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The foundation for successful investment is being aware of behavioural biases and controlling these, setting realistic investment objectives and having an appropriate asset allocation to achieve those objectives. When we talk about investment behaviour, we are considering all the aspects that go into making investment decisions including investment psychology. This article focuses on the latter, as in the current investment environment where the prices of equities and other financial assets are extremely volatile, and many have fallen a lot in value very rapidly, the emotional/psychological toll on many investors is extreme. Fortunately, this will not be the case for everyone, as we are all wired differently, due to different events that have shaped us over time.
Humans have evolved to manage short-term crisis issues. We have an inbuilt fight or flight instinct. While perfect for making quick decisions when confronted by a hungry sabretoothed tiger, it does not lend itself to making sound investment decisions. The investing equivalent of a sabre-toothed tiger is a sharp equity market decline. Our first instinct is often to run, i.e. sell, when the best course of action is to sit tight. Selling after a market decline can harm long-term returns. The 2015 Dalmar study found that, the 20-year annualised return of the US equity market was 8.2%pa while the average investor in equity funds achieved just 4.7%pa, a gap of 3.5%pa. Analysis of underperformance shows that investor behaviour is the number one cause, whereby investments are sold after a period of poor performance and repurchased only after markets have recovered.
At the other extreme, many investors avoid investment risk altogether. They hunker down in savings accounts. By doing so they are, often unwittingly, succumbing to another behavioural bias, loss aversion, which means they miss out on the higher long-term potential returns offered by investment in growth assets like equities.
One of the key roles of Jarden’s advisers is to counsel clients regarding how these behavioural biases can undermine sound investment decisions. They do this by:
Having an awareness of behavioural biases and addressing them as they arise.
Having a clear investment approach and disciplined decision-making process.
Jarden has a clear investment philosophy and research team who undertake rigorous research to support our advice. Alongside this, Compass (discretionary portfolio management service) clients enjoy an investment process governed by
parameters that provide a roadmap to help guide decisions, especially during periods of market volatility.
Designing a bespoke strategy that aligns with each client’s unique circumstances, risk tolerance and goals. The key element of strategy is asset allocation – how your portfolio is spread across the various asset classes. This is vitally important because asset allocation has a major influence on your portfolio’s risk profile and return outcomes.
Let us explore in more detail the cognitive and emotional aspects of investing that affect us. Often investors will recognise a conflict between what their logical brain says and what their emotions tell them. Although this is not always the case as the following list of biases will attest.
Attention bias - No human has access to all available information to make the optimal decision, and instead, must make the best decision with the information available. This can result in attention bias. For example, when investing it is possible to focus too much attention on what is going on currently and act accordingly. When in fact it is better to focus on the big picture represented by their long-term investment objectives.
Anchoring bias - Describes a human tendency to base a judgment on a reference point that is incomplete or irrelevant. For example, an investor wants to buy shares in a company that is trading at $11, and notices that it was trading at $13 a week ago. The investor jumps in thinking it looks cheap at $11. The company’s circumstances may have changed making the $13 share price a meaningless comparison.
Confirmation bias - The tendency to search for and favour information that confirms one’s pre-existing beliefs or opinions while actively dismissing information that does not align with their view.
Loss aversion bias – As illustrated below, investors typically feel greater pain from a loss than the joy they get from a gain of equal of greater magnitude.
Consequently, the losses are remembered vividly while the gains are often forgotten. Thus, investors are likely to swing into action to prevent a potential loss, even though the concerning event frequently does not come to pass, often resulting in a sub-optimal portfolio which hinders the achievement of their investment objectives. As illustrated in the following chart, missing an extremely small number of the best and worst days in the equity market can have a significant impact on investment returns in the long term.
Recency bias – It is common for humans to expect an event that has occurred recently will occur again soon or continue happening. Unfortunately extrapolating the recent past into the future often turns out to be wrong. A clear example of this is how investor sentiment aligns with stock market returns.
Herd mentality bias – The world is a large complicated place. We are often overloaded with data and information. There is a strong argument that with so much information it is hard to see the wood for the trees. In such a world it is often simpler just to follow what other people are doing, on the basis that if enough people are doing it, it must be the right thing to do. Also, it feels good to be part of the crowd and doing what they are doing. Unfortunately, this often turns out not to be the right thing to do. The fear of missing out (FOMO) in a rising equity market is another manifestation of this. A clear example of this is how investor sentiment aligns with stock market returns.
Achieving Investment Objectives
Acknowledging these biases and thinking about them when making investment decisions can help ensure that investment objectives are met and are not compromised by making ill-timed changes to investment portfolios. This underlies the need to have investment objectives that are appropriate for you.
An investor’s risk profile and investment objectives can change over time as their circumstances change. However, it is unlikely that either will change frequently or materially over time. Frequent changes to investment objectives that result in frequent changes to asset allocation typically reduce the likelihood of investment objectives being achieved. Consequently, when an investor is considering a change, they should ask themselves, “Have my investment objectives really changed? Are my current investment objectives no longer suitable? Am I merely caving into an investment bias?” Your adviser can help you through this difficult process when these psychological biases are niggling.
Why all the fuss about achieving investment objectives? Because it matters. While it may manifest as nothing more than the value of your financial assets, it means that you can use these funds as you planned. People who achieve their investment objectives have the options to do what they want, when they want.
Investing is Not a Precise Science
Unlike endeavours like engineering where relatively precise calculations can be made, investing is as much an art as a science. Investment theory gives a framework within which to think and make decisions, but not precise outcomes. So, remember that:
- No investor can be expected to know everything about an investment. Does anyone consistently achieve 100% in school exams? No. The same applies when investing.
- Left field events happen periodically. We were highly focused on the prospect of a recession created by central banks in reaction to economic pressures, and out of nowhere came COVID-19.
- Luck happens. Both good luck (enjoy it but do not take credit for it) and bad luck (do not beat yourself up).
- History can help to understand what may happen in the future. However, it is never quite the same. While everything usually appears obvious in hindsight, the only way to know for certain is to travel into the future as Marty McFly did in Back to the Future II.
One final point. While it is exciting to have investments that generate exceptional investment returns and disappointing when they generate poor returns, it is the overall portfolio return which determines whether you achieve your investment objectives. Such a portfolio is likely to contain a fair proportion of more mundane investments, which generate good but unexciting investment returns. Constantly chasing potential winners comes with a much higher risk of not meeting your investment objectives and having to endure high levels of emotional stress.
This article was originally published in the latest Jarden New Zealand Investment Outlook. Read the May edition here.
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The foundation for successful investment is being aware of behavioural biases and controlling these, setting realistic investment objectives and having an appropriate asset allocation to achieve those objectives.