matters and need to understand and learn better money management techniques. My answer to your question is that as a financial planner I have realized that my clients who are sometimes senior doctors, Engineers or entrepreneurs are experts in their respective areas but generally they are not good with money skills required in their lives.

Let us see in detail why should we teach out kids about Money?

Why should you educate your kids about money?

  1. Lack of formal learning About Money matters: Money skills are required in different areas of life but unfortunately there is no formal education of money skills at our school level and we don’t educate our kids about money skills. At college level also there is hardly any learning about money matters in most of the streams. To a certain extent people who come from the commerce background learn few things about money matters like taxes, insurance, banking system & investments but people who opt for other streams like Science, Engineering, Arts etc. hardly learn anything about these topics so when practically they have to take financial decisions like buying a house, opting for loans or their investment decisions, they don’t understand anything and for that reason they keep taking wrong decisions & learn by trial and error. This basic learning about few fundamental concepts at school level will help them to understand things better and take proper decisions.
  2. Biases & Beliefs: whatever a kid gets in the form of information & or experiences get recorded in his subconscious mind. Over a period of time these experiences and information get converted to beliefs and biases and when the kid becomes adult and has to take some decision from his conscious mind, these biases and beliefs will affect their decision making. A very simple example of such biases is most of clients prepay their home loans or other loans even though such loans are giving them huge tax benefits and post tax interest rate is much less than return on their investment. This happens because knowingly or unknowingly they have received this message from their parents it is registered in their subconscious mind. But today when home loans are available at 8.5% p.a.(unlike 15% to 18% p.a. till 1999) and you can save good amount of tax on it is better to plan house with home loan only. so it is important for the parents to see that whatever input kids are getting in the form of information or experience in money matters should be such that will help kids learn right things and keep them away from biases.
  3. Realize your children about value of money : Most of the clients complaint me that their kids don’t value their harden money and they waste it. This happens because they have not earned for money and cannot imagine the level of pain parents take to make that money. So to realize them value of hard earned money we need to teach them importance of money.
  4. Building proper approach towards Money: As a financial planning practitioner I have realized that different people have different approach towards essence of money in their life. Some are very casual, whereas some think very minutely about money matters, some are over spenders and some are very conservative. This approach is generally result of their childhood & young age experiences about money. Most of the people are influenced by the approach of their parents towards money.

This approach towards money results into emotions like anxiety, fear, greed etc. related to money. For example some people give too much of importance to money in their life and so work for 12 hrs or 14 hrs. Now when I calculate I find that they have sufficient money and they don’t need to work so hard. This approach of working so hard creates anxiety and frustration and has adverse effect on other areas of their life like their physical & mental health, their relationship with their kids, life partner etc. but for them money is most important so in such cases when we go in deep to find the reason we find that this approach is a result of some childhood or young age event. So the role of parents comes in consciously educating kids about importance of money in their life and maintaining balance between money and other aspects of life.

Primarily whatever we need to teach our kids about money can be divided in following two aspects.

        a) Practical Aspect of Money: Practical aspect means we need to give them correct knowledge about things which are helpful in their routine life to deal with money matters. Few examples of this are giving them knowledge of topics like what is income, expenses, assets, Liabilities. Giving some basic idea of Budgeting, insurance, investment, Banking system etc with some practical experiences.

        b) Philosophical Aspect of Money: This means that helping kids Building right approach towards essence of money in their lives. This is very important for kids and here parents and their family plays most important role. As a financial planner I find that most of the clients who come to me have disturbed relationship (incorrect approach towards money) with money and this brings unnecessary stress in their lives. This approach or relationship with money is 80% constructed in our lives from the age of two to three years to twelve to fourteen years. After words it is difficult to change it so it is very important to give our kids right approach towards money.

From above discussion it can be easily concluded that as a parent we introduce our kids with money and so it is our responsibility to take this topic seriously and make conscious effort to educate our kids about important money matters and help them built correct approach towards money.

In my next article I would take this topic further and discuss other angles like how and What shall we teach our kids about money matters?

 

Retirement Planning : Facts & Figures

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Retirement Planning : Facts & Figures with Case Study.

In my last article I discussed about the importance of Retirement Planning, in this issue I would like to discuss on how to plan your retirement. So here I would like to help readers with some numbers. For that here below I am discussing two illustrations for Retirement planning, first one with an age of 45 years of Mr. A and second with an age of 35 years of Mr. B. In first case, age of spouse is purposefully taken at 43 and in second case age of spouse is taken same 35 years.

Kindly remember that every individual’s numbers may change and this example is just a basic illustrative example and I have not taken any complications in this so don’t adopt these figures for your retirement planning directly.  

In above illustration I have calculated retirement corpus for Mr. A, who is 45 years old and his wife is 43 years old. Retirement age is taken as 60 so retirement year is 2032 & years to retirement are only 15. Now as you can see that with life expectancy of 90 years and spouse’s age being 43 the total retirement years to support from retirement corpus would be 32.

