To illustrate our emotional responses to the short-term environment, we have adapted a much-used diagram to map out the investor’s probable response to the rise and fall of his/her investments.
Residents of the United States, please read this important information before proceeding
The version below is the result of more than half a decade of studying investor responses to extreme market conditions.5
At each point along the cycle, investors make specific trade-offs between emotional comfort and long-term returns, all of which have connections to our Financial Personality Assessment™ and to the specific actions we recommend to tailor investment solutions to each unique investor personality.
Figure 4: Cycle of investor emotions
The baseline: reluctance and myopic loss aversion
It is worth starting with the word that occurs at both the start and end of the chart: reluctance. This is the ‘default’ state of most investors. In normal circumstances we fear taking a risk and getting it wrong, more than we fear missing out. This reluctance to get involved is compounded by another strong behavioural effect: loss aversion. Simply put, when we make decisions, “losses loom larger than gains” 6 – we believe we will feel more emotional pain from losing a certain amount than the pleasure we experience from gaining the same amount. This may seem intuitive, but it has huge implications for investors. The proportion of loss we perceive for the same portfolio can be manipulated by how returns are presented to us.
Let’s look at the issue from a slightly different angle. Our decisions, made in the frenetic short-term environment – the zone of anxiety – create a very different investment experience to one that is focused on the long term.
Figure 5: Annualised returns as seen through long-term and short-term frames
The chart above shows the annualised returns that an investor in the MSCI World Index would have experienced over time, depending on whether they focused on long- or short-term returns. The smoother (blue) line shows a rolling window of annualised 10-year returns. This line illustrates the returns perception along the journey that should inform our decisions. Ninety-six per cent of the time, the 10-year returns are positive; only turning negative in the catastrophically bad times at the depth of the credit crisis.
Contrast this with the more extreme line, which reflects rolling 1-year returns, which is much more akin to the actual perceptions of investors along the cycle (although, these tend to be even more extreme). In general, the same investment can feel completely different depending on the time frame over which we observe it. As evidenced in the diagram, investors experience vastly more volatile returns if they use a short-term horizon; unfortunately, as we all live in the present, short-term is our natural psychological default. And this comparison between 10-year and 1-year returns understates the magnitude of the problem.
One year is investors’ typical evaluation horizon only in calm times. In times of stress, investors’ emotional horizons can be much shorter. And 10 years may well be on the short side of when many investors actually need to withdraw their capital; for many, investing is about growing a capital base indefinitely.
Failing to invest completely is the first way in which we naturally purchase short-term emotional comfort at a cost to long-run returns. It provides this comfort in a very simple way – you cannot lose if you don’t get involved – but at a very high price.
The expected cost depends on the expected returns from each investor’s ideal portfolio. But it is helpful to look at an investor with moderate Risk Tolerance in a globally diverse multi-asset class optimal portfolio. The expected returns beyond what you’d get from cash for a well-designed, moderate risk portfolio are around 4–5% per year averaged over the long term.7 This is the amount that investors with cash sitting idle pay for their emotional comfort. Leave half of your wealth un-invested and on average you’ll forego gains of 2–2.5% of your total wealth every year. An immensely expensive way to sleep better at night.
Some investors who are naturally prone to reluctance do manage to find ways of getting into the markets comfortably, but this also typically comes at a cost relative to a perfectly efficient portfolio. Such investors will often sacrifice financial efficiency for comfort, for example, by investing only in familiar or local assets, by paying for unneeded financial protection against short-term dips, or by phasing the investment in gradually over time.
These inefficiencies would never be recommended by classical finance professors, but can make a great deal of sense (if not taken too far) for investors who would otherwise be too reluctant to invest at all. What all of these hesitant investors have in common is that they offer a convincing narrative – in some cases in addition to real protection along the journey – that enables the reluctant investor to get into the market.
Unfortunately, our desire for a convincing narrative can be dangerous: The story that is often most successful in overcoming reluctance is a sustained market boom. With the economy booming, and the stock market posting gain after gain, it can start to feel as if losses are highly unlikely. This, combined with being invested in concentrated assets that we think cannot lose, can lead us to chase past success, buying investments with a good recent track record or chasing ‘hot’ funds (with good accompanying stories... tech stocks, anyone?). The evidence tells us that these almost invariably lead to poor performance, but despite the clear dangers of ‘buying high’, jumping in at the top of the market is the way many investors finally overcome reluctance.
“Once you exit the market for emotional reasons, you can’t quickly and easily get back to optimism, but have to gradually claw your way back through despondency, depression, apathy, indifference … and reluctance. This can take many years”
Post-investment: trading can be hazardous to your wealth
Overcoming reluctance early is one of the keys to better investing. Unfortunately, getting actively involved doesn’t mean it is then easy to reap the long-term benefits of being invested.
Investors still need to feel comfortable while putting their wealth at risk, and usually incur further costs relative to the long-term optimum through being too active with the wealth they do invest. Our strong tendency is to do too much. As we’ve seen, being invested in the zone of anxiety is uncomfortable.
One response is to opt out, but frequently those who do invest will make themselves comfortable by being excessively active; by over-trading; constantly trying to adjust their portfolios and take advantage of perceived patterns in the market; and by increasing risk when they feel comfortable, but decreasing it when they feel uncomfortable.
Of course there are good reasons not to be completely inactive in managing one’s investment portfolio. The chief one is rebalancing periodically to reduce the weight of assets that have risen considerably, and increase those which have fallen (this also ensures that the risk of the portfolio doesn’t change dramatically over time).
