The turning of the calendar creates a natural point to reassess how your investment strategy has fared over the past year. For the most part, this can be a reassuring way to understand that you are still on track for whatever investing goals you set for yourself, but it can also be misleading. At this time of year, we should all be careful because our actual investing experience and the memories of our investing experience may not be the same.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
Studies in psychology have shown that our memories can be influenced by a ‘peak-end’ rule. This leads to the rather bizarre finding that people tend to prefer a more drawn out painful medical procedure, which although painful, ends with a relatively less painful period, as opposed to a shorter procedure which ends with more intense pain.
5 Key Takeaways
- At this time of year, we should all be careful because our actual investing experience and the memories of our investing experience may not be the same
- Studies in psychology have shown that our memories can be influenced by a ‘peak-end’ rule
- It is unlikely that the arbitrary point created by a new year will also be when your portfolio is at a peak – this leads to an almost perpetual sense of dissatisfaction with the investing experience caused by our memories of events anchoring us to peaks along the way
- Calendar years are a natural way to frame performance, but you should be careful to look across a number of years to get a better sense of the average level of risk and return within your portfolio
- Long-term investors in a globally diversified portfolio have taken the first steps to investing success simply by getting invested
The peak–end rule - A psychological event in which people judge an experience largely based on how they felt at the end and if this was its peak (i.e. its most intense point), rather than based on the total sum or average of every moment of the experience.
The peak-end rule
A similar peak-end rule can apply in investing. Investors will recognise that how you achieve your returns matters. Think about two investors, who got exactly the same return over the year. They should both be equally happy, shouldn’t they? But what if one of the investors, let’s call her Mrs. Peak, had a strong rise to the middle of the year followed by some losses from that peak just before year-end. The other investor, let’s call him Mr. Trough, lost some money early in the year and then recovered to end with a gain. The peak-end rule would suggest that Mr. Trough is a happier investor than Mrs. Peak. After all, Mr. Trough’s end point was also his peak (Figure 1).
As we come to the end of the year, each investor’s experience will be different depending on their asset allocation. However, for many investors, 2016 may well have felt more like Mr. Trough’s experience. Stock markets on both sides of the Atlantic have reacted better than widely feared to this year’s political surprises and the weakness in sterling further boosted returns from globally diversified portfolios for sterling denominated investors.
The story at the end of any given year could be very different though and you should recognise that any year could feel much like Mrs. Peak’s experience. It is unlikely that the arbitrary point created by a new year, or receiving your latest statement, will also be when your portfolio is at a peak. This leads to an almost perpetual sense of dissatisfaction with the investing experience caused by our memories of events anchoring us to peaks along the way.
It’s all in the timing…
The way to overcome this behavioural trap is to recognise when discrete time periods of performance are influencing your experience. Most of us are aware that a year-to-date performance number is fairly meaningless at the end of the first trading week of the year.
However, for the long-term investor who has a multi-year investment objective, it is just as meaningless in the last trading week of the year. Calendar years are a natural way to frame performance, but you should be careful to look across a number of years to get a better sense of the average level of risk and return within your portfolio.
As we enter 2017 our behavioural perspective remains unaltered – risks that we know about will either disappear or become certainties, and new risks that we haven’t even contemplated will become apparent. Remember, it is because of these risks that you are investing and not despite these risks. Long-term investors in a globally diversified portfolio have taken the first steps to investing success simply by getting invested. There may well be times when your resolve is tested and staying invested feels uncomfortable. In these periods, managing your short-term emotional state may dominate your desire for long-term returns. The bias to take action will be tempting but can also be destructive. Rebalancing your portfolio in these periods can provide emotional comfort from taking control of the situation and also enforces good portfolio discipline.
Finally, the peak-end rule is reinforced by news headlines of markets reaching new highs and of the days when commentators squawk of the billions being wiped off the value of investments. These headlines seldom match the experience of a diversified investor but can provide a salient memory which affects your satisfaction. Focus on what matters – reaching your investing goals and objectives.