  • In the second case of Mr. B, his age is 35 and spouse’s age is also taken as 35 and retirement age is same 60 so years to retirement would be 25 but total retirement years to support would be 30 only.
  • In above table, blocks with light blue background are the blocks which are input blocks. These are to be decided & filled up and the blocks shown with dark blue background are output blocks which come as a result of calculations.
  • Monthly Expenses: In the monthly expense block (f) one has to fill the monthly expenses at current rate if you are retired today. These are the expenses of monthly nature like light bills, telephone bills, petrol bills, grocery expense etc. everything that is of monthly nature. One can also add other annual expenses like travelling etc. by dividing it to 12. Kindly remember that this is the figure that if you retire today then this will be your monthly expenses in today’s value. So while calculating this one has to consider that children are settled at the time retirement so deduct all expenses related to children from your current monthly expenses. Add few expenses like medical cost and additional cost for servants needed in the old age. In both above cases, I have taken this as Rs. 70000 monthly and in block (g) above I have converted them to annual to make calculations easy. So annual expenses required in today’s value to retire are Rs. 840000. Further at 6%(h) inflation you can see that for Mr. A it becomes Rs.2013109 where as for Mr. B it becomes Rs. 3605171 this happens because in case of Mr. B he is 35 year old and years to retirement are 25 as compared to Mr. A where years to retirement are 15 so for Mr. B inflation has more impact. So if you’re annual expenses is Rs. 840000 today it will be 20 lakhs after 15 years and 36 lakhs after 25 years. This will be just first year retirement expense and it will keep increasing every year with increasing inflation.
  • Retirement Corpus: To live a comfortable retired life the total Corpus needed at the time of Retirement (2032) for Mr. A is Rs. 4.89 crores (approx.) and for Mr. B in 2042 would be Rs. 8.35 crores (approx) shown in cell N in above table.
  • Rate of Return on Investments: Also it is assumed that both Mr. A & Mr. B  will earn 12% (cell k)post tax returns on their total portfolio pre retirement and 8% (cell I) post tax returns on their portfolio post retirement.
  • Existing investment & Annual investment needed : It is assumed that Mr. A has already provided Rs. 25 lakhs (cell j)for his retirement and Mr. B has already provided Rs. 10 lakhs. So considering that Mr. A is required to make annual investment of Rs.9.45 lakhs (ap.) (from 45 age to 60 age) (cell) to achieve the needed retirement corpus and Mr. B is required to make annual investment of Rs. 4.99 lakhs (app.) (from 35 age to 60 age) to achieve needed retirement corpus. So even though Mr. B’s needed retirement corpus is almost double than that of Mr. A his annual investment required is almost half. This is because he has 25 years left to his retirement from now where as Mr. A has only 15 years left out to his retirement.
  • Delay in Retirement Planning : last figure in cell p shows that if Mr. A & Mr. B both decide to delay their retirement planning decision by further 5 years and want to start providing for retirement after 5 year then what would be the annual investment required to meet the same target retirement corpus at 60. In case of Mr. A the annual investment needed if he starts after 5 years is 23.46 Lakhs which is more than double as compared to figure of 9.45 lakhs if he starts now. And for Mr. B it is Rs. 10.25 Lakhs against Rs. 4.99 lakhs if he starts now. So five years delay can make this goal very difficult.

Below is the corpus utilization table for above illustration of Mr. A which shows how annual expenses keep growing even after retirement and how corpus is utilized for the same. At 92 years of age of wife the corpus becomes zero.

 This happens because till 76 years of age annual expenses are less than return earned from the retirement portfolio and so retirement portfolio is increasing till that time but after 76 years of age you can see that retirement corpus starts reducing every year because annual expenses are more than return from retirement portfolio.

      Retirement Corpus Utilization Table

 Conclusion: Following are few points which one should keep in mind from above discussion.

1) Retirement is last but important Goal: generally retirement is last goal by time in the life of most of people but it is most important goal as we have to support long retirement years without regular income from primary source.

2) Start Early: Figures of retirement corpus & annual investment needed looks very big but if you start early it is not that difficult and you can achieve it easily. But if you delay your decision for planning and providing for retirement it can become dangerous.

3) Be Consistent : Most of the people when they start providing for retirement they don’t remain consistent in their strategy or sometimes don’t invest consistently and stop in between. This can disturb your retirement planning so keep investing consistently.

4) Calculate for yourself:  If any of you want to make such calculation for yourself then kindly mail me on lohana_prakash@ascentsolutions.in . I need your current age, Spouse’s current age, retirement age, Monthly expenses in today’s value, existing provision for retirement if any. Rest of the things we will assume and give you figures of Needed Retirement Corpus & Annual investment. On receipt of above data my team will revert in two working days.

Importance of Retirement Planning

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Retirement planning is one of the most important part of total financial planning of an individual. Retirement years are the beautiful years of life. After taking his education when an individual starts his working life, he is burdened with lots of different responsibilities in his life. But retirement years are the years when one can live life that he wanted to live. At the same time, in retirement years when once physical and mental ability is continuously deteriorating, so in such times certain expenses like need for driver, servants to help increases so importance of having sufficient financial resources is very important. As a financial advisor I handle many clients and see that people don’t plan their retirement years seriously. So let us first see some aspects why retirement planning is must.

Changing Socio Economic Structure of Our Society: Socio economic structure of our society is continuously changing. We never saw our parents planning for their retirement years so precisely, because they believed that their kids are their retirement planning. Till now we have seen a joint family culture and the relationship between kids and parents in our country has been such that if you ask parents what corpus they have accumulated in their life they will say that their kids are their real wealth and they (kids) will take care of them and on the other side kids were also comfortable taking care of their parents in their retirement life but slowly and gradually we are adopting Western culture, joint family culture is ending so I believe that going forward this will change and parents will not be comfortable giving their financial burden to their children and kids may also not be comfortable taking this burden. So with this change our dependency to our next generation can lead us to miserable condition in retirement years.

Recent case of Mr. Vijay Pat Singhaniya (Chairman of Raymond group) who after his retirement handed over his wealth to his son is suffering from financial crisis in retirement years, is a live example for this.

Increasing life Expectancy: In 1947, when India became independent, it was said that life expectancy was around 49 years which kept increasing and current figures suggest that life expectancy is currently around 71 years due to better living conditions and advancement of medical facilities. But this figure of 71 years is an average which includes people from rural areas and people who live below poverty line and don’t have proper medical facilities, so actually for people like us who are health conscious and live in urban areas with good medical facilities; life expectancy is more than 80 years. So due to increasing life expectancy dependent years are becoming longer and we need to plan for that otherwise our old age can become miserable part of our life. Generally when we plan for Retirement, we take life expectancy at 90. If we consider our working life from 30 to 60 and our Retirement life from 60 to 90, during our working life every year we have to earn for almost two years, first for the year in which we are in working life and second for one year in retirement phase. For example, a person who is 35 he is also earning for his 35th year of life and also for one year of retirement phase which he has to fund and there will be no income. Following image gives more clarity about that. Generally investors don’t consider this fact.

Improving life style: Our life style has been continuously improving due to which our cost of living is increasing. Our earlier generations had a very contented and satisfied life style. Their cost of living during their working life was also not very high so needs in retirement life were also limited, against that we are increasing our life style very fast during working life itself so once the cost of living is increased during working life it has to be maintained for retirement life too. Famous Tennis player Boris Becker who lived a lavish life style and now suffers from the Bankruptcy post his retirement is one such real life examples of lavish life style and poor retirement planning which resulted in crisis during retirement years.

