Reining in bias enhances returns on investments

Reining in bias enhances returns on investments
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Highlights

We discussed about the importance of goal setting at this space, the critical part of the financial planning.

We discussed about the importance of goal setting at this space, the critical part of the financial planning. While planning, one has to take account of various biases, the very qualities that define us.

Don't consider bias as something crude or unintelligent; some of these are highly cognitive and thus hamper our thoughts to act in a certain way that could impact our investment decisions.

Biases are behavioural and make us to accept certain assumptions as true and hence suffer losses due to the choices we commit.

A recent study published in The Wall Street Journal informs about the understanding or lack of it on the impact of compounding in investing and the bias that is carried by many investors.

"Research shows that this bias matters; Households with a stronger bias tend to save less and borrow more.

They have portfolios that include more short-term assets and an overall lower net worth."

The results of a study conducted by the University of California reveal some shocking aspects of investors.

When asked about "How much money would someone have after investing $400 monthly for 40 years while receiving a 10 per cent average annual return?", the average response was $211,200.

The correct answer is $25,94,211. The actual is about 12 times the average response.

Einstein famously said about compounding as the eighth wonder of the world. How does a single cell become a person? The first cell splits to become two and the two become four and so on.

After just 47 doublings, you have ten thousand trillion (10,000,000,000,000,000) cells in your body and are ready to spring forth as a human being. That's compounding at work.

The beauty of compounding is simple; re-invest the return or interest continuously. But, it's easier said than done as this requires a high degree of consistency in our behaviour.

Particularly when investing in equities, evidence shows that long term investing invariably creates greater wealth for individuals.

Equally difficult is to rein-in the urge to act when the markets turn volatile, not just during falls but also in a bull phase also it's important to stick to the goal.

Of course, like all good things don't last, not all compounding is good. For instance, a chain reaction in a nuclear fission reaction starts with just one neutron.

In a chain reaction, the neutrons released in fission produces an additional fission in at least one further nucleus. This nucleus in turn produces neutrons, and the process repeats.

If each neutron releases two more neutrons, then the number of fissions double each generation.

If this is controlled, we could generate electricity equal to 200Mev (Million Electron Volts) from each fission and if left uncontrolled, it's total destruction and annihilation of the surroundings; a nuclear bomb.

So, people should also be aware of how a high interest rate debt could turn devastating. It's equivalent to the nuclear bomb in their finances. The reverse compounding is a wealth destroyer for investors.

The WSJ states further that, "Because people with bias don't understand how interest accumulates, they are more likely to take on expensive loans. The interest quickly adds up.

On a $5,000 credit-card balance, for instance, a customer paying three per cent monthly minimum will spend $5,188 on interest alone. It will also take that customer more than 17 years to pay off the debt."

Daniel Crosby says it best -- "Wealth compounds, wisdom compounds, bias compounds." As we grow our tendencies or biases become stronger if remain unchecked for.

So, it's important to identify our inherent biases and act against them to enjoy a fruitful investing.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at [email protected])

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