Today I want to look at how emotions can influence an investor when making decisions on their investments.
This subject has been discussed in depth over the years and is now known as Behavioural Finance. Essentially, the concept behind this is that whenever emotions get involved, investors can get hurt (not physically, of course!).
As long ago as 1934, Graham Benjamin, author of “Security Analysis”, said:
“The investor’s chief problem, and even his worst enemy, is likely to be himself”!
So what are the main mistakes that investors make when they let themselves be ruled by emotion? Well, there are quite a few.
Let’s look at some of the main ones:
1. Hanging On To Poor Performing Shares
Some people simply hang on to losers! This is to do with loss aversion when they don’t want to sell as they hate admitting they were wrong. Secondly, they don’t like to abandon all hope of recovering the original capital sum invested.
Others have an emotional attachment to shares they inherited from their parents and may have a lot of money in one sector (which means they are not diversified).
2. Overconfidence
Investors quite often feel that they can beat the market, even when this has not worked in the past. When the overall market increases, an investor can look at their gains and attribute this to skill, and think that they can repeat this in all market conditions.
Overconfidence can also keep investors from meeting their investment goals as they could well invest too little due to overestimating the possible future returns.
3. Believing In Last Year’s “Hot Stocks”
Of course, certain funds or shares can give a stellar performance over a short period. Some investors then feel that they must pour more money in to make the most of this great performance.
They could then be buying something that is now very expensive, but greed is a powerful emotion and they could well be fearful that they will miss out if they stop buying now.
Many investors find themselves doing this. This is what Erik Davidson, Managing Director of investments for Wells Fargo Private Bank had to say:
“In all other areas of life, we want to buy more if prices go down. With investments, people buy when prices go up.”
4. Not Having An Investment Philosophy
Over the years investors can amass quite a large collection of shares and funds with no overall investment philosophy.
This means there is no discipline to their investments, so the ‘obvious’ risk to them is that their asset allocation (how much they hold in stocks, bonds, property and cash), is totally out of line with their comfort zone.
Of course it will be quite usual that they only have stocks and shares with no balancing investments (such as bonds). This often means they are taking too much risk.
Also, lack of diversification can be a big issue. Some, wanting to have say UK equities, decide to buy several UK Equity funds run by different fund managers, thinking this means they will have diversified.
What they miss is that the managers running these funds will quite often be buying the same companies totally defeating the investor’s objective!
5. Not Matching Their Investments To Their Goals
Some investors simply amass more and more wealth without stopping to think what it is they want to achieve from this.
So, how long is it since you took time out to really think about what you want?
Have you ever done it?
To get you thinking about this, if you did not have to work from today, how would you fill your time?
It really is worth sitting down and thinking hard about what you need to do to lead the life you want, and then building your own financial map and resulting strategy to get there as safely as possible.
6. Following The Herd
It is perfectly normal to be prone to this, however it could really damage your wealth.
Do your remember the tech stocks boom of 2000?
Valuations of these companies were totally unrealistic, but millions of investors were sucked in to invest their hard earned money because others they knew were doing it.
7. Timing The Market
Some investors think that they can wait for the stock market to fall to its ‘bottom’ and then buy while shares are cheap. They stay out of the market waiting for ‘the moment to buy’.
By being out of the market, the risk is that the investor will miss the big rises that really boost performance.
As an example of how important this is, if you take the years January 1986 to December 2010, here are the annualised rates of return based on missing certain periods:
Totally invested – 10.18%
Missed best 5 days – 8.54%
Missed best 15 days – 6.46%
Missed best 25 days – 4.75%
Source: Dimensional Fund Advisers
The chance of investing at the right time is so small it is simply not worth the risk. Our view is if you constantly wait to invest at the right time, it will never arrive as how will you know when the right time to invest is?
Studies Demonstrate The Investor Behaviour Effect
So, typically, what is the effect of this emotional behaviour on an investor’s money?
We’ll finish here with a study conducted by American research firm Dalbar, that looks at rolling periods of 20 years, and how an average investor in mutual funds compares to the Standard & Poors (S&P) Index.
S&P Index – 9.14%
Average Equity Mutual Fund Investor – 3.27%
This was the result of the 20 year period ending 31/12/2010, but shows a typical 6% behaviour gap that has been repeated in their various studies over time.
So this is why we believe in a buy & hold strategy – it works.
Quotes by Albert Einstein and Nils Bohr are perhaps relevant:
“Insanity: doing the same thing over and over again and expecting different results.”
“Prediction is very difficult, especially if it’s about the future.”
It is vital for a successful investing experience to eliminate emotion from your decisions. The evidence is there to see – it can really harm your wealth!
Review how you invest your money. Are you making some of these mistakes by letting emotion rule your decisions?
Ray Prince is a fee based Certified Financial Planner with Rutherford Wilkinson ltd, and helps UK Resident Doctors and Dentists plan to achieve their financial objectives. Just visit http://www.medicaldentalfs.com where you can request your free retirement planning guide.
Rutherford Wilkinson ltd is authorised and regulated by the Financial Services Authority.
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