The psychology of investing

According to standard economic theory, investors are rational and take into account many considerations before making financial decisions.

But while we’d all like to believe that buying or selling stocks is a rational decision, anyone who has invested can tell you otherwise.

There are many forces shaping our investment decisions. The field of behavioural finance examines the set of psychological and emotional biases that make investors succumb to irrational decision-making. Individual investors, portfolio managers and advisors are equally affected.

Master your emotions and you can become a superior investor.

When emotions get in the way of logic, we may act too quickly, not quickly enough, or sometimes not at all. A recent Psychology of Investing report by BMO reveals two-thirds of Canadians are not capable of keeping their emotions in check when they make investment decisions—60% of respondents admitted to investing on impulse at least once.

External influences

Our thoughts are often influenced by what’s most personally relevant or recent. Psychologists call this myopic loss aversion. Research has shown the hardship of losing a dollar is felt twice as much as the pleasure when gaining one.

For instance, investors become too focused on the potential losses they may suffer over the next day, hour, minute or even second—forgetting about the long-term prospects of their investments.

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When it comes to experiencing a potential loss, some will sell prematurely in a panic, while others may hold on to avoid a loss even when there’s little chance of turnaround. It also causes investors who jump ship from a market downturn to stay out longer than necessary. Those who do return have usually missed the greater part of the rebound.

Another example of irrational decision-making was seen at the height of the financial crisis in 2008. Investors decided to exit stocks and lock into the safety of U.S. Treasury Bills even though they provided negative yield. Turns out fear can be a stronger driving force than arithmetic.

Investors are also affected by lingering perceptions, thinking what has happened in the past will continue into the future. The 2011 Franklin Templeton Annual Global Investor Survey provides us with a great example of availability bias, where investors were asked how the market performed post financial crisis in 2009 and 2010, as measured by the S&P500.

Nearly half the respondents thought the index was either down or flat. In reality, those years experienced double-digit gains.

The same goes after an extended bull market, where people invest in nearly anything. Bear markets become a distant memory and unlikely possibility, but we must remember a reversion to the mean is inevitable. We saw this happen when tech stocks were all the rage. Some companies were generating no revenues, let alone profits, but the stock prices kept rising until the bubble burst.

Investors also fall into psychological traps like overconfidence. Researchers have found people are consistently overrating their abilities, knowledge and skill—especially outside their areas of expertise. This overconfidence can cause excessive trading, which can lead to diminished returns.

As reflected in trading behaviour, men are more susceptible to the overconfidence bias than women. The research of University of California professors Brad M. Barber and Terrance Odean has found after examining the investment transactions of 35,000 different households between 1991 and 1997 that men traded 45% more often than women.

Women who traded excessively underperformed a buy-and-hold approach by 1% on average, while men underperformed by 1.4%. Also, single men trade 67% more than single women, underperforming a buy-and-hold approach by 2% on average.

The frictional costs of trading also have a detrimental effect on returns. For example, if an investment yields 15% annually and is left to compound for 30 years, you only pay taxes when the investment is sold. At a 35% tax rate, you’d achieve an annual after-tax return of 13%.

On the other hand, if you traded continuously and still earned a 15% return, you’d constantly trigger taxes, thereby reducing your return to less than 10%. Long-term investors have an edge by taking advantage of the tax mechanism and allowing the power of compounding to work its magic.

Even investors who don’t purchase individual stocks for their portfolios have fallen into similar traps. Peter Lynch, the investor behind the successful market-beating Fidelity Magellan Fund, calculated that despite his fund’s success, more than half of his investors lost money. His fund was publicly traded, so investors poured in after a couple of good quarters and exited after a couple of not so good ones.

Investors are also susceptible to herd mentality. Take the daily short-term rhetoric that occurs on CNBC or BNN. Even the savviest investors are likely to need a great deal of willpower to keep from following the crowd.

But investor John Templeton had found a solution. During his management of the Templeton Group, he secluded himself from the crowd, living and working in the Bahamas.

In a 2004 interview conducted by Eleanor Laise from Smart Money, Templeton said, “I’ve found my results for investment clients were far better here than when I had my office in 30 Rockefeller Plaza. When you’re in Manhattan, it’s much more difficult to go opposite to the crowd.”

Long-term mutual fund assets, then and now

Source: Strategic Insight

Keep clients cool

Because we can’t all move away to a tropical paradise to get the job done, here’s how to help investors keep their cool and act with discipline.

• Invest within your expertise. Do your research and come to informed conclusions. Be confident in your investments, but don’t fall into the confirmation bias trap, where investors only give importance to facts that support their view.
• Keep track of your investment thoughts, reasoning and feelings in a journal. When you want to make a move, look back and remind yourself why you own the security. Be honest and understand the root cause for wanting to take action. If all the primary reasons for your investment are still valid, there may not be a reason to sell.
• Don’t try to predict the future. Instead, base your investments on strong business fundamentals. Set guidelines, maintain a consistent framework and find investments that fit within it.
• Focus on the long term. Many focus on short-term gains and losses, but it’s better to keep an eye on the long-term state of your wealth. Make an investment plan to help stay on track with your objectives.
• Give yourself a cooling-off period. Get a good night’s sleep and rethink your decision. The great thing about the markets is there’s always another deal to be found.

Susy Abbondi is an equities analyst at Duncan Ross Associates.