Cognitively Yours 1.2

 

Raja R, Author

"Hardwired to short term and impatience for instant gratification lead to sub-optimal returns and may result in one falling short of one’s  long term goal"

In the last blogs, we had seen how we find things through mental short cuts-by trial and error leads people to develop rules of thumb and this results in errors. The mental short cuts are like back of envelope calculations and one has to the understand the limitations of these short cuts. We had seen our fear of regret leads to sub-optimal investment decisions. Regret bias also leads to procrastination and comfort in status quo.

In this blog, we will discuss that which is closely related to what we discussed in the earlier blog. Impatience or present bias leads to sub-optimal financial decisions. We as investors choose immediate gratification instead of taking advantage of larger longer-term pay offs. The measure of impatience is a strong predictor of retirement savings and retirement of health. With the gradual phasing out of defined benefit plans of pension, there is an urgent need to ensure that investors have a longer term investment horizon.

Richard Thaler did a study of behavior of MBA students of managing the endowment portfolio of a small college and investing it in a simulated financial market. The market consists of two mutual funds A and B and you must allocate amongst them. Before the game begins, however, you have to choose how often you would like to receive the feedback and have the chance to change your allocation every month, every year or every five years. Give us information and let us use that information, as often as possible. Thaler’s group tested whether this intuitive answer is right but by randomly assigning them to receive feedback at varied intervals.

At the end of 25 years of simulation, subjects who only got performance information once every five years earned more than twice as much as those who got monthly feedback How could having sixty times as many pieces of information and opportunities to adjust their portfolios have caused the monthly feedback investors to do worse than five year ones?. The answer lies partly in the nature of the two funds the investors had to choose from. The first fund is a fund investing in bonds and low average rate of return but was fairly safe. The second is a stock fund. It had a much higher rate of return but also a much higher variance, so that it lost money in about 40 percent of the months. In the long run, the best returns resulted from investing all of the money in the stock fund, since the higher return made up for the losses. Over a one or five year period, the occasional monthly losses in the stock fund were cancelled out by gains, so the stock fund rarely had a losing year and never had a losing five year stretch.

In the monthly condition, when subjects saw losses in the stock fund, they tended to shift their money to the safer bond fund, thereby hurting their long term performance.  At the end of the experiment, the subjects in the five year condition had 66 per cent of their money in the stock fund, compared with only 40 percent for the subjects in the monthly condition. Subjects who got monthly feedback got a lot of information but it was short term information that was not representative of the true, long term pattern of performance for the two funds. The short term information created an illusion of knowledge- knowledge that the stock fund was too risky. More information may lead to less understanding. People who got the most feedback about the short  term risks were least likely to acquire the knowledge of the long term returns.

Hardwired to short term and impatience for instant gratification lead to sub-optimal returns and may result in one falling short of one’s  long term goal.