Breaking the Cycle of Investment Regret
May 26, 2014 by Dave
Filed under Investing, Investor Behaviour
Franklin Templeton Investments has produced a booklet to help investors harness emotions to make better investment decisions. The issue is that although equity investment returns become stable once you stand back far enough and can see the very long term, within months, years or even multi-year time frames, returns are very variable, leading investors to draw conclusions and take actions that are usually counterproductive.
The field of behavioral finance is emerging as the study of how reason and emotion interact to produce financial decisions. Whereas conventional economic models assume that individuals will act rationally, behavioral finance recognizes that many decisions are made irrationally and that individual smay even make the same mistake repeatedly over the years, even when the error has been pointed out to them.
The booklet reviews some of the brain structure related to such decision making, then goes on to explain several of the most common behavioral mistakes.
1. Loss aversion: the pain of loss outweighs the pleasure from gain. Since 2008 the tendency towards loss aversion has been demonstrated by the repeated monthly withdrawal of assets from equity funds, despite very healthy returns from this category.
2. Anchoring: holding fast to the past. People tend to use a particular point in time as their reference point. For example, if I made an investment in the world equity market at the end of 1999, I saw a big downturn, a recovery to the previous high level, another decline and then another recovery, all in just over 10 years. The market is what it is and does what it does, regardless of when I invested my money. There is a tendency for me to want to sell when my market value recovers to a prior level and to not invest more until that time. In 2003, after the approximately 50% decline on the broad market and at the beginning of a recovery, a client who started investing right at the end of 1999 looked at his account report and told me he was not going to invest another dollar until his account had recovered to its original value. When I pointed out that this meant he would only invest more AFTER gains of close to 100%, he said that yes, that was exactly what he meant. My efforts to point out that logic dictated investing BEFORE prices rise were in vain. Although markets did indeed recover with time, before too long he transferred his account elsewhere without adding a dime to his investments. For me, this was a crystal clear example of emotional decision-making at work.
3.Herding: our tendency to follow the crowd. While in some parts of life following the crowd may be helpful, it is often harmful when investing. For example, many investors are as concerned about beating the market or the competition as they are about achieving significant financial goals such as retirement income security. Beating the market is not a personal financial goal and certainly does not accomplish success by itself. In my career I have seem investors rush into emerging markets, technology, resources, housing and bonds – at least five examples of herding that did not end well for the participants. Herding often leads to under-diversification and thus increases risk. To avoid herding, a caring financial advisor will insist on a policy of rational diversification and objective decision-making. Many times I have told clients NOT to invest in something and this doing of nothing has proven to be extremely valuable. Many investors do not realize that an advisor can add as much value by helping to avoid mistakes as he can in recommending the right things to do. The problem is that mistakes avoided do not show up on an account report, and so this value is often under-appreciated.
4. Availability bias: most recent is most relevant. People tend to make decisions based on the most current information or what is the most easily recalled. For example, the media may report heavily on a particular event or trend, and this focus may lead investors to adjust their strategy, even when their existing plan was doing just fine. There is a tendency to want to take action, to DO SOMETHING when confronted with news. Unfortunately, a solid financial and investment plan should be quite boring, and some people find this dissatisfying, preferring to take actions that may damage their plans.
5. Mental accounting: the value of money varies with the circumstances. People tend to compartmentalize certain pieces of their wealth and treat them differently without reasonable cause. They may view money that is earned differently than money that is inherited, money in one account as different from another account, or money targeted for retirement as different from other long term goals.
To make effective financial decisions requires a few foctors to be working together. First, it is important to work with a financial advisor who understands behavioral tendencies and is not afraid to tell you the unvarnished truth – to tell you when you are about to make a mistake and why. Second, it is important to know yourself, to learn from your experiences and remember errors that you made or were going to make. Third, have a structured investment plan that is focused on the appropriate time frame. Remember, investing is actually boring. Finally, take the time to make informed decisions and educate yourself over time. Once a financial plan is in gear, avoid the tendency to make large decisions over and over again. Success is not an overnight event but a gradually evolving process of working with your financial advisor over the years, building a stronger relationship while you become a better decision maker.
The full booklet can be found by clicking on this link, or going to the web address below.