Mind vs Emotion
Why letting your emotions rule your head when it comes to money can lead you down the wrong investment road.
It takes a crisis like the GFC to really see how emotion can overrule logic when it comes to our investment decisions.
Constant media coverage about falling share prices and declining fund performance helped to create enough panic among investors to cause them to sell up and invest in cash. The move may come at a cost in the longer term.
The problem is that while cash doesn’t suffer from the same ups and downs as shares and other investments, there’s a price for that peace of mind.
You lose the advantage of already being in the market when confidence and prices recover. It means that you may have sold when prices were low and, to get back into the market, you may be buying at levels higher than you’d like – far removed from the adage ‘buy low, sell high’.
Investors flee the markets in droves when prices are at their lowest. It’s partly fear, as they watch the value of their portfolios drop, and partly the strong desire to follow the crowd, a sort of reverse gold fever.
Fear of missing the boat
And when markets trend higher, more investors than ever are attracted to the activity. This is fed by the views of friends and family as they share their views about buying and selling at that particular time and by increasing media and internet coverage.
When markets are rising the term ‘irrational exuberance’ is often applied to the frenzy of buying, after the former US Federal Reserve chairman, Alan Greenspan used it in a speech in 1996 causing a strong reaction in global share markets. Of course there is also ‘irrational pessimism’.
Cut my losses?
But history shows that those who are able to withstand short-term fluctuations in their portfolios can look forward to improved growth over the long-term.
We are our own worst enemy, writes finance guru and economist James Montier in his book The Little Book of Behavioural Investing (John Wiley, 2010). We are all prone to stumble into “mental pitfalls”, according to Montier. “This is true in investing as it is in every other walk of life.”
Timing the market – fact of fiction?
One example of these mental pitfalls is the attempt by many investors to try to time their entry into the markets as well as their exit aiming to sell at the top and buy at the bottom.
Few succeed, notes Montier, citing an annual US study that compares the performance of the S&P 500 over the past 20 years with investors’ actual returns. While the index increased an average 8 per cent per year, investors in equity funds reduced this performance to just 1.9 per cent as a result of “buying and selling at just about the worst possible point in time”.
Taking out the emotion
It’s not always easy to find the courage to go against the crowd or to hold out while markets are falling, even if it might be the rational thing to do.
What you can do
While emotion governs the majority of human decision making, being aware of behavioural biases can help you avoid them.
Question your decisions. Are you making a choice based on emotion or informed financial analysis? You should always be able to provide a sound justification for your decision.
Set your investment goals. Your financial adviser is a good place to start.
Know your risk profile. Discuss your various options with your adviser.
Keep informed. Read a range of balanced economic analysis, such as that produced by reputable research houses (eg Standard & Poor’s) or organisations such as the Reserve Bank of Australia. Learn to sort fact from sensationalist media articles. Your financial adviser is a good source of high-quality financial information.
Diversify your portfolio. Diversification can assist in avoiding investment biases by helping you to see your portfolio as a whole, and part of a long term strategy. Investing through a managed fund can also help you avoid becoming attached to certain stocks and can be an effective way to diversify if you don’t have a huge amount to invest.
Seek advice. Professional financial advice is critical to investment success. Financial advisers have access to a range of material not available to individual investors. When you are making investment decisions, your financial adviser can help by offering guidance and a balanced viewpoint.