So the above aspects clearly show that to enjoy our retirement years we need to plan them properly. Now let us see some research and data about retirement planning

Research says that 47% of working population in India has either not started providing for their retirement years or due to some or other issue have stopped providing for retirement years ( according to report of HSBC). So Let me ask this question to all of you. Have you started providing for retirement years? Also have you actually prepared some written Retirement plan? Kindly check your financials and answer yourself for this.

Let me clarify that Retirement planning doesn’t mean that you will stop working at 60 years of age. You may continue to work for whole your life but if you have proper retirement plan in place you are not bound to work for your financial needs. You will work at your choice.

Here I would like to end this with conclusion that Retirement Planning is very important and one must have his written Retirement plan in place. In my next article I will be writing more on numbers and ways to Plan for Retirement..

Availability Bias in Investing : How it affects your Financial Decisions?

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One of my friends is working in an engineering company at senior management level. 60% of his personal investment portfolio consists of his employer company shares. When, I ask him why he is buying so many shares of his employer’s company. He always gives me details of performance and future plans of his company. When I discuss about other good companies and their results he is not ready to believe and invest in them. This is availability bias. We believe in information which is easily and readily available to us.  This is a very common bias. In above case of my friend he trusts his company like anything because that information again and again comes in front of him but don’t look at information about other companies or don’t trust them.  But when the same information about his company comes to me, I don’t give much importance to it because I also have similar information about other companies too. So importance of information about any company is similar and I analyse all the companies with same importance.

We create the picture of the world based on the information available to us. Also we give more importance to information which is served to us more dramatically or loudly rather than considering quantitative factors. To prove this I will ask you one question. Tell me the name of bath soaps available in India?  Now observe yourself you will easily come up with 3 to 4 names that first come to your mind than you start struggling and still can come up with 1 or 2 more names.  Now think why the first three names came to your mind immediately. Some of them have given very good advertisements again and again which you have seen and have made place in your brains. So you first come up with these names. This is availability bias. The other brands of soaps may be better than these soaps but as you have not been given that information about these soaps you remember these three and believe they are better. The things which are made available to you more number of times come immediately in our mind and we believe them more. Further if the ads are more dramatic we believe them more. We don’t go into quantities analysis.

I remember last year when we were going for the vacation in the month of June by plane and just one week before that my son saw a Tv programme on plane crashes, he clearly refused to come with us because he believed that there are high chances that our plane may crash. So by watching that programme on plane crashes probability of plane crash in his mind went up and his decision to travel by plane was influenced heavily by that information. If he had not seen that programme he could have easily traveled to planes for his whole life.

Human brains give more importance to easily available and recent information while taking any decisions.  One of my clients is working in an infrastructure company, the company was not doing well for last few years, and so overall company had not given any salary rise to employees this year. Around a month back when I was discussing his portfolio with him, as a part of my investment recommendation I suggested him to invest some of his funds in few infrastructure equity funds. These funds were specific thematic funds and will invest in share of infrastructure companies but he was very pessimistic about the future of infrastructure companies and was reluctant to invest in infrastructure funds because of low performance of his own employer company. Two days before I was writing this article, I received a call from him asking me to invest his funds in infrastructure funds, when I went into details to find why his behaviour changed I found that his company got few orders one after another and this was sufficient to convert his pessimism to optimism. So the information which was available to him was very positive about infrastructure industry so future image he was making was very bright. On the other hand upto few days back it was reverse because information available to him easily was not speaking well about future of infrastructure companies in India. When I was arguing with him and giving him information that infrastructure companies will do well he was not  was not ready to listen & consider the information that I was sharing. So we believe in the information that is easily available to us and start making very important investment decisions or life decisions on those basis.

Many clients when first come to me have bought lots of life insurance policies for investment. When I analyze those policies and tell them that they are not worth investing and they should buy insurance only for life cover and not for investment purpose. Their answer is simple that at the beginning of my career I saw all my colleagues & friends investing in life insurance policies so I thought it is correct approach and did the same. So they believed what information was available to them.

When entire media speaks well about the economy and markets, you will see that inflows in equity market will generally increase and vice versa. So when positive information is shown to us again and again we start believing it otherwise not.

Impact of Availability Bias : Due to effect of availability bias our decisions are biased towards the recent and easily available information. Sometimes we prefer wrong information to no information. There are two aspects of this point explained below.

 a) We Don’t try to find the information: We generally use the information that is easily available to us and don’t try to get the correct information or other information that is not easily available to us. Due to this approach sometimes we prefer wrong information to no information. This means that if wrong information is easily available we believe that rather than finding correct information. Due to this we buy brands which give more advertisements. Investors buy financial products which are shown to them. Suppose you are in touch of a lic agent he will recommend you life insurance policies and you will buy life insurance policies.

b) We digest the information in the form it is provided to us: We don’t try to analyze the information and accept it in the form it is shown to us. Few years back LIC had launched a single premium policy where money was doubling after 10 years. Few clients came to me with marketing leaflets sent by few agents claiming that policy gives 10% returns. Clients were asking me that 10% returns are very good so let us invest in that plan. They never realized that this 10% is a simple rate of return and not a compounded return. Compounded rate of return is close to 7.15% p.a. So they never analyzed the information that was given to them. This leads to wrong decisions.

How to avoid Availability Bias:

1) Look at information that is not easily available : Try to find information that is not easily available, also try to find information about products which you are not buying. This will make you slightly uncomfortable but make it a habit.

2) Meet the people who look differently than you : Try to meet and understand views of the people who think differently from you. If you believe that markets are good for investment than try to listen and understand the people who believe that markets are not good for investment right now.  Think and analyze their view and then take important investment decisions.

3) Give your past mistakes a hard look : look at the mistakes you made in past and analyze why you made these mistakes. Was there lack of information analysis or you relied on the information easily available. Make the necessary changes in your approach of looking at the information.  

To conclude with availability bias is a very serious bias and has significant impact on our decisions so while making our important financial decisions we should try to dig more information and try to analyse it in more details before we make and decisions.

Nifty 50 @ 10000, what should investors do now?

