By: Siobhan Cassidy, MoneyMarketing Contributor
Facts are the investor’s friends, say the experts, but there is no point pretending that people can simply keep their feelings separate from their investment decisions. It is better for investors and their advisers to acknowledge feelings, understand the risks, and design plans that mitigate against them.
Investors are told to ignore the noise, the headlines and the market turbulence. Even when things look like they are going to hell in a handbasket, they are urged to keep their eyes fixed on the fundamentals and on the long term. So why do so many find it so difficult to fight the urge to respond and take action quickly (‘Sell sell sell,’ investors hear their instincts shouting)? “Because we are wired that way,” says Paul Nixon, Head of Behavioural Finance at Momentum Investments Group. “From an evolutionary standpoint, this makes sense as during stress in the past we needed a quick reaction and not logical deliberation.”
Linda Eedes, Investment Professional at Foord, agrees that “it has to do with evolutionary psychology”. She says, “Fear is a very basic survival mechanism. As a response to perceived danger, it’s very useful. As a species, it has served us well, but it can result in poor decision-making with regards to our investment decisions.”
Kurtney Durgaparsad, Technical Investment Specialist at Alexforbes, says, “Humans are inherently emotional beings, so removing all emotion from financial decisions is unrealistic.” Unrealistic but somehow necessary, it seems, considering that, as Durgaparsad adds, “Looking at retirement funds, our insights show that members who actively switch between investment portfolios of their choice (whether to time markets – chase performance or avoid losses – or in response to emotions) typically lose around 2% and 3% per year.” Durgaparsad goes on to explain that the consequences of this “can be quite severe if you consider that every 1% additional return over a 40-year
retirement savings period can translate into one’s pension lasting between two to five years longer in retirement”.
Nixon gives more detail on the damage that emotional decision-making can cause to investments, pointing to a so-called ‘behaviour tax’ tracked by Momentum. This metric, he says, shows (since the Covid period) “approximately 3.5% per annum in lost returns through investors reacting to market news and events”. The damage extends beyond individual investors, he says. “Over time this erodes confidence in financial advice and the industry in general, especially considering that market returns in the last decade have struggled to track inflation even.”
The consensus among experts is clearly that emotional decision-making is bad investing practice. However, Eedes agrees, there is no use trying to keep feelings out of investments. “Rather than trying to fight emotions, as investors, we must understand that we are emotional beings. The best way to protect against making poor decisions when we’re feeling very emotional is to have a sound investment strategy in place.” As an individual, she says, that might mean working with a financial advisor to “understand what you are at risk of doing in those times of market stress and to put in place the means to protect yourself”.
An adviser will help clients to separate emotions from their decision-making process, making them aware of the risks and the common mistakes investors make, and helping them to stick with their plan even when their gut is telling them to change course. A good rule of thumb at these times, says Nixon, is to remember that if your investment goals aren’t changing, neither should your approach to reaching them (i.e. your investment strategy). “Ask yourself if your goals are changing, or if this is just a reaction,” he says.
“Staying rational as an investor is a proactive rather than reactive journey,” says Eedes. “Smart investors do deliberately structure their lives and design the investment process to protect themselves from the type of toxicity in the market that could cause them to behave irrationally or emotionally.”
