Sunday, January 30, 2011

We work in default mode

Have you ever missed the money that is deducted from your pay-slip every month as PF contribution? It is very likely you don't even know what the contributions along with interest have amounted to, over the years. If, on the other hand, you had been investing the same amount in a bank account at the same rate of interest, would the corpus have amounted to so much? Very unlikely, if you come to think about it, for you would have dipped into the money along the way; it would have come out in small chunks and you would never have realized it.


There are people who sometimes buy some shares and forget about them entirely for some years, or even decades. One fine day they wake up to discover that the shares are worth a significant sum of money.  If they had been keeping track of it regularly the temptation to sell the shares somewhere along the way would have been too high.


The power of compounding is incredible. It multiplies your money to unimaginable proportions if left untouched over a long period of time.


The same effect can be observed in real estate. Since the amount of investment is very high to start with, you put in all you have, and borrow a substantial sum. You take a large loan from the bank and get into an EMI commitment, all that you can afford. As you get additional income along the way, your focus is to prepay the loan to bring the loan down to more manageable levels. You adjust your lifestyle in order to be able to pay more towards loan repayments. All the while, when you are focusing on the repayment, the land or apartment is left to grow in value undisturbed. And one fine day you find that you are free of the loan and your real estate is worth a substantial sum of money.


In all the above cases, there is not too much thinking or decision making to be done along the way. You make the decision at the time of buying, and then operate in a default mode. You would of course do well to monitor the portfolio once in a while for any signs of fundamental changes in assumptions; but you leave the portfolio pretty much alone. 


The key to wealth creation lies in not being too active!  All of us like to operate in the default mode; the trick is to identify those default actions that are beneficial to us in the long term and then get into the habit. Too much thinking and analysis could be detrimental in this situation; in fact too much thinking and analysis is injurious in most situations!


We can use this insight into a fundamental trait of human psychology to our advantage. It is good to have certain long term goals for investments and then keep working toward s them in a programmed manner. It is not really a good thing to switch from one investment to another too often. It is good to go in for borrowings, especially for buying your house, and for investments, since it forces us to work towards the repayment.


Whatever your income is, decide on how much you want to spend, and put the balance into a separate account. This account should be earmarked for investments, and linked to a demat account as well. Whatever investments you do are from this account, and whatever returns you get, including dividends, go into this account and not into your spending account. Once a month, you invest the balance money lying in this account into some investment, whether in direct equity, equity funds, fixed deposits, debt funds, real estate, or gold/silver. Any sale or redemption proceeds go back into this account. This way you have "paid yourself first" by diverting money into your investment account from your spending account.


As to the investment account, you don't take anything out; just keep putting in. Any money that is used from there goes into investments; any money coming in from investments comes into the investment account.


You should also be aware of how the same tendency to operate in a default mode is misused by marketers in structuring financial products. All insurance products that have a savings element attached to them compel you to pay the premium periodically, which is good; they also compel you to not look at how your investments are performing too often, which is also good; hence, when you finally get some money back in the end, it seems like a big sum to you.


However, what we ignore is the fact that a huge percentage of premiums paid on such insurance products goes towards administration charges, agents' commissions, and all other kinds of charges. Since we are operating in a default mode, we do not think about this, but we should. What if the same money that we paid as premium goes into our own investment account and we invest in a mix of equity and debt mutual funds? The insurance company too does the same thing – runs a mutual fund at the back end and puts our money into a mix of equity and debt.  When we do it on our own, we will save on all the commissions and the miscellaneous charges. And if we leave it alone long enough, and not check our corpus too often, one fine day we will be surprised at the amount of money we have left.


Think about it. And think of other ways in which you can get into some "good habit" default modes of operation. And think about how many other ways marketers dupe you by taking advantage of the fact that we all operate in default mode.


Raag Vamdatt (Financial Planning Demystified) said...

Hi Dinesh,

Yet another great article!

An excellent way of working in the default mode is using mutual fund systematic investment plans (SIPs) for investment - investment is automatically done every month, without any analysis or market level.

Something I personally have benefited from, and feel every investor should be doing...

Dinesh Gopalan said...

I agree. When you have to cut the monthly cheque, and don't have much choice in the matter... that's what works best