Sometimes in life when you’re faced with a tough decision, you’ve just got to go with your gut.
Investing is not one of those situations.
As humans we have evolved over thousands of years to possess an instinctive fight or flight mechanism, a natural urge for survival that kicks in during times of great stress.
Unfortunately, as investors we have not yet evolved quite enough to habitually react to stress in the capital markets with intellect, rather than instinct.
This urge to run, to flee the downturn and seek shelter in safer financial surroundings is only natural and often understandable – but that doesn’t make it right.
Investors can be all too ready to point the finger when their portfolios don’t perform as expected. But very few of us realise that our decision to act on instinct, rather than the prevailing market condition, is often to blame for our investment’s under-performance.
Investors are under-performing their own investments.
Studies of investor behaviour have shown that emotional decision making (reacting to market downturns and/or chasing performance) has seen the average managed fund investor under-performing the broad market index by about 3.5% per annum over 20 years.
A 2016 report compiled by leading financial analysts DALBAR concludes that investment results are more dependent on investor behaviour than on fund performance, with those holding on to their investments more successful than those who try to time the market.
In addition, investors who leave the stock market during times of volatility may miss the best trading days (and the market recovery).
This can have a dramatic impact on long term investment performance.
Data compiled by one of the world’s largest investment management companies illustrates the variability at play when investors try to time the market.
Take for example the annualised return of the ASX 300 – the investment index that tracks the combined performance of Australia’s 300 largest listed companies.
Excluding the 10 worst trading days in the five years to December 31, 2015 would have delivered a healthy 13.7 per cent return per annum, while those unfortunate enough to miss the 10 best trading days in that time would have only experienced a 0.6 per cent return per annum.
On the other hand, those who stayed the course throughout the troughs and peaks would have recorded a solid annualised return of 6.7 per cent.
Similarly, looking at the ASX 300 over a 15-year period – investing is about playing the long-game after all – the variability between the returns appeared to be smaller (12 per cent per annum without the worst performing days, compared to 4.6 per cent without the best performing days). However holding fast throughout led to an improved 7.9 per cent return per annum, which would be a healthy portfolio performance in anyone’s books.
Sometimes, the best thing to do is nothing at all.
A study by behavioural economist Ofer Azar, which appeared in The Journal of Economic Psychology, collected data on more than 300 soccer goal keepers to show how action bias can influence goalies (and investors) in their decision making.
The premise was that a goal keeper’s emotional reaction to failing to stop a penalty kick was stronger when they did not act – that is, remained in the centre of the goal – as opposed to when they made a decision to dive left or right, despite not knowing which way the ball will go.
This emotional response helped create an unconscious bias towards acting – choosing to dive one way or another – despite the fact that an analysis of penalty goals showed not acting (i.e. remaining in the centre of the goal) gave them the best chance of stopping the ball.
Mr Azar concluded that investors could also be affected by this emotional bias towards acting during a downturn on the market, making them more likely to sell their investments (action) rather than leave their portfolio alone (inaction), regardless of the financial advice they receive.
The only certainty in investing is that there will be periods of uncertainty in investment markets.
Maintaining discipline and focusing on your long term plan is crucial when faced with these fluctuations.
Successful long term investing is as much about managing your behaviours and emotions as it is about selecting investments.
As American football coach Lou Holz once said: You don’t need the big plays to win; you just have to eliminate the dumb ones.
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