Guarding against mindless investing
As we all know, investing money can be challenging at the best of times. And many of our behaviors when facing uncertain or stressed markets can have an impact on our financial outcomes.
As the global pandemic has presented us with increased volatility and uncertainty, we thought it would be beneficial to look at some of those behaviors, remind ourselves of the risks they can present and discuss how to combat them.
Behavioral bias: What drives investors to select one response over another?
This is dependent upon a number of factors: the investor’s objectives, including their risk tolerance and return target and the investor’s beliefs on market cycle positioning and the potential market outcomes during that time horizon. Depending on the investor's beliefs, preferences, emotions and past experiences, they can come to contrasting conclusions. This results in different investor behavior and sometimes opposing investment strategies.
Humans are human
Human beings are not machines. Traits such as overconfidence, narrow framing and loss aversion are well–documented and can impact how investment decisions are made, contributing to errors such as buying high and selling low. Advisors should not ignore human nature and rather find ways to work with it, taking practical steps to create better investment outcomes for their clients.
Houston, we have a problem
Our brain is an incredible organ, it processes more than 11 million pieces of information every second – yet sometimes, our brain fails us. It can lead to the wrong answers or desert us altogether. Our brains have two parts: the intuitive and automatic part, known as the Blink side; and the reflective and rational part, known as the Think side. When we invest, we can often end up trusting the initial Blink side of the brain, which provide emotional reactions to issues and only occasionally do we recruit the Think side of the brain and be more rational in our decisions.
What sorts of behavior does this drive investors toward?
This refers to an individual’s tendency to prefer avoiding losses to acquiring equivalent gains: the pain they experience from the loss is nearly twice as strong as the pleasure from the gain1 , resulting in wanting to avoid losses more than seek gains. In February and March 2020, global equities experienced their fastest–ever 30% decline. Investors selling their investments at this point, would have missed out on the subsequent recovery (as of 16 November, MSCI World in GBP terms is not only recovered all the loses from earlier in the year, but is at above its highest level pre COVID–19).
Recognizing this potential brain flaw in ourselves can help us relate better to our clients. When investing, overconfidence often translates into trading a lot and having high portfolio turnover. Overconfident investors tend to trade more. They may also tend to be more thrill–seeking: drawn to trading because of its perceived entertainment/gambling–like value.
You've seen it happen and have probably spent time talking clients out of this instinct to chase returns.
By the time investors can identify a clear trend of the past in order to extrapolate it into the future, they have missed most of the move.
Unfortunately, this bias leads an investor towards buying high and selling low, not a winning investment strategy.
Source: Refinitiv DataStream, Investment Funds Institute of Canada, Russell Investments. Flow of funds based on IFIC monthly fund flow data. Growth of $100,00 based on S&P/TSX Composite Index annualized returns from January 1, 2006 to December 31, 2019. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
Think back to your most recent trip to the supermarket – despite the vast amount of choice most of the time, we arrive in the same aisles and we stick with what’s familiar to us. What does this behavioral bias look like when we are investing? It can have an impact on our decision–making process, missing out on potential return opportunities as we are blinded by familiarity.
Your value as an advisor
These common behaviors are predictable, and what’s predictable can be managed. As humans, we all suffer from some biases. But many of these can be reduced by a robust, objective and disciplined process, and as an advisor you are well-placed to help your clients stick to their process. Talk to them about the common biases that exist, get them to think about which biases they may have, and then discuss the strategies you can use to overcome them.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
1 Kahneman, D. & Tversky, A. (1979). "Prospect Theory: An Analysis of Decision under Risk". Econometrica.