Rational Investors, Irrational Actions

The normal expectation is that investors make investment with their best interests in mind and that they would do any action necessary to hold that aspect as long as they are staying invested.

However we have found various emotional and behavior barriers that come in the way of making sound investment decisions. One such decision was witnessed earlier this week while we were chatting with the client.

Aswath (name changed) who is mid fifties client works in the IT sector in Chennai. He has his office on OMR and since he frequented the stretch for the past 15 years, he was confident that the area would boom and invested in an apartment on the same stretch some years ago (his second apartment for investment purposes). Due to a saturation of properties in OMR area or any other reason, he has not been enjoying a great rental yield on his properties and for the last year the property has been kept locked without a tenant, he has been paying an EMI of about Rs 45,000 on a loan of about 60 Lakhs he has taken originally on that property. Overall in the past 5 to 6 years, if you consider the EMI interest as also the opportunity cost of funds, he is at a big loss. Due to the current pandemic the situation has worsened and he is not even getting the price he paid for the apartment six year ago.

Yet he remains steadfast that he will wait for the price to reach the same price he paid for before he sells.

All of us have at some point in time have faced this dilemma, that the investment we have made is really down and in the near future does not have prospects for revival. While there is an option to liquidate it and move it to a more productive asset, we continue to stay invested.

The is due to a behaviour trait that is called Loss Aversion. Loss Aversion is a behaviour by which we are aware of the loss, but we are unwilling to accept it. So we will live with an unwise investment decision rather than make the change to a positive decision because the acceptance of a loss is painful and we would like to avoid that pain.

While recognizing the loss, the investor needs to answer the following questions,

  1. Is the situation temporary or permanent ? If the situation is temporary then the recovery may happen automatically and hence staying invested would make sense.

  2. If the situation temporary, what it the timeline for recovery and also analysis of alternative investments and their return timeline. This would give the investor an opportunity to judge if staying with the investment is profitable or booking loss and moving to another investment is better.

  3. If the situation is permanent, then the quicker you get out the better..

So the next time a stock that you bought for Rs 100 goes to Rs 40 , due to fall, examine the reason, if the fall is purely due to temporary market actions, stay invested. On the contrary if it pertains to something about the governance issues or anything fundamental about that stock, get rid of it and move to a better investment, it may never return to its investment value.

While the loss can be painful, not recognizing the loss and staying with a loss will prevent you from enjoying future profits and thereby be a barrier to your wealth creation.

Do read and share your thoughts at info@finsherpa.com


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