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SIP and present bias

  October 16,2021

How SIP takes care of Present Bias?

You must have heard about the Systematic Investment Plan and the importance of setting up a SIP. But what is the reason behind Systematic Investment Plan or automating your savings and investments?

This blog post will talk about how automation of investments can take care of Present Bias.

What is automation?

As the name suggests, automation is the process where you put things to run on auto-pilot. We can automate different parts of our lives, such as bill payments, paperwork and even investments. There are several benefits of automation, especially with investment.

When we automate our investments, a part of our income gets automatically diverted to an investment account. It is much easier to save or invest an amount of our income through automation.

But deciding on investing a sum of money every month isn’t easy for many people, especially for people who haven’t invested consistently.  

What is SIP?

A Systematic Investment Plan (SIP) is a way to automate mutual fund investments. After setting up a SIP, a pre-determined amount of money is debited to your mutual fund investment amount from your bank account.

SIP is essential for many investors as it can help save or invest more money. But why does this take place?

It is because SIP helps us to overcome Present bias. Present bias is our tendency to overvalue immediate rewards at the expense of long-term goals. It is the inclination to prefer a smaller present reward than a larger later reward. However, the preference is reversed when both rewards are equally delayed.

Present Bias in Everyday Life

Present bias is not just an investing behaviour. It shows up all the time. Some examples of present bias in everyday life are delaying preparing for a meeting until the last moments or ditching your plan to clean your wardrobe to binge-watch.

So, we can see that binge-watching feels better than cleaning our wardrobe. This is even though we know that cleaning our wardrobe is important than binge-watching.

How does Present Bias impacts investment decisions?

Present bias may have devastating consequences when it comes to financial decisions. Overspending or expecting a future windfall might make it challenging to save now and hinder long-term investing performance.

Take, for example, retirement. When you’re young, unmarried, and just starting in your job, saving for retirement may seem insignificant compared to enjoyable holidays or extravagant purchases. However, the strategy of “I’ll get to it later” might result in a higher hill to climb the longer you wait. That lack of long-term planning and saving might eventually have an enormous influence on your retirement preparation.

If the money was in your account, you might be able to persuade yourself to spend it.

How SIP removes present bias?

You can’t spend money you don’t have. You can only spend money when it is in your account. Placing it out of sight serves as a reminder that it has been set aside for other use.

Paying yourself first allows you to put the money you need for savings and expenses “out of sight, out of mind.” When confronted with an appealing purchase, this makes it much simpler to resist temptation.

You might feel the pinch in the first few months. You may not be able to buy everything that you want. But slowly, it will become a part of your life, and you will design a fulfilling life around it. SIP is a simple yet powerful way to achieve your goals.

Conclusion: Present bias is a common bias. Besides our day to day lives, present bias also influences our investment decisions. Because of the bias, we postpone our investments and focus on activities and things that make us feel good in the present situation. Automation is the best way to overcome present bias in our investment decisions. You can carry out automation in different investment options. If you invest in mutual funds, SIP is a facility that allows you to automate your investments and achieve your financial goals.  

This blog is purely for educational purposes and not to be treated as personal advice. Mutual fund investments are subject to market risks, read all scheme-related documents carefully.

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