Investment Risks And Human Nature

It is one thing to believe that you can behave wisely, and totally another thing to actually behave rationally when disaster strikes or greed seduces. This alarming state of affairs is very much apparent in how many of us handle our financial investments. Despite the seemingly obvious mistake, it is common to see gross financial blunders like getting into scams and buying high and selling low.

Being human, the psychological factors that relate to investing are every bit as important as the traditional tools of finance. In fact, for the average person, control of the emotions is a more problematic factor than lack of knowledge in finance. This is why everything becomes so clear in hindsight when you’ve had enough time to soberly analyze the situation. For things to work out in the best manner, you need to both understand investment risks and human nature.

While the problem of correct investing has always been with us, recent developments have made it more significant. For the first time in many years, a large number of Filipinos are now pulling out their savings from the safety of their time deposits to look for better yielding investments. Many of them are retirees who had hoped to get most of their monthly expenses from the interest of their money. However, the prevailing low interest rates now have made that impossible.

No Free Lunch

Aware that many bank customers are not savvy investors, the BSP has mandated that there should be a client suitability test if they will be going into certain types of investment. Despite all the written assessment of the customer and the description of the nature and mechanics of the investment, a large number of bank clients still do not comprehend what they are getting themselves into.

First of all, a person must understand that there is no such thing as a free lunch when it comes to financial investing—you must give up security in return for higher returns. Note that the higher the interest rate, the riskier is the investment. Those used to trading with physical assets like real estate can frequently have transactions where it is possible to make large profits with no additional risk. This is rarely the situation when it comes to cash.

The nature of monetary investments is radically different from non-financial investments like real estate. This is because the market for cash is much more efficient, as cash is a unique commodity that can instantly flow to where it is most desired or leave when needed. In real estate, for example, it is not too difficult to buy a property at a price significantly below its true value, as property is not easily sold and is not a liquid asset.

Nevertheless, investing in other instruments may be the right decision for you. But in doing so, you must be aware of how they work and if they will be suitable to your situation. To gain sufficient knowledge on this is beyond the scope of this article. But for the complete novice, it may help if I give some light on these types of investments.

Bonds Vs. Stocks

Most investments (other than savings or time deposits) offered in banks fall into either bonds or stocks. Bonds are certificates of indebtedness of companies or the government. Stocks are ownership shares in companies. Generally, bonds are thought to be safer since you are more likely to be paid. Stocks, on the other hand, can have a higher return but entail more risks since company profits are more unpredictable.

However, banks rarely offer bonds or stocks directly unlike stock brokers. Banks usually offer mutual funds or UITFs (unit investment trust fund) that are generally composed of either bonds or stocks, or a combination of both. Mutual funds and UITFs enable the small investor to get the benefits of diversification and professional fund management as both of them pool funds from many investors. Another hybrid investment sold by banks is one with life insurance added into the mix.

Some experts recommend directly investing in the stocks if you have sufficient cash to diversify your selection. The advantage of this is that you will be saving on the cost of the fund management fee. To do this, you need the services of a reputable stock broker. This path is not for everyone as you need to learn a lot about stock investing and also be in control of your emotions as you will be the one managing your portfolio.

It is in stocks where courage is needed. Baron Rothschild, an 18th century member of the famous banking family, once said that “The time to buy is when there’s blood in the streets.” This is because people tend to overestimate the impact of disastrous news, and stocks tend to become undervalued as they are sold in a panic. Despite this fact, few people have the emotional fortitude to follow this wise advice. If you intend to follow this contrarian strategy, check first if the panic is indeed justified.

The opposite of selling out of fear is buying or not selling due to greed. This is why there are stock market bubbles. When the stock market is booming or a company is doing great, people think that the blissful situation will go on forever. Stocks prices are bid up to stratospheric heights beyond any reasonable valuation. When the inescapable crash comes, fortunes are lost.

Finally, although most believe bonds are safer than stocks, this is not always true. It is also possible to lose money in bonds. When interest rates goes up, the price of bonds go down. If your investment time frame is very long, like 10 or 20 years, stocks tend to be better than bonds.

When you go beyond the simplicity of a regular time deposit to seek better returns for your cash, there are far more factors to consider. Take the time and effort to understand the risks and rewards of the different investment vehicles and how to select what would be the best fit for your needs. By understanding both your investment risks and human nature, your chances of success in your investing are doubly enhanced.

*Originally published by the Manila Bulletin. D-4, Sunday, June 16, 2013. Written by Ruben Anlacan, Jr. (President, BusinessCoach, Inc.) All rights reserved. May not be reproduced or copied without express written permission of the copyright holders.