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On 8th of Nov. 2016, When Govt. Of India took a strong step to demonetize 500 & 1000 rupee currency notes, Nifty 50 which is one of the most important indices of National Stock Exchange and looked as a benchmark index to see markets of our country was trading at 8500. It was like an earthquake situation in the economy and from next day all media channels & everybody started predicting what will happen in markets. Almost everybody predicted that markets will fall sharply as economy will slow down because Indian economy is a cash economy and there will be heavy cash crises for next few months which will affect consumption badly and in turn markets will fall sharply. Initially markets crashed by around 5 to 6% but later on it started rising surprisingly with sharp speed and crossed 10K at the end of July-2017. So almost in the period of last six months Nifty 50 has gone up from 8k to 10k which is around 25%. Now the question arises that why markets went up by 25%? What will happen now from here? Whether it will go up or down? While reading the title of the article you must have thought that I have the answer of these questions but let me tell you that I don’t have answers for all these questions but yes I can definitely analyze the current situation and tell you what strategy you should adopt.

Overvalued Markets: Current rally of Nifty from 8k to 10K has made markets extremely overvalued and risky. Markets have gone up only based on future expectations.  But to understand this let us first understand EPS (Earnings per Share) & P E Ratio (Price to Earnings Ratio).

Earnings Per Share (EPS): First understand this by a simple example. For instance, there is a company which has issued 100 shares and has earned net profit of Rs. 1000. In this case Earning per share would be Rs. 10 (Earning per share= Net Profit/no. of shares issued)

Price to Earnings Ratio: Price to Earnings Ratio is the ratio which reflects relationship between market price of the share and Earning per share of the company. It is arrived at through following formula.

Price to Earnings Ratio is an indicator of valuation of the company. It gives you an idea whether company is available at cheaper valuations or costly valuations. Let me explain with an illustration.

There are two companies Company A and company B. Both are in the same industry and following is the chart of their data.

Looking at above table, at first instance it looks like company A is cheaper because its share is available at Rs. 100. And company B’s  share is available at Rs. 200 so a layman investor would jump up and buy the Shares of company A considering that he is buying a cheaper company. But look at EPS, company B’s EPS is Rs. 25 whereas company A’s EPS is Rs. 10 only so PE Ratio of company B is 8 times and it is lower than company A which is 10 times. This indicates that your return on investment is 12.5% (25/200= 12.5%) for company B and for company A it is 10% (10/100= 10%) so if other factors are same which company’s share would you like to buy now? Company A which is expected to give you 10% return on your investment or company B which is expected to give you 12.5% return on your investment. 

You can also look at PE Ratio like this, if you are buying company A with Rs. 10 EPS at Rs. 100 per share, this means you are paying price which is 10 years of profit of company A and if you are buying a company B with Rs. 25 EPS at Rs. 200 per share, you are paying price which is 8 years of profit of company B so which one you should buy now?  

Lower the PE Ratio Better it is: From above discussion one point you should understand clearly is lower the PE Ratio better it is and so you should buy stocks when they are available at lower PE Ratio and you should look at PE Ratio for comparison between two companies of same industry and not the price on standalone basis.

PE Ratio of Nifty and important lessons: while calculating PE Ratio for any index like Nifty we have to take value of Index and divide it by sum total of EPS of all the companies in that Index. Normally PE Ratio of Indices like Nifty is given on the website of NSE.

Now to understand current valuation of market let us see below table which gives some historical figures of Nifty 50, PE ratio and EPS to understand relationship between EPS and markets and analyze current situation.

Above table shows Nifty level at the end of every year from 1998 and at last I have taken recent level of Nifty on 31st July 2017. Logically there is direct relationship between markets and EPS (profits of the nifty companies) so Nifty should grow as much as EPS for Nifty companies taken together grows. But this is not true over short term because over short term participants(people who are trading ) in the market react to market events in more sentimental manner than logical manner so even though EPS has fallen markets may go up. To understand this you can see that in 1999 EPS has fallen by around 19% but still Nifty 50 has gone up by 67. Ideally Nifty 50 should have fallen but it has grown up so it shows that Nifty 50 has gone up due to sentiments by 87%. But when ever EPS has not grown and Nifty 50 has gone up than in next few years Nifty 50 has fallen even though earnings are positive, this can be seen in 2000, 2001 & 2002. In all three years EPS has grown positively but Nifty 50 has fallen because it had grown faster than EPS in 1999.

Similarly, in 2006 & 2007 EPS had grown by 13% & 19% but Nifty 50 had grown by 17% and 36% respectively so in next year 2008 it gave negative returns to the extent of 54%.

Lesson from the History: Above table shows that whenever market runs ahead of earnings growth it becomes overvalued and then either markets have to fall to match EPS or market may remain stable or range bound and EPS will grow to match market level. Similarly, if EPS is growing faster and markets are not growing than at some time in future markets will have to grow faster than EPS to match it.

Can we Predict Markets? : No, we cannot predict the markets, we can only understand whether markets are overvalued, undervalued or fairly valued. When the markets are undervalued investors can become aggressive and invest more in Equity, When markets are fairly valued investor’s should remain neutral and invest in equity as per their asset allocation requirement and when markets are overvalued investors can become conservative. In above table we can see that when EPS has grown faster, PE ratio has fallen and from there in next few years market has given good returns so lower the PE ratio better it is to invest in Equity.  Let us see below Table.

 

Every investor has his own Asset Allocation, suppose you have kept your asset allocation at  50% Equity and 50% Debt so that is your basic asset allocation. Now in case when markets are in undervalued zone (below 18 times PE ratio) you can think to increase your equity allocation from 50% to 60% or 70% and in times when markets are overvalued (above 22 times PE ration is ) you can slowly reduce your equity allocation from 50% to 40% or even less than that. In the times when markets are at fair value (between 18 to 22 times PE ratio) you should keep your equity allocation at 50%.Please remember that these levels of Equity allocation will differ for different investors based on their risk profile and asset allocation.

What to do in current situation where Nifty 50 is at 10000?

 In current situation when Nifty 50 has crossed 10K we have to see what has happen to EPS growth. Post demonetization say form Dec-2016 to July 2017 EPS of Nifty 50 companies has grown by around 5% where as Nifty 50 has grown by around 25% (from 8000 to 10000) and this has made PE ratio to reach at 25.69 times level which is highly overvalued. Historically, whenever PE ratio has reached these levels equity market has not given good returns for next few months or years. In current situation we cannot predict on which side markets will move but one thing that I can surely say is markets are in highly overvalued zone so when markets are overvalued we should become conservative and should reduce our equity allocation. But this doesn’t mean that we should totally exit from equity. If as an investor you are keeping your equity allocation at 50% equity now you should reduce it to 40% to 30%. So if markets fall sharply you will not be affected badly and will have liquidity to buy equity at cheaper prices.

