It’s at times like these that taking a step back and trying to better understand ourselves as investors can be a really useful exercise. Once we truly appreciate how investing makes us feel and why, we can avoid impulses driven by emotion and adopt a disciplined, systematic and rigorous framework for investment decision making.
This article examines some of the emotional reactions that many of us feel when faced with difficult market conditions. If we can define these emotions and understand their effects, we can isolate them, reducing their influence on the investment decisions we make.
1. It’s normal to react to what’s happening around us, right?
When markets are fast moving, particularly if they’re falling, we can feel a loss of control over our investments and a greater tendency to take action at any cost. This can result in the ‘panic selling’ of investment assets that have recently fallen significantly in value – something that history has often shown to be the wrong thing to do. It can also see investors looking to ‘time the market’ – making buy or sell decisions by attempting to predict future price movements. However, it is notoriously difficult to time the market; rather we would encourage investors to get invested and stay invested, remembering that ‘time not timing’ is the better strategy for long term investment success.
- The temptation to over-trade can have a detrimental effect on investment returns.
- Stock picking and phasing investments into the market can be difficult.
- It is sometimes better to do less and trust in your investment process, retaining belief and confidence that your portfolio has been constructed to weather bouts of short-term market turbulence in order to deliver positive returns over the longer term.
The case for investing for the long term: Over a single 1-year period, S&P 500 Index total returns vary a lot. However, over a rolling 20 year period, annualised returns are much smoother.
US Equities: S&P 500 TR
Past performance is not indicative of future results
2. What effect can a fear of loss have on investment decisions?
As investors, we can be much more sensitive to losses than to gains, with investment losses making us feel twice as bad as returns make us feel good. Instead of looking at losses in isolation, we would recommend that investors consider their investments on a portfolio basis, understanding that it is the combination and mix of different assets that ultimately determines the overall risk and aggregate returns of a portfolio.
- Focussing on the isolated performance of individual investments through narrow frames tends to increase investor sensitivity to loss and ultimately investing mistakes.
- Investing across a range of asset classes and geographies can deliver better risk-adjusted returns and more consistent long term performance.
- It can also take the stress out of tracking the performance of relatively few assets, where losses can have a major impact on overall returns.
3. How can ‘autopilot’ be a solution for busy investors?
At first glance, this question appears contradictory. Being ‘on autopilot’ is rarely considered a solution to anything – certainly not a remedy for a lack of spare time to properly address one’s financial affairs.
Believing that we’re too busy to commit to a financial plan can be caused by an emotional reaction to market events. It can result in a tendency to procrastinate investing in the market or reviewing existing investment holdings. Market volatility can be commonplace and waiting for the ‘perfect’ time to invest can result in investors’ cash sitting on the side lines rather than being put to work.
- An autopilot approach to investing, in the form of committing to a plan for an Investment Counsellor to phase investments into the market at regular intervals, can be a good solution for time-poor investors. This can result in a regular, disciplined, and systematic approach to portfolio rebalancing and a default position whereby available capital is utilised and put to work as early as possible.
- Discretionary investing can also be an effective solution for busy people. It outsources the day-to-day investment decisions of portfolio management to a professional who manages the investor’s portfolio to a set of pre-determined parameters such as risk appetite and investment objective.
The case for getting invested and staying invested: The chart below shows the annualised return of the FTSE 100 Index (1985 – 2015). It shows that missing just a few of the best days over the 30-year period has a significant impact on the annualised return.
FTSE 100 Daily Total Return from 31/12/1985 to 31/12/2015
Past performance is not indicative of future results
4. What effects can overconfidence have on investment decisions?
Research suggests that human beings tend to have an inflated view of their own abilities. When it comes to driving, for example, most people rate themselves to be in the top third of the population – though by definition of course half of us are below average. Similarly, we tend to have unfounded confidence in our decision-making abilities, believing that we have above average ability to accurately forecast future events. Whilst elevated levels of confidence can be a benefit when confronting the challenges of life, it can be a hindrance when making decisions designed to achieve positive investment outcomes.
When investors are overconfident, they can overestimate their ability to identify winning investments. As professional wealth mangers, we would advise that a well-diversified portfolio avoids over-concentration of risk in any one particular area and delivers the best results for investors over the longer term for the amount of risk taken.
5. A question of skill?
A tendency to overestimate just how skilful we are at making decisions that result in positive outcomes may come from a characteristic known as ‘self-attribution bias’. This states that when we make a decision that results in a positive outcome, we view this as a consequence of our skill and judgement, but when a negative outcome occurs, we attribute this to bad luck or to events outside our control. This carries over into the area of investment decision making, where we tend to use our investment successes as proof of our ability, whereas any failures are put down to bad luck.
Short-term investment outcomes generally involve considerable luck and it is hard to differentiate between luck and skill over a short time period. That is not to say that we do not believe in skill, just that it can only be truly discerned over a longer timeframe.
In summary, many of the emotions and beliefs outlined in this article are held deep within our psyche, and though they may serve us well in certain circumstances, can be to our detriment when making investment decisions. It’s at times like these that it can be extremely worthwhile to engage in an interactive dialogue with an investment professional to guide you through challenging market conditions, such as those witnessed so far this year.
Given the point we are at in the market cycle, it is certainly worth looking at the overall positioning of your portfolio to ensure that it is correctly aligned with your long-term investment ambitions. Reviewing your investments with your Investment Counsellor should help you avoid some of the impulsive, short-term decisions that can be to the detriment of so many investors.
Past performance is not a reliable indicator of future performance. Where an investment is denominated in a currency other than your local currency changes in exchange rate will affect the performance of your investment.