Investors err in seeking complex solutions

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Advisers are at pains to convince clients to follow the KISS principle: 'Keep it simple, stupid!'

Investors are prone to making mistakes. Even the best of fund managers make mistakes. But small investors, mainly because of their lack of knowledge and understanding of the investment process, are prone to making mistakes which are even psychological in nature, rather than analytical.
There are mainly three situations when retail investors make mistakes while planning their investments.

First, there are decisions which are based on emotions rather than on logic.

Second, when they act under peer pressure and spend money, forgetting about their ability to meet those expenses.

And then, most investors believe that a simple investment solution cannot be the best solution. They look for complex solutions even if the final result is barely different from the one which one can arrive at with a simplistic approach.

Investors, especially retail investors who barely have any exposure to investment processes, often take investment decisions based on their emotions rather than on sound logic while planning their finances. For example, owning a house is often considered as a symbol of financial success, even though real estate is usually very illiquid and at times, although rarely in India, has depreciated in value.

Another example of emotional decision-making is one's inclination to invest most of his/her money into one asset class rather than going for a proper portfolio allocation. Such decisions are often based on the grounds that the asset class in question had performed well for the past few months or year.

Although pure investment logic says that if an asset class has outperformed other assets classes by a substantial margin, in all probability that asset class would start underperforming very soon. So rather than putting a major chunk of one's money in that asset class, one should allocate a smaller portion there. But being driven by emotions, most investors usually do the opposite.

Peer pressure is another influential factor for investors to forgo logic while investing. Often it happens that a group takes an investment decision and then another person, closely associated with the same group, takes an investment decision influenced by the same group although this particular person's risk profile and needs for investments are markedly different from the other members of the group. Often we see major influences of friends, family members, social groups, etc, in arriving at one's own financial decision-making.

When one is constructing a portfolio, often seasoned investment managers prefer to follow the KISS principle — 'keep it simple, stupid!' However, most investors don't accept that a simple portfolio could be rewarding in the long term. For them, simple is difficult. They often look for a portfolio that would involve complex strategies, forgetting that for them it's much easier to understand and keep track of a portfolio with simple strategies. There are some other common mistakes also that investors commit, financial planners and advisers say. One of them is to not have any timeframe for an investment. Ideally, all investments should be done with a goal and a timeframe in mind.

Over-leveraging is another mistake that's common among investors. This happens because often an investor cannot, or fails to, properly calculate his/her income and expenditure. For example, such an act often leads to a situation where one takes up a monthly outflow, say an EMI, which he/she cannot fulfill in the long run.

Another common mistake among most retail investors is to prefer investments which save taxes for them even if there are investment options that can give them better posttax returns than the tax-saving ones. Investors should always look for investments which give them better post-tax returns. Tax-saving products should be one of the options, but it should never be the first option or the only option.

On this page, the article by Umang Papneja gives some more examples of how investors make mistakes while taking financial decisions.

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