By Grant Lister, Alexander Forbes Private Wealth.
The last quarter of 2018 can be described as the worst period that investors have experienced since the global meltdown of the financial markets in 2008/9.
When these moments of market correction occur, astute investors sit tight while others panic and make irrational decisions. In the chart below we can see that as the markets are rising, our emotions are that of relief, thrill and euphoria. However, when the markets start to fall, we get anxious, experiencing emotions such as denial, fear, depression, panic and then we capitulate and move our money into “safe assets”, such as cash. Then, as the markets swing back, we are caught in a low growth fund at what should be the point of highest potential for earning.
So what are the psychological reasons for this behaviour?
This is the behaviour that only remembers the recent events and not the whole duration of the investment. It is the psychological observation that people’s judgments of the unpleasantness of painful experiences depend very little on the duration of those experiences.
The typical comment is that: “I have lost money”. Well have you really? Since the time you invested to the present, are you negative or positive. If you are a long term investor and have been in the market for the past five years, you most certainly have made money and not lost? Is your emotion only based on the past few months?
We tend to make judgments on the state of the markets based on recent events. There has been a major pull back in the JSE over the past quarter which makes investors forget the last positive 10 years of returns. Our decision making is based on the negative emotions recently experienced.
What is loss aversion?
Loss aversion is a tendency in behavioural finance where investors are fearful of losses and try to avoid losses more so than they tend to focus on making gains. For example, it is better to not lose R1 000 than it is to gain R1 000. The more one experiences losses, the more likely you are going to be prone to loss aversion. Interestingly, investors feel the pain of loss between 2 and 2.5 times as much as they enjoyed equivalent gains.
More often than not, investors find themselves buying high and selling low. And when the market starts selling off sharply, investors will panic, move their investments to cash, and sit on the side-lines. Unfortunately, some of the biggest one-day upswings in the market occur during these volatile periods.
If an investor stayed fully invested in the market from 1995 through 2015 they would’ve had a 9.85% annualised return. A period of 20 years however, if trading resulted in them missing just the ten best days during that same period, then those annualised returns would collapse to 6.1%. That is a result of missing just 10 days in 20 years.
Balanced asset allocation elevates a lot of this anxiety. Having your funds negatively correlated to each other will smooth out some of these bumps. Shares, cash, bonds and property and then a healthy global exposure will provide a platform for above average returns.
Check your emotions before making a financial decision. Remember it is about “time in the markets” and not “timing the markets”.