Investment Decision Making in Systematic Investment Plans

Sum evaluated how heuristics affect investment decision making in Systematic Investment Plans. 

Investors face two challenges: making good decisions and sticking to them. Most individuals do not make decisions in the rational, well informed and unbiased manner assumed by standard economic theory. There 

are bounds to human rationality, self control and self interest which can be explained as under:

Bounded rationality (Human problem solving abilities) Limits on time and intelligence means individuals cannot be expected to solve problems optimally. Experimental evidence suggests most people use rule of thumb (or heuristics) to cope with the limits of their abilities and these heuristics can in certain contexts lead to systematic errors in decision making.

Bounded Self Control: When the right thing to do is apparent, people may fail to do it for reasons of self control (most of us have eaten, drank or spent too much)

Bounded Selfish: Failure to pursue own self interest to the extent normally assumed of homo economics

Status Quo Bias in Decision Making: The option to do nothing or endorse a previous choice

Portfolio Diversification and Investor Perceptions of Risk

There is evidence that investors in SIPs often display attitudes to risk and portfolio construction that are at odds with accepted investment principles. I try and explain some of them as follows:

Myopic Loss Aversion: Seeking to avoid short term losses despite the long term horizon usually in planning for retirement. There is also evidence that the balance of funds on offer unduly influences individual’s choice of asset allocation in SIPs

1/n heuristic: Investors take the range of offer as implicit guidance from the investment vehicles as to the appropriate asset allocation strategy – a so called endorsement effect

Company stock ownership/ Investing in industry in which the investor in employed: One of the most worrying aspects is the high level of investment in own company stock / same industry amongst employees in SIPs. The strategy is dubious as the stock is correlated with the employee’s labor income and future employment prospects. It appears employees do not view their employers’ stock or the industry in which they are employed as risky. The example of Enron highlights this heuristic in investing. Majority of Enron employees invested their pension plans in Enron own stock. Thus when the company went bust, employees lost their jobs and their savings at the same time. Another theory that supports the above belief is that investors like to invest in familiar industries/ companies. There is also a home country bias linked to this theory.

The obvious solution to dealing with significant behavioral barriers to the effective use of SIP for retirement provision is to offer some form of education to participant; which brings to light two kings of investors:

Planners: Who take active interest in providing for their own retirement

Avoiders: Who are either intimidated by financial matters or are simply uninterested

Less attention can be given to those planners who will seek information anyways; in order to have impact on avoiders’ information should be straightforward

Stakeholders in the investment industry should encourage investor education not only in later but also in spirit. It is this lack of education which caused investors to build unrealistic expectations from equities while not weighing the inherent risk in them. The result is a flight of capital from equity markets of domestic individual investor. Wounds take long to heal especially those caused by bears and bulls. It’s about time the investment industry presents a similar flight of capital from SIPs caused by losses to investors who have made wrong pickings without adequately considering the risk/ return interplay.