In times of market turmoil, sometimes even very smart people forget the principles behind good investment management. Many of our most ingrained instincts, important for keeping us out of danger by making us fearful, can create an innate urge to rush around and do something.
But, despite our hard wired instincts, empirical evidence shows us that staying the course gives us the highest probability of having a successful investment experience.
To understand why we’re sometimes so quick to doubt and question during volatile markets we need to understand some of the behavioural biases that impact our investment decision making.
Our behavioural biases are the result of survival instincts that have evolved and been honed over thousands of years. While these behavioural biases served us well hunting for our families, many of them work against us when investing.
Academics have categorised the major behavioural biases that lower our probability of a successful investment experience:
- Overconfidence – most of us think we’re smarter than everyone else, meaning our portfolio will undoubtedly perform better than everyone else’s. It won’t.
- Hindsight bias – market movements appear obvious after the fact, so the future must also be predictable. It isn’t.
- Familiarity bias – only investing in securities we ‘understand’ or ‘know,’ this breeds a false sense of control and leads to highly concentrated portfolios. Markets don’t reward familiarity.
- Regret Avoidance – ‘never again’. If we lost money in a company in the tech boom, we may decide to never to buy that company again. Markets don’t reward risk avoidance.
- Self-attribution bias – giving ourselves credit for being smart when successful, but attributing failures to factors beyond our control. You can’t be smart and (un)lucky, you’re just one or the other.
- Confirming evidence trap – paying attention to information that supports our biases and ignoring information that refutes it. So when markets fall, we think they’ll continue to fall and therefore don’t buy, even though the expected rate of return has increased. This leads to buying high and selling low … not smart.
There are valid evolutionary reasons for these biases but when it comes to investing you should leave them at the door. Unfortunately, that’s not easy.
What happens when we don’t? We pay for it.
Here’s the evidence. DALBAR, one of the leading providers of investment research on the United States funds management industry, found that over the 20 years to 31 December 2010 investors did a poor job of controlling their biases and paid for it with materially lower returns.
Average share and bond investor performances were used from a DALBAR study, Quantitative Analysis of Investor Behaviour (QAIB) 03/2011. QAIB calculated investor returns as the change in assets after excluding sales, redemptions, and exchanges. The method of calculation captures realised and unrealised capital gains, dividends, interest, trading costs, sales charges, fees, expenses, and any other costs. Annualised return is determined by calculating total return to investor net of the sales, redemptions, and exchanges for the period. The fact that buy and hold has been a successful strategy in the past does not guarantee that it will continue to be successful in the future.
With the help of behavioural biases the average equity investor in the US cost themself 5.31% per annum in lost performance. If they had been invested in the market portfolio for the whole 20 years their portfolio would have been worth 2.7 times what it is now! Note the above market portfolio is available to all investors at low cost and requires no forecasting or speculating.
Fixed interest investors did even worse, the average fixed interest investor lost 5.88% per annum relative to the market. $1 invested in the market portfolio for the whole 20 years would have been worth 3.1 times what the average investor earned!
And the media doesn’t help. But then again the media isn’t interested in helping. They sell more papers, deliver more advertising, and make more money from feeding your biases and fears than they ever could from telling you to take a deep breath and stay invested.
The lesson? Investors’ returns are more dependent on investor behaviour than investment performance. Investors who succumb to their behavioural biases will suffer lower returns in the long run than investors who stay the course.
Our clients avoid the costs of behavioural finance. How? By listening to us. It’s our job to make sure they stay the course. It is our goal to turn our clients into good investors so that they have the greatest probability of achieving their goals.
It may be hard, but then again the right thing often is. That’s why we’re here to help each step of the way.
By Scott Rainey, Financial Adviser at Bradley Nuttall Ltd, Level 1, 95 Oxford Terrace, Christchurch.
Find out more about Bradley Nuttall’s Wealth Management and Investment Managementmethods
A disclosure statement is available free of charge on request.
