Hoarders vs Investors

How hoarders can make a transition to investors

Enough has been written about investors' obsession with gold and real estate. Hard facts about long-term returns have been published, showing that these assets may not be a good long-term choice. However, investors view such research with skepticism. They continue to prefer physical assets to financial ones, and hold an abnormal amount as cash. Are we mere hoarders of wealth? What does it take to become investors?

First, we are guided by the nominal value of assets. What matters is the real value, after adjusting for inflation, but that is not very intuitive for most investors to perceive. When we are told no one loses money in real estate, we believe it because we have only heard of rising prices. That fact is that with a positive rate of inflation, assets prices move up over time. This is true not just for gold and property, but also for rice, dal, petrol etc. A nominal increase in price does not mean that an asset has become more valuable. As hoarders, we are happy with nominal value; as investors, we will ask about the real value, after inflation.

Second, we like assets even if they do not work for us. Assets are acquired for their ability to earn a return. This should come in the form of a regular  income, such as dividend, interest, rent, or by way of appreciation in value, which we can actually realize when needed. Assets create a sense of security and represent accumulated wealth. They are, therefore, social symbols, which tell the rest of the world that our incomes are far higher, and that we own assets acquired only by the wealthy. Ostentatious display of jewellery and lavishly decorated homes are all social symbols of wealth. When we want to belong to this class, we accumulate assets without caring for the income or the intent to realize gains. We are also reluctant hoarders, unwilling to sell these assets and strip down our social status. As rightly put by ace investor Warren Buffet - "If you buy things you don't need you'll soon sell things you need". As investors, we want the assets to work hard for us and earn returns.

Third, we obsess about the protection of invested capital. The notion is that an asset should have undiminished value dominates our choice. A physical asset, which can be seen and felt, is the obvious choice for the hoarder. Since inflation increases its price, there is a false sense of security about increasing value. The long-term return from assets that do not work cannot be different from the rate of inflation. We see the steadily rising price as hoarders, and expect this from all assets. As investors we know that what goes up will certainly come down and vice-verse. As hoarders, we fail to see the economics of asset prices.

Fourth, we do not understand the dynamics of markets. We prefer an oversimplified version of the way prices should behave since we seek a linear growth in the assets we hold. Assets prices are not influenced only by demand and supply and could also be distorted structurally. The real estate and gold markets in India are dominated by holders of black money. The unaccounted for cash invested in these assets is generated and stored outside the banking system, and is not sensitive to the changes in borrowing costs that the RBI tries to manage. Large-scale tax evasion, ill-gotten bribes and payoffs, and unaccounted for incomes hidden from the taxman feed these assets purchases.

It is a combination of these factors that turns several investors into happy hoarders. When the government says it wants to do something about this preference, it needs to work towards ensuring that the large hoarders and evaders stop distorting these markets. Before blaming the small hoarder, who is unable to make the transition to an investor, we need actual asset builders who will guide. That is the missing link

Loss Aversion

Why you pick loss over gain

It was mid-2007 and mutual fund investments were giving fabulous returns. Enamored by a particular fund, an acquaintance invested nearly 50% of his SIP money in it. It seemed like a good decision as the fund gave returns as high as 150%. Like many others, he didn't think anything would go wrong. But then on 15-Sept,2008 the Lehman Brothers filed for bankruptcy, and stock markets across the world started to fall. When the NAVs of his star fund went into a free fall, performing worse than the others, the acquaintance conducted a desperate check on the various schemes he had invested in. He found the funds full of speculative stocks.

Despite this, he could not get himself to redeem the accumulated fund units and limit his losses. So the losses continued to pile and he continued to hope that he would recover these. He justified these as being paper losses, convincing himself that til he redeemed the units, the paper losses would bot become 'real' losses. In fact, he started buying more units to average down the cost of buying a single unit. A few months later, the fund manager quit the mutual fund and the value of his investment fell abysmally low. It was then he decided to get out of the fund. Why did he wait till the last minute to rid himself of the pilling losses? He has been a victim of 'loss aversion'.

What is loss aversion?

Loss aversion is the tendency to avoid a loss rather than make a gain. This concept is rooted in the Prospect theory, according to which people tend to base their decisions on perceived gains rather than perceived losses because the emotional impact of losses is far greater than that of gains. Extensive research in behavioural economics shows that people experience twice as much pain when they face a loss in comparison to the pleasure they feel with a gain. So the pleasure derived from a rising Sensex is not as deep as the pain one suffers when it drops sharply.

Another reason  people stick with losing propositions is that they find it difficult to admit they took a wrong decision. They keep hoping that they will recoup the losses, and in the process, they end up deepening these. "When you sell a loser, you don't just make a financial loss; you take a psychological loss from admitting you made a mistake. You are punishing yourself when you sell.", says Jason Zweig, a personal finance columnist at

Wall Street Journal, in his book, Your Money and Your Brain. "Once you make an investment, you can't help regarding it as yours. When you buy a stock...it becomes a part of you. From that moment forward, the prospect of having to get rid of it becomes a wrenching thought," he adds.

