The power of the investing habit
The psychology of habit formation is the real reason why SIP investing is beneficial in ways that don't seem obvious in the beginning
By Dhirendra Kumar | Apr 8, 2019
Last month, I read a wonderful book named 'The Power of Habit', by Charles Duhigg. The book details--through anecdote and science--how our routine behaviour is driven mostly by habit or the absence of habit. It also delves deep into how habits get created and changed, and how this can be achieved consciously. While reading the book, it became clear to me that savings and investments fit right into the framework that Duhigg had described. Not just that, habits in one area can be the trigger for those in other areas, but more on that later.
For a long time now, it's been pretty clear that the value of investing through systematic investment plans was as much about psychology as about the arithmetic of investing. While the conventional, numbers-driven rationale for SIPs is the main thing that encourages investors to start investing, it's the habit-inducing nature of SIPs that keeps them investing.
If you put this in the context of exactly why SIPs are the superior form of investing in mutual funds, you come to inescapable conclusion that it's the psychological factor that is the real driver for the investing returns and success.
Let's recap why exactly it is that SIPs are so good for your returns. Since SIPs mean investing with a fixed sum regularly regardless of the NAV or market level, investors automatically end up getting more units when the markets are low. The arithmetic is obvious. Suppose you are investing Rs 10,000 every month. When the NAV is Rs 20, you will get 500 units because 10000/20 = 500. However, if the market dips and the NAV drops to Rs 16, you will get allotted 625 units, as 10000/16 = 625. This is the key. You have automatically bought more units when the markets are lower.
When you want to sell your investment, all the units you own are obviously worth the same. However, your profit margin is higher for units that were bought at a lower price. Effectively, on the entire chain of investments, you have paid a lower average price, which translates to higher returns. Thus, SIPs automatically enforce the investor's goal of 'Buy Low, Sell High'.
That's the arithmetic, but where does the psychology of habit come in? That happens because the biggest problem in investing is not where to invest. Instead, it is to invest at all and keep investing through thick and thin. People invest sporadically, and then stop investing when equity markets fall. This comes naturally to most investors, generally because falling equity prices are presented as a crisis in the mass media. SIPs do the job because investing becomes a habit. It gets ingrained in your behaviour patterns, it happens automatically every month and you don't have to overcome any inertia to invest every month.
The interesting thing that Duhigg describes is that habits are contagious. If you form one small habit in one area of your behaviour, then that can act as a trigger for further behaviour modification. Of course, this can be positive or negative, but looking on the positive side, all you need to do is to start one small monthly SIP in one fund. The obvious starting point would be a tax-saver fund. That's all. As the money accumulates without any further effort, sooner or later, you'll add more SIPs. Once you add them, you may actually cut down on useless expenses in order to invest.
The interesting part is that if you decide that you will invest through a non-automatic route every month, then, for most of us, none of this happens. We invest a bit here and there but it doesn't become a habit. There are no second-order positive effects. Psychologically, it's a completely different phenomena. The power of habits never kicks in.