I have a friend. A Brigadier in the Army, Mohan Lal Aswal. He came to know that I have an inclination towards personal finance. He also attended one of my talks which I occasionally give on request to a group of long term investors. He was convinced about whatever I spoke and whatever I had advised people on. Especially on Insurance. A few days back, he rang me up and asked some advice on insurance policies which his wife had bought for his children who are both working.
I sought the details of the policies before I commented upon them. He sent me two files. I studied them over a few hours and then sent a note to him stapled to the file. It said, “Please cancel both policies. Do not pay any more premiums. One of the premiums is due next week, that premium should not be paid.”
“Buy a fresh term cover of ICIC Prudential/Kotak Life for sum assured 50 Lakhs and invest the balance (Existing premium on two policies- New Premium of Policy) in two good mutual funds. The total returns would be more than what LIC would pay the kids for the two endowment policies you have bought for them and the sum assured in case of a mishap would be ten times more.”
Do you think he followed my advice? No. He did not. His first response was, “Yaar, I have paid two premiums each on both policies i.e Rs 21413/- per policy x 2premiums x 2policies = Approx Rs 84000. How can I forego that? To Aswal, this was a loss. He would not get a single penny on this amount as per LIC rules — in case policy is cancelled before paying three premiums, nothing will be refunded. Some of you may want to pay the third premium and then seek a refund. That also may be worthwhile provided you get more money as refund than the premium paid+interest on that amount.
This was a clear case of two psychological biases at play. One was loss aversion. We al are prone to be loss averse. We dislike losses for the pain they cause us. We like to be happy. Losses ruin that happiness. So rather than book a loss and be faced with that reality, we fool ourselves by keeping the losses in our portfolio as share certificates or Insurance Certificates.
I had also calculated and showed on that piece of paper that the returns from simple PPF + Term Insurance for him would be much higher than LIC and instead of PPF if the same was invested separately into a good mutual fund, the amount on maturity would be still bigger. But human nature being what it is, he was not convinced.
The second bias which played out was Sunk Cost Fallacy. What we have already spent is sunk and cannot be retrieved, would you like to drown 18 more healthy premiums to save the two drowned victims or premiums? A rational mind may not, but an emotional one would.
So, dear readers sometimes it may make a lot of sense to not go for that concert for which you have purchased tickets and paid for and you find that just when you are moving out it is raining cats and dogs and you may get stuck in a 4 hour long traffic jam. Sit at home and let the ticket cost remain a sunk cost. You would be happier and better off.