Emotions and investing
"Emotions are contagious, and emotions have no business in investing." Well, that’s easy to say for someone who is arguably regarded as one of the best investors, if not the best, on the planet – Warren Buffett.
But the somewhat disappointing reality is that there can only be one ‘Oracle of Omaha’ and that as investors we’re all irrational in dozens of subtly different ways.
In this context, Behavioural Finance can offer both fascinating and yet at the same time confusing insights into the human psychology. It offers long lists of psychological biases to which we’re all prone by virtue of the simple fact that we’re human but little in the way of practical advice of what to do about it. Below you’ll find a list of six tangible things that we all most often get wrong in investment decision making. Focusing on getting these right won’t necessarily turn you into the next Warren Buffett but will be likely to help you become a better investor.
- Failing to see the big picture:
Conventional finance theories still argue that individuals act rationally and consider all available information in their investment decisions. Unfortunately though, the Homo Economicus is a theory that does not stand the test of investing in reality. In fact, studies have found that people tend to make investment decisions without considering all implications. This is a trap that psychologists call ‘narrow framing’. We tend to focus on investment decisions one by one, without considering the impact on our overall portfolio. This means we miss out on diversification opportunities, make new investments that cancel out existing investments, or decline opportunities that look risky on their own but would be a good addition to the overall portfolio.
- Using a short term decision horizon:
There is no definition of short term vs. long term investing that is either commonly accepted or particularly tidy in its reasoning. However, what is commonly accepted is that we frame decisions narrowly in time. We base our decisions on anticipated performance over short time periods, when what matters is growing our wealth in the long term. The time horizon we pick makes a big difference to how we evaluate an investment. For example major equity indices have posted losses in about 40% of one month periods – which doesn’t seem a good investment. Over 5 years, however, we would have only observed losses about 15% of the time, and almost never over 20 years.1 Perceived risk is magnified by short time horizons. Most of us take too little risk because our emotional time horizon is myopic, relative to what matters. We misalign our decision frame to our objectives.
- Buying high, selling low:
We naturally tend to be more prepared to take risks when we’re comfortable, and fewer when we’re not. When are we comfortable? When markets have been rising for a while and we’ve been surrounded by good news. We’re uncomfortable when we’ve been through times of stress and chaos. Unfortunately this means we all have a strong tendency to take on a little bit more risk when markets are high, and less when they’re low: we buy high, and sell low … and would do better just to buy and hold. Or, to use another of Warren Buffett’s famous quips: “Be fearful when others are greedy and greedy when others are fearful”.
- Getting emotionally attached to concentrated investments:
I often speak to clients who have a concentration of wealth in one or more stocks. They of course know they should be more diversified, since concentrated positions in any security represent potential investment disaster, particularly when those positions are in the company they work for. However, selling these positions can be a challenge when we have become emotionally attached to them – maybe they were left to them by a relative or something bought on a whim years ago. The first step to overcoming this bias is to acknowledge that it exists and the significant potential risks of it, then to seek competent advice to help make decisions based upon objective knowledge.
- Action Bias – trading too frequently:
Many of the above biases lead to this one … for example, narrow framing leads us to make small frequent decisions. However, even without the biases above we generally do too much; in volatile markets, in particular, we have a strong bias towards wanting to do (or be seen to be doing) something about this turbulence – it makes us feel better. If your portfolio is reasonably well structured to start with, however, then usually simply doing nothing would often be a much better option. The more you trade, the higher your costs, and the higher the chance of trading emotionally or based on pure noise or inaccurate information. Most of the time the best advice is simply to do less than you’re inclined to.
- Mental accounting – failing to deploy your finances where they are most effective:
All of us are guilty of the tendency to mentally break our finances into categories (known as mental accounts) and treat each differently: essentials, vacation money, savings, inheritance money, etc. This can simplify decision making and help us to keep track of everything, but also leads to inefficiencies because we fail to notice that if we transferred money across accounts we’d be better off. For example, many people roll over large credit card balances charging high interest rates, whilst maintaining savings balances paying very little … and just never notice that this is simply giving away money because they mentally compartmentalise these as two quite different accounts. Money is fungible … let it go where it’s most effective. In particular try not to compartmentalise your investments, but make sure they all work together in an effective overall asset allocation.
Remember always that no matter what approach to your investment you take, they can still fall in value and you might get back less than you invested.
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