Are you aware how much your emotions affect your investment decisions? Most of us are not . . . and that lack of awareness endangers the success of our investments.
Financial research has identified some common cognitive errors and biases in the decision-making matrix related to how we manage our emotions. This affects a wide range of financial decisions—commercial real estate investments, speculative residential property purchases, and expansion or contraction of businesses—but we’re going to focus on the damage they do to your portfolio of publicly traded stocks.
Buying and selling in the public stock markets is often driven by the strong emotions of fear and greed, which are fed by the financial media. As a result, there is a very high correlation between the volatility of investments and investor behaviour, as the sketch below shows. You can see the interaction of fear and greed, and how these emotions prod us to buy and sell at precisely the wrong times.
When markets are rising, new investment commitment follows in full inflow; when markets are falling, the net flow into the global stock markets follows. Investors are doing the exact opposite of what conventional wisdom dictates: they are buying high and selling low.
This suggests that most investors do not understand that lower prices reflect higher expected returns. As stock prices are falling and expected returns are rising, market participants as a whole are selling. Alternatively, when stock prices are rising and expected returns are falling, market participants in general are buying. Expected returns of securities are measured more or less by their cost of capital: a higher cost of capital for lower priced securities drives higher expected returns. This, of course, involves more risk, so risk and return are related.
In brief, investor behaviour causes poor market returns. The interplay between fear and greed that causes investors to buy high and sell low results in dramatically lower returns to the average investor than expected. This is demonstrated by the yearly studies the research firm Dalbar does to quantify the impact of investor behaviour on real life returns. They compare investors’ returns to a benchmark (for example, the S&P 500 in the US). The results of their 20 year study ending December 31, 2009 indicated that the average investment return was 8.2%, but the average invest-or return over the same time period was only 3.2%. This underscores that it's time in the market that makes the positive difference to returns, not timing the market.
In fact, you might conclude that the average investor would have been far better off simply making an investment in the S&P 500 and not touching it again for 20 years! Assuming some cost for fees, this untouched investment would have earned about 8%. This, sadly, is not what investors actually do. Instead, they watch Bloomberg, they listen to Jim Kramer, they read the daily papers . . . and then they trade. Overall, this approach tends to result in trades that are driven by fear and greed, costing millions in poorly timed investment decisions.
We are apparently rational beings, so why do we continue to engage in trading that produces such poor results? The simple answer is that we allow our emotions and our biases into our decision-making process.
To take an example, one of the major behavioural biases is overconfidence. Research shows that we tend to have an unjustified confidence in our abilities and decisions: generally, we are susceptible to being overconfident in life and tend to rate our abilities higher than an objective measure would indicate. In one study of adults over the age of sixteen, the majority placed themselves in the top quartile (top 25%) in driving ability, a statistical impossibility as, by definition, half must be below average. We are all prone to this kind of behavioural bias and it most certainly affects our investment decisions, making it partially responsible for the 5% differential in investor returns versus the market returns.
In addition, several other well documented cognitive biases have been identified which can get in the way of having a better investment experience. Given this situation, how do we combat these biases? How do we offset the tendency for our buying decisions to be influenced by greed and our selling decisions by fear?
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.