If you don’t have time to read through the whole article, you can check out our short version below.
- “Loss aversion” is normal but can cost you dearly. The loss of spending power through inflation may happen if you hold too much cash over the long term.
- Rein in your fear of investing—understand that time is your friend. Studies have found that the longer your holding period for stocks, the lower your probability of incurring a loss.
- Get to know yourself, understand the investments you want to make, and be comfortable that you can stomach whatever risks you are taking on.
If you are afraid of investing, take heart that this is quite normal behaviour.
It may not be helpful behaviour if you want to build a larger retirement nest egg. But this phenomenon called “loss aversion” is very well established as “normal” in humans. We generally fear losing money.
A study by American economist and professor, Richard Thaler, and others from American universities said “empirical estimates find that losses are weighted about twice as strongly as gains”. The “disutility” (or loss of satisfaction) of losing Rs.100 is “roughly twice” the “utility” (satisfaction) of gaining Rs.100. In simpler terms: You feel happy to receive a Rs. 100 voucher , but would be twice as sad if you forgot to take your withdrawn Rs.100 from the ATM.
The problem: Loss aversion can cost you over the long-term
The investment choice over many decades has been between
- the possibility of a near-term loss through investment
- the certain loss of spending power through inflation, by holding cash over the long-term.
US$1 million from 1926, held literally in cash—the metaphorical “money under the mattress”—will today have lost around 93% of its spending power. Put simply, the US$1 million will be able to buy only around 7% of what it would have been able to buy 93 years ago. Similarly, the savings you have now will most likely be worth a lot less in real spending power in 20 years.
Investment marathon: Stocks perform best over the long run, while cash performs poorest
The long-term history of US stocks, bonds, and cash tells us that stocks perform best, bonds next, and cash in a bank account barely keeps up with inflation.
Tip 1: Time is your friend
How do you manage your fear of investing? Start by understanding that time is your friend in investments.
Studies have found that the longer your holding period for stocks, the lower your probability of incurring a loss. For example, Morningstar’s study of US stocks from 1926 to 2017 found that 26% of the stocks recorded negative one-year returns. But when the holding period was lengthened, all 15-year period annualised returns were positive.
In addition, if you have never invested or are relatively new to investing, consider starting small and building your investments over time. This will also help you build investing discipline by setting aside money regularly for investments.
Regular savings plans are useful in this regard. DBS’ for example, lets you start Mutual Fund SIPs from as little as Rs. 500 a month.
Tip 2: Know yourself, and understand your investments
Notwithstanding the evidence supporting the case for long-term investment, your personality and personal circumstances may not lend themselves to taking on too much risk. Hence, you have to know yourself, understand the investments you want to make, and be comfortable that you can stomach whatever risks you are taking on.
Tip 3: Match your investments with your risk appetite
All banks and other financial institutions will assess your risk profile before recommending or selling you an investment product. The questionnaires vary, but the key elements tend to be your investment time frame, experience, personal financial circumstances, and ability to accept losses.
They will rate you on a number of risk categories, all of which then determine the type of investments they will offer you. These are questions you should think through and answer carefully because a mismatch between your risk appetite and your investments may cause you emotional or financial discomfort. And that, in turn, may result in you selling a loss-making investment that may in time turn profitable if you had held on for longer.
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This article is for information purposes only. We recommend you get in touch with your investment advisor for any financial advise.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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