Investing success hinges more on mastering our emotions than it does mastering financial markets. That's because of how susceptible we are to a host of unconscious biases which often hijack our rational thinking. Identifying our emotional shortcomings is the first step in combating them. The second is putting in place steps to counteract these impulses writes David McLeish from Fisher Funds.
Investing isn't easy. This isn't just because of the collective knowledge and skill of market participants with whom we all compete with for great investment opportunities though. As if that wasn't enough, we also have ourselves to contend with.
As humans we are hardwired to act according to a series of deeply ingrained cognitive biases – many of which undermine our chances of investment success. What's more, we are most vulnerable to these behavioural flaws at precisely the wrong time – just when the opportunity is greatest for those who can keep a cool head and remain rational.
Avoiding loss is not a good investment strategy
Our aversion to loss is one of the most deeply ingrained biases of all. That's because our survival as a species has depended on it for thousands of years. But when it comes to investing, this bias can flood our emotions with fear when instead courage is required.
We all know that buying low and selling high is a winning long-term investment strategy. But instead of reacting rationally when bargains are to be had, this bias focuses our minds on the impact that falling prices have already had on our portfolio. The result is a compulsion to want to stop the pain by any means possible, causing us to sell when markets are down.
Acting on emotions can be disastrous for your investment returns
Every one of the 10 best return days in the US share market over the last forty years has occurred within periods of major market corrections – for example immediately following the Black Monday 1987 crash, during the Global Financial Crisis of 2008-9, and at the height of the Coronavirus Crash of early 2020.
Had investors not been invested on those 10 days, their 40-year investment return would have been less than half the return of an investor who had remained invested throughout this time. This massive difference in investment outcomes goes to show just how big the implications are from letting our loss avoidance bias control our actions.
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Betting that share markets will continue to fall hasn't been a great strategy either
Another closely related bias is how we over-emphasise recent events in our decision-making. Also known as the recency bias, this causes us to expect the recent past to be repeated in the near future. This too is a dangerous investor trait when markets are falling – given the share market is down only roughly 34 per cent of all months.
An examination of the investment flows in and out of the longest standing equity fund we have at Fisher Funds, the New Zealand Growth Fund, strongly confirms this tendency. In every month following the 10 largest quarterly falls in the New Zealand share market since 2007, clients have overall withdrawn funds. That is clients consistently sell down their equity investments after large falls in the share market.
If you see a bandwagon, it's too late
A third bias which feeds on the prior two, is when people believe a course of action is the right one just because "everybody else is doing it". Known as the Bandwagon Effect, this bias allows people to rationalise irrational behaviours, like the ones previously mentioned in this article. At its worst, this can result in panic buying or selling – neither of which have a track record of success.
Self-awareness and self-management are the key to unlocking better investment returns
Recognising when these biases are impacting our thinking is an important first step to catching them before they cost us money. This alone will put you miles ahead of the investing pack.
However, our awareness of these mental flaws won't always stop our emotions from hijacking our actions. When you feel that happening, stop. Give your left brain time to wrestle back control. Ask yourself questions about the basis for your decision and force yourself to produce hard evidence that backs up your proposed action. This can trigger more logical, fact-based thinking. Consulting a trusted adviser can also help.
While we can't erase our biases altogether, by being aware of them and putting in place steps to counteract them, we can vastly improve our chances of investment success.
• David McLeish is a Senior Portfolio Manager – Fixed Interest at Fisher Funds.