Management of Personal Finances and Investment Decisions

Introduction

Making wise investment decision is never an easy task. An investor’s expectations from the financial market play; the gains he hopes to make, play a very important role in the kind of instruments he or she chooses to invest in. These expectations guide his behavior on the bourses, and eventually even go on to impact the price of the securities, the volume of trading and sundry other financial operations in play at the market.

From centuries, man has been motivated to make more money and explore newer avenues of making financial gains. The establishment of companies and later trading in their perceived market value (shares) and derivatives all testify to this basic aim. Today, with diversification, there is such a huge glut of investment instruments and choice available on where and how to invest their money that investors are literally spoilt for choice.

The choices can range from simple savings accounts to complex stock and bond portfolios. Post-Liberalization, Privatization and Globalization (LPG) in 1991 and with the unleashing of the Indian economy, the Indian investor’s mindset has undergone a sea change. Guided by a primal instinct to make more money, he has gradually begun to move away from fixed return options to more attractive avenues for investment that promise bigger, unprecedented gains from the market.

Along with the variety of options available, an average investor’s knowledge of various products has also grown steadily, leading to the emergence of newer companies and their offloading of innovative financial instruments in the market.

In such a diversified, gradually maturing market, it’s important to understand what ticks an investor’s mind and what factors guide his choice of a particular set of instruments to add to his portfolio.

A consensus has built in recent years, among market watchers that psychology has begun to play a very important role in the selection of particular stocks – the timing of the investment and the final impact of all these factors on the movement of the stock prices and other indices that rule capital markets. We know for sure that what were earlier considered as rational, logical decisions of stock market participants, could also be an outcome of certain irrational trends that must also be subject to scrutiny in order to truly understand and be able to predict stock price fluctuations. Consequently, emotional intelligence has been a new area of study among investors and market watchers.

Decoding the Indian financial system

Savings and Investment both are important to the growth of any robust economy. Further, the growth of an economy also depends on the intrinsic strength of its financial system. Capital is an important factor of production, and once the goods are out in the market, their exchange also happens through the financial markets. The main activity of a financial market is to facilitate the trade of the perceived value of one financial asset for another, either in the form of interest, dividend or capital appreciation. Capital markets are the platform that brings savers and borrowers together. Savers lend money to borrowers in lieu of securities and with these funds borrowers meet the capital requirements of their businesses.

The financial system of a country exists only to channelize savings in the form of money and monetary assets and oversea their investment in profitable business ventures. It exists to satisfy the needs of all stakeholders – savers by giving them the promise of gains from their idle funds; and borrowers, the funds they need to grow their business.

A successful investor must therefore be an astute observer of the market; know which business or market segment is growing and why; predict the risk that he is willing to take in investing in that segment (i.e. understand his own risk appetite); set clear investment objectives for himself; and how long he would like to keep his money locked etc., in order to be able to make wise decisions with his investmentsover a period of time.

Several important changes have swept the Indian financial market since the roll out of the first tranche of reforms in 1991. We have moved away from an agrarian economy to veer towards services and goods manufacturing too. We have slowly been opening our markets to foreign players too, which implies more competition for the domestic players, who need to infuse capital and technology in order to survive in this tough market. All this has called for huge changes in the financial sector, and made it more transparent and dynamic. Some of these macro-economic changes have also resulted in giving Indians a higher standard of living and low inflation rate, but on the flip side, the income disparities between the middle and the lower middle class have expanded and need to be bridged, with more structural reforms and the spread of financial literacy.

Financial Literacy

This is the crying need of the hour. Financial literacy implies a basic awareness or knowledge of the investment options available to an average India. This awareness is presently very low among Indians, who are unaware of the risk and return features of the financial market and are therefore unable to choose the right instruments for meeting their financial goals. This puts hurdles in the path of the financial planning process and the lofty goal to maximize wealth for all, and reduce the yawning gap between the rich and the poor.

Financial Management

Planning is crucial for the management of personal finances. No individual can meet all his financial goals without some amount of financial planning. The process begins with the drawing up of a monthly budget, keeping tabs on the daily outflows; regulating your expenses; reconciling the inflows with the outflows and checking and re-checking your personal balance sheet to be able to live within your financial means and not be drawn into debt. The idea is to, over time, build your assets through regular savings and now have a mountain load of loans and unpaid liabilities.

Financial planning also involves keeping your financial goals in sight – the education of a child, buying a house, meeting an unforeseen medical expenditure etc., - so one is always able to manage one’s expenses.

Last but not the least, financial planning also calls for wise investments in a carefully picked portfolio of various financial products based on parameters like you age, risk appetite, income, and the period for which you want to remain invested in a particular instrument to meet a certain financial need – say, a daughter’s marriage. All these are important factors in determining the risk-return factors of the stock market. Financial planning is not possible without financial literacy.

The Psychology of an Investor

Stock trading is very much a mind game. A very astute trader, who has played the market for a long time, can also make mistakes if he is emotionally charged up, and not in the right frame of mind to pick up, stay in the trade, or quit at the most opportune time.

Finding his trading niche is vital for a trader to make consistent profit in the markets. When a trader trades within his niche, he will look for various ways and means of improving his trading. As a natural corollary, he will develop his trading skills, and profits will increase.

It is hard to sustain success and profits over a long period of time on the bourses, if a trader does not have the mindset for it, is unprepared, ill-informed and non-confident.

The question that begs to be asked is - how does a trader find his niche?

The reason why many traders don’t experience initial success is they have been using a trading style that does not go well with their personality. This is where psychology or an understanding of their risk profile comes into play. A trader interested in understanding the trading style that matches his personality, would do well by asking yourself:

• Am I prudent and patient, i.e., do I do carefully work towards a goal? Do I enjoy the process of trading?
• Am I extrovert and impulsive, crave instant gratification and prefer to obtain quick results?

A person who craves quick results and is easily bored may gravitate towards intraday trading, where he/she is guaranteed a fast outcome to his/her trade, while a person who prefers security and is sang-froid may be drawn towards position trading, where he/she will not be exposed to large equity swings and can work steadily towards his/her outcome.

Traders make investment decisions based on their personality type, so if you are intraday trading and not experiencing the success you hoped for and deserve, the questions above will help you understand if this style is right for you.

Finally, investment decisions are not just made on the basis of a trader’s personality style, which is an internal factor, but is also guided by several external inputs, such as the information he receives from his peers and the media. Friends, family, colleagues and various media channels also affect investment decisions. That is why followers of behavioral finance do not believe that decision-making, related to investments is an entirely rational process. Of course, all sorts of personal prejudices, biases, opinions, goals and emotions, news events come into play, which eventually move markets. Indeed, demographic and socio-economic factors such as gender, age, education, income and marital status can also impact a trader’s risk tolerance, investment behavior and financial decision-making process.