29 Nov 4 Elements that Could Be Undermining Your Investing
Much gets written about how individuals sabotage their own investment returns through their behaviours. As we’re in the throes of a volatile market right now, it’s worthwhile understanding 4 of the key psychological factors that could be undermining your investing.
The information in this article is a summary of a great paper put together last year by Doug Isles of Platinum Asset Management. It can be accessed here and we recommend you have a look.
1. Loss aversion
The work of psychologists Kahneman and Tversky demonstrated that losses are felt far more acutely than gains. Indeed, their work has shown that the impact of a loss is up to two times the satisfaction from a gain. Since the market has positive days only slightly more often than 50% of the time, an investor reviewing their portfolio returns on a day to day basis can literally feel like “one step forward and two steps back”.
2. Fear of missing out (or, as it is now fashionably abbreviated, “FoMo”)
Based on conversations with hundreds of financial advisers and many investment researchers Doug concluded that, in a similar way to loss aversion, relative underperformance is also felt more acutely than relative outperformance. With funds generally being compared to a benchmark, some investors treat an underperforming return as an opportunity cost, as feel this in exactly the same way as they would a “loss”. Doug felt that there is a significant body of evidence pointing to this behavioural pattern and investors tended to throw money at an outperforming fund in the next time period.
A tendency to check returns more frequently leads to a higher probability of encountering negative outcomes at a particular point in time. As noted above, on a daily basis, the market positive vs negative outcomes are little more reliable than a coin toss, but over the long term (say 7 to 10 years) equity markets rarely show a loss. The same is true for the track record of long-term outperformance by fund managers. Good managers do not always appear at the top of the monthly, quarterly or even annual performance charts. As such, it is far better select a fund manager based on a 3, 5 and 7 year return outcome.
Investors have a tendency, in aggregate, to chase assets that have performed well. Fund management businesses receive a large inflow following good performance. This very tendency can be exploited by market participants with an understanding of investor psychology. Good companies going through a soft patch can be overlooked or oversold and thus can offer outsized rewards.
When these four elements are combined and considered together, it’s possible to better understand how to manage your emotions through various markets. Falling into any or several of these will be detrimental to your investment journey!
An appropriate investment approach is to commit to a long-term investment in growth assets with a manager with an outstanding long-term track record in combination with a savings plan that reviews the balance infrequently and “harvests” the rewards after the full investment horizon has borne out.
The only reasons to change direction should be if the investor’s own goals change, or if the fund manager they are using, suddenly changes its approach!
Nassim Nicholas Taleb made this telling point in his book Fooled by Randomness. Assuming an investment with an annual return of 15% with 10% volatility, Taleb shows that the probability of making money increases over longer time periods. The following table is an expanded version of Taleb’s example, showing that, conversely, the probability of loss increases with shorter time frames.
|Time Frame||Probability of Making Money||Probability of Losing Money|