By: Paul Nixon, head of technical marketing and behavioural finance at Momentum Investments
It is estimated that up to a staggering one in ten South Africans suffer from dyslexia. A common side effect of dyslexia is that words and even numbers drift into and out of focus, which of course results in severe challenges to reading, learning and sometimes everyday routine tasks like paying a bill.
Unfortunately, something quite similar is symptomatic to the world of investing. We have long term investment goals that sometimes shift out of focus as we are faced with assessing the risk or danger inherent to a situation – for example the COVID-19 pandemic or even the US election that looms in November. How and why does this happen?
Money is an emotive subject and the relatively new field of financial therapy has drawn strong links between our ‘relationship’ with money, that begins in childhood, and latent financial behaviour this often results in. Renowned neuroscientist, Joseph Ledoux, used chemical trackers in the 1970s to trace the fear response to the part of the brain which became known as the brain’s centre for fear and risk.
Our natural instinct in times of apparent threat is to intervene and often this intervention, while ‘feeling’ right, is far from it. Airline pilots, for example, have instinct trained out of them to avoid pulling up (pointing the plane skywards) on the wheel in the event of an engine stalling. In a similar fashion, skiers are trained to lean forward to slow down, which seems completely counterintuitive.
Our long-term investment goals should be linked to our risk preferences. We can think of a ‘risk preference’ as a character trait of being attracted to or repelled by ‘risk’. Your personality, which is highly biological and hereditable, is strongly associated with the tendency of taking or avoiding risk and with resultant financial behaviour. We know that risk preferences are stable because experiments have shown that the proportion of people’s wealth that they choose to expose to financial markets is relatively constant, even in the face of bad news about the current value thereof. In the face of bad news like a global pandemic our perception of risk inherent to the situation causes this market dyslexia and we struggle to focus on our long-term goals. Instead, we focus on what is directly in front of us.
The result, however, is two problems. Firstly, when assessing risk in the short term we are predisposed to a number of processing errors. A good example is ‘problem framing’. This means that if we perceive a short-term loss, we may actually be more attracted by risk at the chance of recouping these painful losses. We often see this in casinos where people become more likely to gamble as they incur further losses. This is also clear in financial markets where investors become increasingly sensitive to decreasing investment returns and so more and more likely to try and find other investments that they believe provide a better chance at a recovery.
The second problem that may override our perception of risk is reliant on recent experiences. A series of investment gains could make us underestimate risk in financial markets while a series of losses may have the opposite effect. Our risk propensity may therefore make us risk averse after a loss or hungry for more risk after gains. Whichever effect underpins our decision may be based on faulty processing.
In both cases, however, short-term risk perception and the subsequent risk propensity or willingness to take risk has become misaligned with our long-term risk preferences. This ultimately results in decisions that detract focus from the long term. This behaviour is highlighted in a recent white paper by Momentum Investments that analyzed the risk behavior of over 40 000 investors over more than a decade.
There are three simple rules to investing that apply in all markets. These rules force more focus on our long-term investing goals:
- Put your money to work: The largest behaviour tax investors will pay is from sitting on the sidelines and waiting for something to happen or being overly conservative. Investing in companies or stocks over the longer-term must yield a return above debt instruments. Firms are borrowing, confident that they are able to generate profit over and above the cost of this capital and investing in these shares allows investors to participate in the resulting successes and failures alike.
- Take your free lunch: The cliché about eggs and baskets is still very relevant. By spreading risk across different types of investments, the investor can mathematically enhance returns or reduce risk even below the average risk of the portfolio. This is why an outcome-based investing portfolio is so effective. The mix of assets is always optimised to get investors to their goals.
- Leave it alone! Unless your circumstances or the goal changes, the plan to reach that goal shouldn’t change either. The best thing to do in a global pandemic or before, after or during the US election is therefore simply, nothing.
With Momentum Investments, its personal. We help you stay focus on what matters – your investment goals – with solutions that are designed to give you the best chance at achieving those goals.