But frequently, trades are enacted more in response to random market movements than to genuine changes in the risk-return expectations of assets. At best this drags down performance due to high transactions costs. But the effect can be considerably worse: the short-term emotional component of these decisions tends to lead us to take on more risk when it feels comfortable to do so (when times are good and markets are rising), and to pull away from risk when things feel uncomfortable and markets are low.
In other words, when responding actively to the investment journey, our natural psychological tendency is to buy high, and sell low!8
The turnover test
One famous study grouped real investors into five groups according to the proportion of their portfolio they turned over every month. The bottom group barely traded at all, while the top group changed nearly 25% of their portfolio every month. This is a massive difference, and one reasonable interpretation is that the most active investors are presumably those who are reading the financial pages, paying attention to their portfolios, and staying informed. In other words, these are the experts. It would be reasonable to expect that this group did better from their investing than those who are not paying attention at all. But when the researchers looked at the returns of each of the groups, they found quite the opposite: The less investors traded, the better they did.
Figure 6: Trading can be hazardous to your wealth
We’ve seen, therefore, the costs of being perennially reluctant or perennially overactive. This does not mean that the investor is either only one or the other. Most of us are both simultaneously: leaving too much capital doing nothing on the side, but dabbling constantly with that portion of wealth invested. What action we take can change with the twists and turns of the market cycle. And both tendencies are costly ways of making ourselves comfortable in the short term. The vast majority of investors would do much to reverse this balance by putting all of their long-term wealth to work (i.e., excluding wealth that they need to meet cash flows in the short to medium terms) and then largely leaving it alone.
Changing responses through the cycle
As we describe below, the phases that investors pass through along the Cycle of Emotions can each be mapped to specific responses.
Optimism to (irrational) exuberance: herding and fear of missing out
As markets pick up and the economy enters a positive phase, our natural state of reluctance diminishes. Enough good news stories about successful investments, and friends telling you how well they’ve done in the markets, and our fear of failure quickly turns into a fear of missing out. Our natural aversion to loss may now cause us to take action to increase short-term emotional comfort, this time by entering the market. This now feels comfortable because we’re with the herd, not against it; and because the sustained period of positive results has helped to blur our recollections of losses and perceptions of risk (ironically, just when markets have furthest to fall). The more psychologically immediate loss is now the thought of not getting great returns when everyone around you is profiting from their investments.
In one sense the costs of this enthusiasm can be less detrimental than perennial reluctance. Buying high certainly reduces returns, but as long as you subsequently stick with it, eventually average returns will turn positive, which is better than the zero excess returns of being out of the market altogether. However, buying at the top also has the effect of making subsequent short-term experiences far more unpleasant, increasing the chance of compounding these costs with further emotionally driven decisions.
Denial to panic: reference points and endowment effects
The point at which we enter the markets fixes in our minds a reference point against which we judge further gains and losses. Should we enter at the top, a great deal of our future experience will be of loss. Since we’re so averse to losses, this frequently means that at the very point when objective evaluation of negative information is most useful to us, we take steps to shield ourselves from it.
So at the top, investors often have high expectations and decisions have a high emotional component. When reality starts to intervene, investors start to shield themselves psychologically from the bad news, and move into denial. This reluctance to sell often has the effect of keeping markets artificially high for a while, allowing the bad news to accumulate. No one wants to sell at a loss and so instead of falling, volumes dry up. This is particularly evident in markets for large, indivisible, illiquid assets that form a significant part of investors’ total wealth, and which have a strong emotional component – that is, residential property. But sooner or later some investors will be forced to sell, bursting the dam and precipitating falling prices. Investors then move on from denial to fear, desperation and panic.
Capitulation to reluctance: expensive comfort and the anxiety premium
On the way down, loss aversion and denial tends to cause investors to hold on to their investments. As their portfolio plummets, the emotional pain of selling at a loss increases too, but at a diminishing rate. Losing 5% hurts, but the first 5% hurts the most. Once you’ve already lost 30%, the difference between -35% and -30% feels less significant than the difference between -5% and no loss at all.9 Meanwhile, the emotional stress of sticking with falling investments, combined with the fear of even greater losses ahead, builds up and takes its toll.
Some investors sell at a loss because they’re forced to by a lack of liquidity, inducing the forced sales that often precipitate the rapid decline.10 11 But most of the time when investors sell in crises, it is not because they have run out of financial liquidity (at least, seldom to the extent of needing to liquidate their entire portfolio). More often the investor, rather than running out of financial solvency, depletes their reserve of emotional liquidity, and lacks the emotional resilience to hold their investments through the stress, fear and anxiety. Eventually the depletion of emotional liquidity, anxiety and fear of further losses trumps the aversion to realising losses already sustained.
In crises, we sell far more because we are scared, stressed and anxious than genuinely in need of our wealth to be in cash. This is not ‘irrational’ – it is perfectly reasonable to capitulate in order to remove the extreme anxiety of staying invested in a falling market – it’s just really, really expensive. Once you exit the market for emotional reasons, you can’t quickly and easily get back to optimism, but have to gradually claw your way back through despondency, depression, apathy, indifference… and reluctance. This can take many years, and in the process you miss out on the recovery from the bottom, which can often be both fast and powerful.
And, unfortunately, it is when markets are panicked, anxious or fatigued that the potential upside is greatest. Those investors who can overcome these short-term needs can capitalise on the anxiety and myopia of the rest. But, of course, it is at such times when this is most difficult. After a costly ride through the emotional cycle, we end up once again at RELUCTANCE, the baseline we started from, which causes us to forgo returns by not putting our wealth to work.