Behavioral Aspects of Investing

Going by Maslow’s Theory of Hierarchy of Needs, every human being starts with attempts to fulfill his or her biological and security needs, before embarking on attempts to satisfy other higher-level needs related to socialization, recognition and self-actualization. Investing one’s earnings, is, in a way related to the basic security need. Research has indicated that human psychology plays a predominant role in how an individual decides on where to invest.

Investment can be defined as “the act of committing money or capital to an endeavour with the expectation of obtaining an additional income or profit”. In the context of Personal Finance, where we are talking about how an individual invests, the avenues for investment include, but are not limited to, Savings Bank deposits, Fixed Deposits with Banks and other Companies, Govt Bonds, Public Provident Funds, Pension Funds, Stocks (or Equity shares) of listed companies, Mutual Funds, Insurance, Gold, Real Estate and other instruments. If we look as the Returns, in general, Savings Bank Deposits yield the lowest returns, followed by Fixed Deposits, and instruments like Equity, Mutual Funds, and Real Estate could result in higher returns in the longer term. Now, how does an individual decide on how much to invest in Bank deposits, how much in Mutual Funds, and how much in Equities directly etc..?

While the answer to the above question will be determined by several factors such as the person’s age, the immediate, medium-term and long-term funding needs for day-to-day expenses, as well as planned events and unexpected emergencies, the behavioral factor, relating to the ‘risk-adverseness of the individual plays a critical role in deciding on the portfolio of investments.

A lot would depend upon how the individual would react to short-term dip in the value of his/her investment. Essentially, what this boils down to is the ‘perception of loss’ as seen by the individual concerned. While some can digest short to medium-term losses, some can never accept erosion of capital. And, again, even this tendency varies depending on the situation, and the immediate past anecdotes in the individual’s life.

Thus, while there are no such things like one-plan-fits-all in the realm of investing, the tricky thing is that even in the way the portfolio for an individual is structured based on his/her profile, the element of changes in behavioral responses needs to be assigned a high priority when designing the plan. While professionals can suggest a ‘good’ portfolio for an individual based on all the parameters discussed above, the individual needs to be educated and empowered to take the right decision depending on the swings in behavioral patterns at any given point in time.