For New Investors: For new investors, they should not make a mistake of waiting for correction to happen in the market. They should start investing through Systematic Transfer plan Mode. Suppose one has to invest Rs. 100 out of which 50 rupees will go in Equity then he can keep these 50 rupees in liquid funds and invest them slowly over next 12 to 18 months in equity so if markets fall sharply he is not affected badly and has some money in liquid to average out and if markets keep increasing he is not totally left out.

How Recency Bias affects your Portfolio performance? How to avoid Recency Bias?

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If I ask you to recall name of 10 people you met this month, whom do you recall? Just observe, mostly you will recall name of 10 people whom you mate recently.  This is recency effect.  Similarly, if I ask you for opinion on behaviour or performance of any of your colleagues or employees kindly observe how you give your opinion and what affects your opinion maximum, Most of the time their recent behaviour or performance will influence your opinion. If one of your colleagues was very polite and humble since beginning of your relationship but has not behaved well recently, your opinion will move towards negative side or if any of your employees has not performed well recently then your opinion on his performance will not be good even though he has been performing well since beginning. So your recent experience affects your opinion the most. This is recency Bias. Events which occur recently have maximum impact on your mind.

 Recency Bias is one of the most common biases affecting our investment and other life decisions. Here we remember the events which happen recently or information which we received recently. Also the events which took place recently or information which came last affects our decisions maximum.

Let me give you one more example, Say if from tomorrow you have to go for some project or work to a city which is two hour from your city by train for next one month and I ask you that what are the chances that train comes by time in India? What will be your answer? When I ask this question in my seminars most of the people have answer in the range of 70% to 90%. So they believe that out of ten times 7 to 9 times train will be on time. Now if suppose your answer is 70% you believe that out of 10 times you travel, 7 times train will be on time. Suppose you have to travel from tomorrow and you have to catch a train that arrives at 7.30 a.m. and departs at 7.35 a.m. You reached station by 7.25 and announcement was made that train is late by 90 minutes. Second day again you reach station by time and train is late by 70 minutes, Third day again you reach by time but train is late by say 2 hrs. Now I meet you on platform you are very frustrated and angry and I ask you the same question that what are the chances that in India train comes by time? What will be your answer? Mostly the answer that comes is in the range of 0% to 30%. Now observe what happened here, earlier when you said 70% chances are there, it came from your subconscious mind and this registered slowly form your childhood when you started travelling but these last three days experiences changed your answer totally and dominated your decision making behaviour. This same thing happens in Investment decisions as well as other decisions of life.

When it comes to investing people invest in the instrument which have done excellent recently. Particularly if you will see in stock market maximum investment comes when markets are at peak.

Above chart gives data from Oct-99 to March-2017, red line shows Sensex levels where as black line indicates gross mutual fund investments. The chart clearly shows that whenever markets are doing very good and going high, investments in equity funds sharply rise and vice versa. So most of the times investors invest when equity market is very high and stay away from markets when markets have fallen sharply. This behaviour is seen universally. The reason behind this behaviour is recency effect. When markets goes up and up the returns of equity mutual funds are very good in recent past so investors look at recent past and start investing in equity. Here subconscious mind starts believing that this behaviour of markets will continue and they will make good returns so investment at these points increases. Similarly when markets fall they the recent past is not good so they start believing that markets will fall further so they avoid investing more money in equity.

How Recency effect creates illusion of Safety & illusion of Risk?

Actually recency effect creates illusion of safety & illusion of risk in the minds of investors. Let me show you with a historical example.

In January-2008, when Sensex first time touched 21000 levels it was all time high and in last one year ( from Jan-2007 ) to Jan 2008 Sensex had moved up from 14000 levels to 21000 levels so it was rise of around 50%. In this month (January -2008) equity mutual funds had highest net inflow from investors of Rs. 13678 crores in one month. Here at this point Sensex had gone up by around 50% in one year but economy (corporate profitability ) had not grown by even 20%  and no economy can grow by 50% in one year so at this point markets were extremely overvalued and risk reward ratio was unfavourable.  But due to recency effect investors start feeling very comfortable and forgot to consider risk of overvalued market on the contrary they start believing that this will continue so here there is illusion of safety. There was no safety at 21000 Sensex levels but there was illusion of safety. This behaviour of investing more money at higher market levels created a bubble in stock market and what happened next we all know.  On the other side when markets started falling immediately after this and saw the bottom Sensex levels in Mar-2008 ( when Satyam fraud came out) of around 8344 the net investment in equity mutual funds was around Rs. 544 crores only, which was not even 10% of what came in Jan-2008. Here markets had fallen by around 61% so ideally there was hardly any risk because economic activity in the country or corporate profitability had not fallen by even 5% which shows that markets were undervalued and risk reward ratio was favorable but unfortunately those investors who were ready to buy equity at 21000 Sensex levels were found equity markets costly at 8300 Sensex levels and were not ready to buy equity. Isn’t this a strange behaviour ? Yes but the reason is at 8300 Sensex levels actually there was not risk, whatever worst could happened had already happened but as the recent past was negative there was illusion of Risk. There was not actual risk but there was illusion of risk only.

Both these behaviours were irrational in nature those who invested more money at 21000 levels in Jan-2008 had increased their avg. Purchase price as a result of which they could not make money for next few years and saw negative returns in next one year. Similarly those who were not investing or redeeming their money from equity funds at 8300 level in Mar-2009 could not gain out of the rising market in 2009-10 because the fall was an opportunity to reduce their average purchase price in equity but they lost it and the opportunity was gone. Ideally they should have behaved exactly reverse of their actual behaviour. But recency effect did not allow this.

Recency Effect in Real Estate: Recency effect is not only seen in equity investing but also in real estate investing. From 2005 onwards real estate prices in India and particularly Gujarat started moving up, as a result we saw that those who invested in properties between 2005 to 2007 got good returns by 2009 and at this time equity market had fallen sharply so at this point of time real estate investment had given very good returns and equity investment had not given good returns in recent past. As a result investors started investing in real estate more and more money and this behaviour again repeated what had happened in stock market in 2007. By 2012 property prices went up sharply. Maximum investment happened in 2012 and after that property prices in most of the regions have fallen or art stagnant from last five years.  Those who bought properties in 2005 had multiplied their money by four to five times by 2012 so ideally they should have sold their properties and booked profit but they behaved exactly reverse and bought more properties in 2011 & 12. So this brought up their average purchase price up towards the prices of 2011-12 and lost the golden opportunity to book profits.

