Emotions get the best of most investors.
As an investor, have you taken stock of your personal behavior as it relates to managing your own money?
If you haven’t, let me tell you it matters—a lot.
It’s well documented that investment success is linked in part to behavior. Some investors continue to make the same mistake over and over again: They buy high in the face of euphoria and sell low in the face of fear.
In fact, I suspect such behavior has a lot to do with the horrible returns the average investor has achieved from 1991 to 2010 as reported by a recent DALBAR study. It is a pitiful 2.6 percent annual return.
Making bad bets in the face of euphoria and fear have a long record in the financial markets. But why do investors do it over and over?
If you ask any expert in behavioral finance, they’ll tell you we can’t help it. The discipline’s most popular themes like heuristics, framing, and anomalies covering topics like prospect theory, mental accounting, and herd behavior, all tries to provide scientific answers to the very unscientific question: Why do investors keep shooting themselves in the foot?
Here are a few reasons:
You are only using half of your brain.
Research suggests that your right brain is dominating your left brain. The right side of the brain—the emotional, primitive side—overrides the left or logical and analytical side of the brain when investors evaluate their decisions. Essentially, the emotional inputs are so strong that they routinely override any reasonable analysis when it comes to investing. There are several emotions that play into investment decision-making, but it’s constructive to look at two of the most obvious: overconfidence and loss aversion.
You think you are better than average.
That’s called overconfidence.
A 1981 survey of automobile drivers in Sweden, pointed out by JP Morgan Asset Management, shows that 80 percent of the drivers surveyed said they were better-than-average behind the wheel.
I’m not trying to be the “Master of the Obvious” here, but only 50 percent of the drivers can be better than average! This simple example of human nature goes a long way toward explaining a lot about why investors overestimate their ability to pick winning investments. Think you’re a better-than-average investor? Studies show you are probably not.
Again, just look at the recent study by DALBAR – and that 2.6 percent annual return – while according to JPMorgan Asset Management, the worst return for the S&P 500 over a 20-year rolling period, going back 61 years, is 6 percent.
The reasons for this disparity are myriad, but they definitely include overconfident behavior – such as thinking a personal prediction is the best one, excessive trading, market timing, and selling winners too early combined with keeping the losers too long.
Six of one…isn’t that the same as a half a dozen of the other?
It depends on you. It’s a function of more emotion. It’s called loss aversion. According to work by economist and Nobel Prize winner Daniel Kahneman, investors feel twice as much emotion over losing money as they do over making money. Said differently, investors feel more regret than pride when they weigh their investing decisions. A gain of 10 percent feels good, but the pain of a 10 percent loss feels twice as bad.
From my perspective, that’s why people went into a tailspin over the losses incurred over Thanksgiving week (the S&P 500 lost 4.69 percent) but very few people seemed excited last week over the best weekly return in the S&P 500 since the fall of 2008 (a 7.5 percent gain).
It’s dangerous because investors lose context. Have you ever said to yourself, “I’m going to hold that stock until it gets back to even.” It happens all the time and when coupled with overconfidence, it really hurts performance.
Protecting yourself…from yourself.
Most people plan for market returns, but end up with the returns like those noted above. That’s a shame, because if most investors who ended with up paltry returns simply removed emotion from the equation, they probably would have ended up with something much closer to the 6 percent S&P 500 return mentioned previously – which again was the worst return over a rolling 20 year period.
The solution? Formulate an investing strategy based off your Private Wealth Design and stick to it. When managing your own money, base your investment decisions on either your immediate need for liquidity or on a long-term strategy within a complete and comprehensible financial plan, despite any fear or euphoria you may feel.
And if you don’t have a plan, please get one.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. All performance references are historical and are not a guarantee of future results.
All indices are unmanaged and may not be invested into directly.