Think Tank

Understanding investments and therefore its process is a multi layered discipline. An investment plan is tailored for an individual keeping his requirements as the constant. Among the various attributes taken into consideration, one of the most important variables is the investor’s attitude towards risk. The challenge is to go under the surface and into the psyche of the investor in question. This makes the process psychologically intensive. Thus we might not be too far off if we take the liberty in summoning the great Sigmund Freud, with due apologies and a dollop of salt, in helping us understand the mental tugs involved. While his theories were quite complex, his structural model can be borrowed for drawing an amateurish yet delightful model on how we behave and interact with the opportunities around us.

In the psychoanalytic theory of personality Freud saw the personality as having three aspects, which work together to produce behavior in an individual viz: the Id, the Ego and the Superego. These have to be well balanced in order to have reasonable mental health and psychological energy.

The Id - The Id is the component of personality that is present from birth. Unconscious by definition, it includes the instinctive and primitive behaviors. Driven by the pleasure principle, it aims for immediate gratification of all desires, wants, and needs. If these needs are not satisfied immediately, the result is a state of anxiety or tension. It allows us to get our basic needs met while it doesn't care about reality, about the needs of anyone else, only its own satisfaction. The investor is tempted to chase the latest hot stock and seek supernatural returns. Sometimes even ready to bet a large disproportionate part of his portfolio on chasing a story. The need to time the market and jump winners is inherent in many investors causing anxiety or tension. In many ways it is the small guy on the left shoulder telling the investor to take that risk, bet on that under-researched hidden story and go with his instinct.

The Super Ego – The super ego stands in direct opposition to the Id. It is the moral part of the mind and is an embodiment of parental and social values. It strives for perfection, even though this perfection ideal may be quite far from reality or possibility. It develops due to the moral and ethical restraints placed on us. An investor is at many times looking to conserve capital at all costs. His ability to take risks is severely diminished and he thus enforces far too rigid rules upon the management of the portfolio. He has heightened values of conservatism and the need to set aside or plan for the generations. He feels guilty on assuming any level of risk and is uncomfortable with it. It is that small guy on the right shoulder telling the investor to abhor risk and conserve at all costs.

The Ego – The rational part of the brain, it develops from the growing awareness that one can’t always get what one wants. It operates in the real world via the reality principle. Realizing the need to balance the Id and the Superego it negotiates between the two, denying both instant gratification and the delaying of gratification. It attempts to satisfy the Id's desires in realistic and socially appropriate ways. The reality principle weighs the costs and benefits of an action before deciding to act upon or abandon impulses. Freud used the term to mean a set of psychic functions such as judgment, tolerance, reality-testing, control, planning, defense, synthesis of information, intellectual functioning, and memory.

Sounds a lot like an investment plan, doesn’t it? While investing, the Ego strives to achieve the balance between the Id and Super Ego. It has to understand the need to take risk to generate out-performance, and at the same time also bear in mind the need to not assume unnecessary risk. The investment horizon is a balance between the long term needs and the short term cash flows. The decisions of strategic allocations pander to the Superego while negotiating with the Id for immediate term tactical decisions that seek to benefit from sudden opportunities. Instincts must be honed and validated with good research. The investor understands the need to build a portfolio with a well diversified plan that balances his risk profile, attitude and financial goals. With so many competing forces, it is easy to see how conflict might arise between the Id, Ego, and Superego. Ego Strength is the Ego's ability to function despite these dueling forces. A person with good Ego strength is able to effectively manage these pressures, while those with too much or too little Ego strength can become too unyielding or too disrupting. While we are on Freud; one does not know if he ever dabbled in investments (he did see a part of the great depression), he probably could have made one heck of an investment planner.

Disclaimer: The views expressed in the articles are personal of the authors and do not reflect the views of Kotak Mahindra Bank Ltd.