Recently, after demonetization markets have gone up by around 15% to 20% in just 5 months and as a result recent past is very positive and once again investors are investing in equity. So be careful while taking your investment decisions try to avoid impulsive investing.

To conclude with, recency bias is the most common and frequent bias affecting our Investment decisions. So to take rational decisions we have to learn how to keep our decisions free from recency effect. Following are few suggestions which I recommend you to adopt to keep yourself away from recency bias.

Read History:It is said that history repeats itself. So keep reading history of stock markets and investments. Every few years market cycles are repeated and investors make same type of mistakes. Every time when the market is high, the hopes are at peak and due to recency effect investors believe it will keep going high because this time it is different and markets will do very good. Sir John Templeton had said that “The four most dangerous words in investing are: ‘this time it’s different.'” My advice is whenever someone says this time is different, please run away from there. Don’t litsen him more. Reading history will help you to think from the other side and get away from current fancy market rises or falls and you will do rational things.

Delay your decisions by 2 to 3 days: Whenever recency effect is at peak you will feel tempted to take your investment decisions either buying at peak of market or selling at bottom of market after sharp falls. Try to avoid your decision for 3 days. Let 72 hours to pass and your emotions will calm down and you will be able to rationally.

Adopt process and strategies in Portfolio management: Your investment decisions (whether buying or selling) should not be based on current market events or news. It should be based on long term strategies like asset allocation and rebalancing.  Those who don’t adopt strategies are actually adopting tactical money managers. 

Is this Rational? : Whenever you find this type of situation where any asset class whether it is equity or real estate is performing on extreme sides (extremely good or extremely bad), before taking any buying or selling decisions just ask yourself “is this rational?” “Whether this continues rise in equity is rational?” Means is it supported by rise in profitability or when markets falls sharply try to find whether profitability of the companies have fallen that much or not? This is real logical thinking process and will lead you to rational and correct decisions.

How Sunk Cost Fallacy affects your financial Life?

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Recently me & my wife were sitting idle at home so we planned to watch a movie. Bought the tickets online and went to watch the movie. In first 20 minutes we realized that the movie was boring and it was waste of time. I told my wife, let us move out and go for some shopping or anything else. At this point she had two options, option -1 to leave the movie and forget about Rs. 500 and time that we spent in the movie and enjoy something else which can increase our happiness level in remaining time and option-2 to continue watching a boring movie and waste the time. She selected Option-2 and immediately replied me that “we have already paid for tickets and how can we leave it now, we have to watch full movie”. Do you know why she did this? She felt that if we move out at this level we will lose Rs. 500. But actually Rs. 500 was a sunk cost. Whether we watch the movie or not had nothing to do with Rs. 500. But watching movie was going to waste further 2.5 hrs and also reduce our happiness level. Whereas if we move out from that movie and do something else we may do something fruit full in those 2.5 hours which can increase our happiness level. This approach of sticking to our initial decision to recover time and money already spend is called sunk cost fallacy. You are running behind the cost which is already incurred and should not be considered for future decisions. Decision of watching movie was not a rational decision it was not taken considering future cost benefit analysis it was taken to justify money and time already invested in initial decision of watching movie.

A sunk cost is a cost that has already been incurred and thus cannot be recovered now, in an effort to recover it we end up spending more money, time and energy. This behaviors of committing more money, time or effort to our earlier decisions is called sunk cost Fallacy. Sun cost fallacy is not only about money spent, it is also about time and effort spent on something. Let us see few more examples of Sunk cost.

– Sunk Cost Fallacy in Corporate Decisions: Many times I have observed this in corporate world that company was conducting a marketing campaign or a product research and in the mid of that campaign or research they realize that this is not going to yield much benefit to the company but by that time they have invested a lot of time and money on the project. So ideally they should leave investing more time and money on that project but generally they will keep working on that with thought to recover the time and money already invested.                                                                         

– Sunk Cost fallacy in Individual decisions: A study was conducted on few people; they were offered two picnics from two different agencies for two different places. One was costing them Rs. 3000 and another was costing them around Rs.2000. They subscribed both the picnics and paid the subscription money (subscription money was not refundable on cancellation) and then they were informed the dates of the picnics and purposefully dates were kept same. Now they had to select the one and on analysis it appeared that trip costing Rs. 2000 would be a better trip to enjoy. But most of the people selected to go for picnic for which they paid Rs. 3000. This happens because they believe that loss of Rs. 2000 is less than loss of Rs. 3000. Logically their decision should be based on the factor that which picnic will give them more happiness. But here the decision is taken based on loss incurred by not going in the picnic so the picnic which is more costly is preferred even though it will give less happiness.

  • Many times I see in hotels when we order something and after eating it we realize that the quality of food is not good or taste is worst but still we continue eating as we have to pay for that food. This is also clear example of sunk cost fallacy as eating a poor quality food can affect our health or if we don’t like the test then it is reducing our happiness but in order to recover the money that we have paid we eat that food. Is this a rational decision? No not at all. Here I am not saying that we should waste the food, we should order the food very carefully but if after that it is not of good quality or test there is no point in eating it to recover the money we have paid.
  • Last year me and two of my friends had subscribed for a workshop around 6 months in advance. We paid Rs. 5000 for the workshop. By the time that workshop actually came close we realized that due to some legal structural changes topic was not of much use to us. I decided not to go for workshop but both my friends attended the workshop by arguing the subscription was not refundable. They spend around Rs. 4500 more and one working day just to justify or recover Rs. 5000 which they had already paid and were a sunk cost.

