Ditch the emotion when you invest
Investing is not easy – particularly when all investors are tempted to act on irrational impulses. Guy Beck highlights the overwhelming evidence that we should do otherwise.
While we all like to think that we are capable of making rational decisions, it appears that when it comes to investing, a switch inside even the most sensible person seems to flick and rationality disappears in a cloud of emotion.
Being an investor is not easy. We have to contend not only with the erratic and unpredictable nature of markets but also the sometimes inconsistent way in which we will be tempted to think and behave.
All investors should try their best to make rational decisions and to make their head rule their heart. Yet for many, while understanding that being rational makes sense, putting it into practice can be exceedingly difficult.
Benjamin Graham, one of the great investment minds of the 20th century, famously stated: ‘The investor’s chief problem – and even his worst enemy – is likely to be himself.’
Irrational investing manifests itself in many different ways:
- Chopping and changing one’s investment plan influenced by what has just happened to the markets;
- Trading shares in an online brokerage account;
- Trying to pick market turning points; for example, when to be in or out of different markets
- Being tempted into buying flavour-of-the-month investment ideas or chasing fund performance.
The list of irrational decision-making opportunities is long and undistinguished.
John Bogle summed this up perfectly in an address to the Investment Analysts Society of Chicago (2003): ‘If I have learned anything in my 52 years in this marvellous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns than the economics of investing have ever dreamed of destroying.’
Emotional cost
The ‘emotional cost’ of investing can, at times, be extremely large. By emotional costs, we mean the impact on returns that are caused by our own actions or inactions – our behaviour – rather than the markets.
People’s temptation to try to get in – or out – at the right time is huge. Imagine if you could have avoided the 50% market fall during the global financial crisis of 2007-08, or the blink-and-you-have-missed-it Covid crash in early 2020 and bought in again at the bottom.
By and large, investors have a woeful track record of timing when best to jump in and out of markets. It is worth remembering that you have to get two decisions right when market timing. The first is when to get out. The second is when to get back in again.
The problem is that markets work pretty efficiently at reflecting new information into prices of company shares and bonds quickly and thus every decision you make is a bet against the aggregate view of all investors trading in the markets. Markets move on the release of new information which is, by its very nature, random.
The returns that a fund delivers are known as time-weighted returns. The return an investor in a fund actually receives is known as the money-weighted return and will be impacted by the magnitude and timing of cash flows into or out of the fund that they make.
Behaviour gap
A well-known piece of research from Morningstar’s ‘Mind The Gap (2023)’ report estimates this ‘behaviour gap’ to be around -1.7% per year on a large sample of US funds.
The solution to this behaviour gap? Own a sensibly diversified portfolio with sufficient higher-quality, shorter-dated bonds to provide protection from portfolio falls, allowing you to stay invested throughout these inevitable episodes of market turmoil that arise from time to time.
As John Bogle, the founder of Vanguard used to say: ‘This too shall pass!’
Guy Beck (right) is a senior financial planner with Cavendish Medical, specialist financial planners helping consultants in private practice and the NHS
The content of this article is for information only and must not be considered as financial advice. Cavendish Medical always recommends that you seek independent financial advice before making any financial decisions.
Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. The value of investments and the income from them can fluctuate and investors may get back less than the amount invested.
