5 lessons to learn from your financial mistakes
By Uma Shashikant
We mostly struggle with regret. In personal finance, we make several decisions about earning, saving and investing. Assuming 30 years of working and 20 years of retired life, we make money decisions for 50 years or more. What is the chance that we get it right always? We are all prone to making mistakes and making them too often for comfort.
We learn from mistakes, or we don’t. We repeat mistakes without knowing why. For example, some of us cannot stop participating in IPOs or betting on penny stocks. Sometimes we make money and brag about it; at other times we lose money and try to forget it. But we cannot hold back when we see another “opportunity.”
Researchers, who have studied the mistakes we make, point out an important distinction. There does not seem to be a problem with the way our brain processes information. Based on experience, we tend to apply similar rules from the past when we make decisions. In fact, we optimise the use of our brain’s energies by automating some of these rule-based tasks, so that we perform them almost instinctively without effort. We apply the brake as the traffic signal turns red, for example, without thinking too much about it.
The problem though seems to be in the noise associated with the information we feed the brain. Or the quantity and quality of information we feed into our thinking process. When we selectively add new variables to the equation, we get it wrong, and make a mistake. If we liked a penny stock because it had a low PE multiple, we pursue that course until we get hit by a stock that turns out to have very poor quality earnings, and therefore a low PE. We turn wary about low PEs, but penny stocks as a category still hold our interest, as we selectively celebrate how some of them became multi-baggers. We then begin to look for something else to identify them.
If personal financial decisions involved choice, and if the choices led to variant results, we would find it difficult to sift good quality information from poor, and end up with a noisy process every time we made a decision. Then our outcomes and experiences would turn out to be different, and we would have no lessons on hand to apply in future. That is why most personal financial advice tends to be rule based even if they are too general to apply uniformly to everyone.
Consider some of the rules commonly advocated in personal finance: Save before you spend; Spend within means and don’t borrow; insure before you invest; invest your savings in a diversified portfolio; invest for the long term; do not draw your investments unless needed; don’t time the markets; allocate assets according to need; set specific goals; save for retirement; and so on.
Each of these rules involves a trade-off and a decision that can result in reward or regret. How much saving is adequate is a question that has not been satisfactorily answered. Many households are unable to decide if they are saving enough or if they are overdoing it and denying themselves the joys of spending Most households borrow to buy a home; many upgrade their cars using loans; credit cards are commonly used and the occasional indulgence that overshoots the ability to pay is dealt with quietly. Loans enable spending tomorrow’s money today and it is tough to say which one might be a mistake: taking a loan, or refusing to take one ever.
As you consider the rules, you will find there is enough information for and against the implementation of each of them. It is common to find such information in conversations with peers and friends, in the press and media and in financial advice available in the market. Personal finance decisions are made with information overload. Therefore, the cycle of making a decision, realising it is a mistake, and then making it again, goes on.
What should you aim for? First, do not make the choice of personal finance inertia. That is the choice where you decide to do nothing, because you worry you will make a mistake. The large savings bank account balances that many carry with quiet guilt is evidence of this unfortunate choice. It is better to make mistakes than do nothing at all.
Second, pause to find the lesson to learn when you make a mistake. Do not deny or blame every person or circumstance, but focus on what you could have done instead and why you did not do it. If you failed to sell off a stock that began to lose money, recognise that limitation and set up a stop loss limit the next time.
Third, recognise the personal limitations you have when you deal with a mistake. You may be unwilling to control your spends; you may be too attached to property to look at anything else; or you may associate day trading with pleasurable gambling to give it up; Every mistake offers an opportunity to recognize what should have been done, and why you did not end up doing it. You may be selective or biased about using information.
Fourth, consider the possibility that corrections can happen any time, when it comes to personal financial habits. Except for a few lucky inheritors, most of us earn, save and spend gradually over a long period of time. It should be possible for us to correct for an illplaced fixed deposit, a wrongly selected IPO, a faulty insurance product, or a wrong mutual fund. Do not stake your life’s earnings, savings or investments into one big thing – it might be too expensive a mistake to correct.
Fifth, the merit about rules is the oversimplification. If it appeals to your preferences, set a few rules and make them your personal finance habits. You may end up with a conservative default position that can offer a safety cushion for the other mistakes you may make with money.
Don’t let a mistake go wasted. Use it to see yourself in fresh light and modify your financial life accordingly.