– Sunk Cost Fallacy in Equity Investing: Sunk cost fallacy works very strongly in equity investment. When people buy shares of a company and suppose company starts doing bad and share price falls then either investor’s start buying more shares of that company with idea to recover earlier invested money or they don’t invest new funds but also don’t sell existing shares just with a mindset that already they have invested good amount of money and time in this company so will wait for the share price to reach to their purchase price. Here when company is really not doing good then there is no logic to buy more shares or to wait for share price to rise and reach their purchase price because money which is already invested is gone and whatever loss they are incurring now is a sunk cost. Logically if as an investor if you had not invested in this company earlier and you were analyzing it for the first time to invest then will you invest in it? The answer is NO. Then why you want to stick to this company just because of sunk cost fallacy. Ideally, if any other company is available with good future prospects then one should sell these share, book loses and move there. But more the share price will fall more the investors will stick to it. Both these decisions are not taken rationally but due to sunk cost fallacy. Also anchoring bias is working together here.

– Sunk Cost Fallacy in Life Insurance Policies: It is very common in India to purchase life insurance policies with investment or tax saving motive. Almost every month 4 to 5 clients come to us with a lot of life insurance policies which don’t suit their life insurance needs and have been sold to them as a investment instrument and when we analyse them, return on investment is sometimes hardly 6 or 6.5% p. a.. We prepare a sheet for every policy where we give calculation that if that policy is surrendered at this stage what will he or she get back and from here if that money along with future premiums is invested in another investment instrument it will give them 11 to 12% p.a. kind of returns and at the end of tenure there are very high chances that he or she will receive double the money that they were to receive from Life insurance policy. But to take this decision one has to book losses from current life insurance policy which most of the people are not able to do. The decision of surrendering existing policy and booking loss is psychologically a very difficult decision because of sunk cost fallacy. Even though most of clients agree with logic to surrender the policy, when it comes to surrender and book losses they cannot move ahead due to sunk cost fallacy.

Why we get stuck with Sunk Costs? & How to free your mind from Sunk Cost Fallacy?

In all above cases you will realize that sunk cost fallacy is most dangerous when we have invested lot of time, money, energy or love in something. This investment becomes a reason to carry on, even if we are dealing with a lost cause. The more we invest, the greater the sunk costs are and the greater the urge to continue becomes.  I found following few reasons for this human behavior.

  • First and most important we feel that whatever time, effort and money were invested till now will be wasted if we change our decision. This is fear of wasting. We don’t learn to accept losses(negative outcomes) of our actions. I always recommend my client to learn this and also teach this to their kids. One cannot go correct always.
  • Sometimes we don’t want to leave our ego of being wrong in our decision so we stick to our old decision. But being rational is about coming out of our emotions while decision making which includes our ego. I have seen many times that clients stick to their investment decisions to boost their ego they are not ready to admit their mistakes.
  • We have not anticipated better outcomes of other opportunities. Like in above case of movie, my wife had not though that we had other better options to spend our time which can give better outcome.
  • Sometimes we are afraid of what others will think if change our decision.

To conclude with, rational decision making requires you to forget about how much time, money and effort you have put on an investment or project and consider only future costs and benefits from the same. So while taking such decisions we should not be anchored to cost, effort or time that we have already put in, we should see whether it is beneficial to continue this or no.

How to avoid Anchoring Bias in Investment Decision?

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In my last article I wrote about what is Anchoring Bias and we also saw few examples of anchoring Bias.  Now this month I would like to throw some light on how it affects our investment decisions and How to get out of Anchoring Bias?

How Anchoring Bias affects our investment decisions?

 Anchoring is basically a state of mind where we give more importance to first piece of information or some numbers or events while making our decisions. Here we get anchored to that information, number or event while taking any decisions. This happens very frequently in Investment decisions. Let me first discuss few real life examples of anchoring bias affecting our investment decisions and then we will see how to take investment decision without Anchoring effect.

  • Anchoring to purchase price of loss making company: Suppose you have bought shares of two companies, company A and company B.See following table and tell me if you are in need of money and you have to sell any one of these two companies, which one you will sell? Company A or B? Most of the investors will sell company A. Do you know the reason why? Because company B is below its purchase price so they are anchored to Rs. 60 the purchase price. Here decision of selling company A is result of company B operating below purchase price and anchoring effect to its purchase price.  Ideally speaking in this case it looks that company A is doing good and is a fundamentally strong company so one should hold it whereas it seems that company B is not a good company and one should sell it and book the loss. This type of cases regularly come to me where investors have bought some shares and they have gone below purchase price but when I tell them to sell it they tell me they will sell it when it reaches to their purchase price. So actually they are anchored to that purchase price which in this example in case of company B is Rs. 60. Here investors need to understand that  the price at which they bought this company is not at all important now , what is important is that fundamentally whether this company will do good in future or not? , is it at fair price currently or not?  But while taking decision of selling company B they are anchored to purchase price.

  • Share Purchase decisions based on higher share prices in Past: Recently I met with an investor who showed me his share portfolio. There were almost 56 company shares in that portfolio and most of them were in loss. When I started discussing about the reason for buying those company shares individually one by one, most of the times his answer was that “this company’s shares were quoting at Rs. 100 per share around a year back and then it has fallen to Rs. 50 so I thought it will come back to Rs. 100 and I will double my money. So I bought it.” So he was anchored to higher price which he saw. The buying decision was the result of anchoring effect to higher price and not the analysis of the company’s fundamental factors.
  • Anchoring to Past Returns experiences: Between 2003 to 2007 there was bull market in equity and sensex went up from 3000 to 21000 and if you look in to data of good equity mutual funds they were giving returns in the range of 25% to 30% p.a. after that markets collapsed in 2008 and started improving in 2009 and by 2012 investors were again getting around 15% p.a.. Returns of 15% p.a. are also good returns for an equity investment. But those investors who invested between 2003 to 2007 and earned high returns felt that these returns are very low and kept changing their funds and financial advisor believing that they are not doing good job and actually earned less returns due to changing funds and advisors. This happens because while analysing performance of their funds they were anchored to their higher returns experience and so believed that these funds are giving less returns. Due to anchoring bias they could not analyze the current situation of economy and see that overall returns in equity market have gone down. This resulted in wrong reactions of changing funds and advisors.
  • Anchoring to Events: Many times clients who had invested at the time Harshad Mehta Scam are reluctant in investing their money in equity by saying that I made losses in the times of Harshad Mehta scam- this scam took place in 1992 and that was the time many of the investors first time invested in stock market in India and were left out with huge losses which they could not forget. This is example of people getting anchored to events which occur in their investing life at initial stages. They are anchored to these bad experiences and not able to leave them behind and take their investment decisions by doing analysis of current economic fundamental in neutral and rational manner.
  • Anchoring to lower Indices Number: My father many times tells me that in my times Sensex was around 2000 and today it is 28000 so it is very costly. I try to explain him many times that over last 20-25 years economy, consumption, turnover and corporate profits have grown sharply and multiplied many times in India and so Sensex reaching 28k is justified but he is not able to digest this logic and make fresh investment in equity shares because he is anchored to 2000 level of Sensex. This is a very common argument that I receive from many senior clients.
  • Subscribing IPO based on belief that they are cheap: Most of equity market investors believe that IPOs (initial purchase offers of shares) are offered at cheap prices and will give more return. Here people get anchored to some of the past IPOs history where those companies turned to be very successful and investors multiplied their money very fast. But as a matter of fact IPOs are generally offered at significant premium and most of the IPOs don’t yield good returns. So due to anchoring to few past successful IPos  and mindset that IPos are cheaper investors buy IPO.
  • Anchoring to lower purchase price mindset of NFO : When it comes to mutual funds, many investors have tendency to purchase new funds which are launched at Rs. 10 because they believe that this is starting price so they feel it is relatively cheaper and will not fall below this price. So here they are anchored to lower price of the new fund and decision of investing in that fund was a result of that anchoring effect to lower price and not analysis of the characteristics of the fund. But actually when a new fund with Nav of Rs. 10 or an old fund with higher NAV invests in stock market they get shares at same price. Ideally old funds are better as they have more experience and have seen different market cycles.