In fact, people don't stop at holding on to a losing investment. They make things worse by investing more in it a bid to average out the cost. In technical terms, this is referred to as the 'sunk cost fallacy' or trying to recover a bad investment by throwing in more money.

Application in financial life

This theory is amply reflected in our day-to-day financial behaviour. People tend to keep their money in safe debt instruments rather than in equity, despite the promise of higher gains in the latter, because the risk, and the implied loss, in equities is enough to keep them away from the high returns. What they don't realise is that the low returns in safe options will not be able to keep pace with inflation, reducing the purchasing power of their funds several down the line.
Loss aversion also makes people remain stuck to stagnant careers instead of spending money on upgrading their skills and looking for a better job. The lure of an improved and a more lucrative career is not enough to make them part with the money for a degree or a part-time course.

How to escape the loss aversion bias

One way of not falling into the loss aversion trap is to keep the big picture in mind or have a long-term view of your investments. So, sit and actually calculate how much the loss in one fund or stock will impact your entire portfolio before you decide to stick with it. If you are dealing in stocks and don't trust your ability to get out of a losing script, resort to stop-loss order. It will force you into a decision and not allow you to become attached to a particular stock.

Another option is to look for ways to turn your losses into gains. Short-term capital losses make on selling shares and equity mutual funds in less than a year's time can be set off against short-term capital gain as well as taxable long-term capital gain. "The easiest way to do that is to remember that selling investments at a loss creates a tax-deductible event"

Behavioural Accounts

Don't be fooled by the mind

Lets think about these two incidents. You had bought an advance ticket worth Rs 500 to watch a movie. On reaching the multiplex, you realized that the ticket had been lost. Weekend shows are typically expensive and since you didn't want to spend the same amount again, so you gave up the idea of watching the movie and came back home.

In a separate incident, when a friend of your planned to watch a film, he realized he had lost the note he had kept aside to buy the ticket Not agonizing too much over the loss, he took out another Rs 500 note and bought the ticket.

Both the incidents were basically the same. You had lost a Rs 500 ticket and not bought a new one. Your friend had lost Rs 500 and had gone ahead and purchased another ticket. The loss in both the cases was limited to Rs 500. So why did your friend buy another ticket and you didn't ?

This is a situation what economists call "Mental Accounting" or the tendency to categorize different money situations into separate mental accounts.

What are mental accounts ?

The term mental accounting was coined by Richard Thaller, an economist at the University of Chicago. He defines it as "The inclination to categorize and treat money differently, depending on where it comes from, where it is kept and how it is spent."

In the first case, the loss of ticket was attributed to the "ticket loss account", whereas in the latter case, the loss was ascribed to the "money loss account". The human mind tends to add the loss on the "ticket loss account" to the price of a new ticket, that is, Rs 500, and so people in such situations are not reluctant to buy a new ticket. For you, the movie was worth Rs 500, but not worth Rs 1000.

In your friend's case, the mind values the price of a new ticket only at Rs 500, whereas the Rs 500 lost is attributed to the "money lost account". This explains the different reactions to what is essentially the same situation.

Application in daily life

Mental accounting comes into play in various situations in everyday existence, resulting in a monetary loss or an undesired spend. The victim often fails to realize how the mind has tricked him into bearing the loss, content in the belief that he has cut a good deal.

Suppose you plan to buy a costly mobile phone and find one tagged at Rs 15,500 in a retail chain. Just you are ready to flash the credit card and pay for it, a friend calls. He tells you he has bought a similar model for Rs 15,300 from a shop just 3 km away. Will you drive the distance and save Rs 200? Chances are you won't.

Consider another situation. You want to buy a toaster and come across one selling for Rs 1,200. Just as before, you find another gadget selling for Rs 1,000 just 3 km away. Will you rush to save Rs 200 ? Chances are you will. Why does this happen ?  On a fundamental level, we are thinking in percentages. If Rs 200 is expressed as a percentage of Rs 15,500, it seems very low in comparison to Rs 200 expressed as a percentage of Rs 1,200. At the end of the day, the saving is all about Rs 200.

Another area where mental accounting foxes us is when we come across a windfall, say a tax refund or bonus. More often than not, the tendency is to spend the money as soon as possible. People consider it 'found' money without realizing that it's their money coming back to them in case of tax refund or deferred salary in case of bonus. A small amount of money that comes to us unexpectedly gets treated lightly and we're more likely to spend it on frivolous things we don't need. Bigger sums that come to us, say, from an inheritance, tend to get treated more seriously and are more likely to be saved.

This is the reason people continue to earn low interest rates on fixed deposits in the bank, while paying a high rate of interest on their credit card debt or a personal loan, instead of breaking the fixed deposit and repaying the debt. Remember that the interest you earn on your fixed deposit will always be lower than the interest you pay on your credit card debt.

The bottom line

We need to realize that the money we earn for various sources is basically the same and we should be careful not to divide it into mental accounts while spending it. So, if you get a good bonus or tax refund, don't spend it by categorizing it as 'found' money.

Also remember that money is fungible. This is the reason you should not let money lie in a fixed deposit while you are paying your credit card balance. It makes more sense to first pay your debt instead of saving money before falling into the trap of  'mental account' foolishness.