How to get out of the anchoring affect?

If you will see in all above cases, decisions taken by investors are not based on fair and logical analysis but these decisions are result of anchoring to some numbers, past events or past experiences. While taking any decisions we should be rational and think on the reasoning of those decisions in a logical way and should not get anchored to some number, event or experience. As far as possible our decision should be based on predefined logical process, like in above case of buying shares, decision of buying shares should be based on process driven fundamental analysis of companies business and not based on their historical prices. So to conclude with be careful while taking decisions and try to be more logical and analytical.

How Anchoring Bias affects your Financial Decisions?

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Anchoring Bias in Decision Making:

In my last article we saw that while taking our financial decisions mostly we react emotionally. We also discussed left brain: right brain theory as well as System 1 and system 2 theory given by Danial Kahneman. In this article I want to discuss Anchoring Bias which affects our decision making. Let us discuss Anchoring Bias in detail.

What is Anchoring Bias?

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. During decision making, anchoring occurs when individuals get anchored to initial piece of information or some number to make subsequent judgments. For example, if you want to take a cable connection at your house and have asked my opinion about ABC cable company and I gave you a bad review about that company and told you that there are lots of complaints against this company and you can check online. Now what will you search on Google, “complaints about ABC Cable company” so here you are anchored to first piece of information. Ideally you should search for “ABC cable company reviews”. There is common tendency in humans that they give more importance to first piece of information while making decisions.

Anchoring bias works more while we have to decide number. In 1974  Kahneman and Tversky two  psychologist conducted a study where a wheel containing the numbers 1 to 100 was there and participants in the study had to spin the wheel and see what number comes on the wheel. Once they spun the wheel and got one number they were asked that whether the percentage of U.N. membership accounted for by African countries was higher or lower than the number on the wheel. Afterwards, the participants were asked to give an estimate. Tversky and Kahneman found that the anchoring value of the number on the wheel had a pronounced effect on the answers given by individuals. When the wheel landed on 10, the average estimate given by the subjects was 25%. When the wheel landed on 60, the average estimate was 45%. The random number had an “anchoring” effect, pulling individual participants estimates closer to the number they were shown even though the number had zero correlation to the question.

One more aspect of anchoring is individuals try to find some anchor while giving answer of a question. For example, if I ask you in which year Gandhiji was born? Now observe how you think and answer my question. Immediately you go back to 1947 and then think that at that time Gandhiji looked around 65 to 70 years old and will answer somewhere near 1880 or 1885. So while thinking this you took 1947 as an anchor and then tried to find answer by deducting Gandhiji’s approximate age. So this is also anchoring effect.

Suppose you are in a market for shopping and you come across a jacket shown in picture which has a price tag of Rs. 1000. Now you like this jacket and want to purchase it so what price will you quote to negotiate? And if the same jacket had a price tag of Rs.1000 after deleting tag of Rs.1500 stating discount Rs. 500 as shown in second image what price will you quote now? In first case when price tag was directly Rs. 1000 most of us will negotiate and quote below Rs. 1000 as per our understanding of fair value but in second case most of us would not negotiate at all thinking that the jacket price is already Rs. 1500 and has offered a discount of Rs. 500 so this is the bottom price. Here in first case Rs. 1000 tag was there so that number became an anchor and in second case first number that was given was Rs. 1500 so that became anchor and we were ready to pay more easily even though in both cases jacket was same and it had not changed value offered in the form of jacket. Isn’t this very common in India? This is a very commonly used pricing policy.

One more example of this is property dealings. If you are negotiating for property with someone and when either buyer or seller speaks some figure then that figure becomes an anchor and negotiations happen around it. For example, if you are selling a house and discussing price with a prospective buyer and you have decided in your mind that you will not sell this house below Rs. 55 Lakhs. If while negotiating price you first put the figure of Rs. 55 Lakhs, then discussion will happen around it and the buyer will put some figure less than 55 Lakhs and matter will generally settle somewhere close to 50 to 55 lakhs. But if you first put figure of Rs. 60 Lakhs then discussion will happen around Rs. 60 lakhs and there are high chances that you will get around 55 lakhs. So in first case when you put 55 lakhs directly the anchor is 55 Lakhs but in second case when you put 60 lakhs you put a higher anchor. Let us take this example further suppose you are a buyer and someone puts a figure of 60 lakhs then both the parties will anchor to that figure but if you want to get out of that anchoring effect then immediately make a big loud dramatic voice and show him like you are shocked with that higher figure, this will help to erase the effect of that number and you will be able to move discussion to another number easily. Another way is to ask many small questions around that number, asking the other party to justify that number. Both these approaches will help you to erase anchoring effect of that first spoken number.

Now as this topic is very long we will continue in next month article with How anchoring affects our financial decisions? and How to get out of it while making financial decisions?