What do we know about the basics of investing? Buy low sell high. Diversify. Invest for the long-term. Sounds easy, but it’s not. Every day I talk to investors who understand these concepts but have difficulty executing them. For many, the gap between the knowledge of what they should do and what they are actually able to do on their own is the main reason they work with a financial advisor.
However, there are still a significant amount of people who decide to self-manage their investments, and the vast majority of these people negatively impact their overall financial portfolio and underperform the market. Why? Because emotion, biases, and simply human nature can interfere with their ability to make sound financial decisions. Especially during times of market volatility like we’ve seen over the last couple of days, it’s imperative to understand the impact that your emotions and unconscious biases can have on the overall performance of your investing portfolio.
The Realities of Emotional Investing
One of these unconscious biases that many investors experience is that we all have a natural inclination to want to own what has done well recently. It makes us feel better. It makes for a good story at a cocktail party to say that we made a big bet on the latest-greatest investment. This effect is common enough that it has its own name: recency bias. Recency bias is the tendency to think that trends and patterns in the recent past will continue in the future, which then impacts certain conclusions, decisions or behaviors. However, recency bias doesn’t make for a good long-term investment strategy.
According to a BlackRock survey of retirement plan participants, 66% of surveyed workers believe that over the next decade, returns on their savings will continue to be in line with what they have experienced in the past, while 17% believe they will experience even higher returns. This shows how this type of bias can be particularly dangerous during periods of rising markets because it can grow stronger as the market reaches higher peaks. For example, a lengthy bull market can lull us into a false sense of security, which can translate into trouble – how do you think asset bubbles are created?
Recency bias works the opposite way, too, when you experience negative events. In 2008, for example, many investors quickly determined that the negative events of the stock market crash would continue and liquidated their investment portfolios. When the financial markets rebounded, many of those same investors realized their error and jumped back into the markets. Unfortunately, they locked in their financial losses and bought back in after much of the recovery had already happened. Recency bias cost those investors a lot. During market volatility, it’s important to stick to your long-term investing strategy and avoid assuming that recent events will continue indefinitely.
We also know we need to diversify, but what does that really mean? It means owning a variety of asset classes, including those that are out of favor. It means buying some more of these asset classes when they don’t do well. Investments are often cyclical so that today’s “must have” is tomorrow’s “has-been”. In other words, a good portfolio has assets that have a negative correlation – when one part of the portfolio goes up another tends to go down. How else can you buy low and sell high if nothing is down when something else is up? This is another pitfall for many investors and is a common subject for analysis by behavioral economists. It’s no fun watching parts of your portfolio go down. Investors can easily make poor investing decisions from seeing some areas of their portfolio decline. But having the discipline to rebalance with your long-term goals in mind will ultimately help drive the best results.
How to Avoid Emotional Investing
Successful long-term investing means not chasing results or trying to time your entry/exit into the market. If you try to do either, you’ll put yourself on a rollercoaster than can be difficult to get off of. Again, the counterpoint to emotional investing is having a long-term goal and a strategy in place. There will be ups and downs along the way, but your goals will always remain clear.
Unfortunately, our brains are wired to want to chase results and make emotional decisions. We know we are supposed to buy low and sell high, but our brains often trick us into buying into the hot investment (buying high) and then selling it when it doesn’t work out (selling low).
According to DALBAR, most individual investors dramatically trail the market. In their 22nd Annual Quantitative Analysis of Investor Behavior, DALBAR examined the behavior of mutual fund investors over the 30-year period ended December, 2015.
The annualized return for the S&P 500 over that time period was 10.35%. The annualized return for the average equity investor? Just 3.66%! DALBAR found that “…investor behavior is the number one cause” of underperformance. They further explain, “The data shows that when investors react, they generally make the wrong decision.”
Professionally managed funds are often not much better. 80% of large-cap active managers underperformed their benchmark over a 3 year period. The same problems that individuals run into when they chase results occur with professionals as well. On top of paying higher fees for active professional management, you’re still likely to get sub-par results.
Given this reality, it certainly sounds appealing to go to a discount broker and do it yourself. However, this self-directed “supermarket approach” of picking a few stocks and funds that look appealing isn’t much better. Despite our best intentions, our cognitive biases (like wanting to follow the crowd and seeking out information that conforms to our beliefs) will come into play. It’s nearly impossible for an individual to eliminate these emotional biases that inevitably lead to poor investment decisions.
Emotion-Free Investing is Hard…but It’s Possible
Because like most people, you will probably have difficulty separating emotion from your decision-making, it’s probably best to stay an arm’s length away from day-to-day investing decisions. This is one of the biggest benefits of working with a financial advisor who will focus on a sound, long-term investment strategy without chasing short-term results. Investors should work with a company that is a fiduciary to ensure that the investor’s best interest will always come first. Investing in a wire house that has an incentive to put your money in their products or products from which they get a kick back is unlikely to be in an investor’s best interest.
And for some peace of mind, turn off the 30-second stock market updates on your phone. Paying too much attention to the short-term noise in the markets can cause us to make knee-jerk decisions that will be detrimental to our overall performance. It’s often far better to understand your portfolio’s long-term benefits and strategy and ignore the short-term ups and downs.
Over the past 100 years, there have been good market periods and bad market periods. Overall, markets have expanded, and investors have been richly rewarded. There will always be concerns and fears about what will happen next, and there will be bear markets in the future. Those who expect otherwise will be disappointed and may react as a result of their disappointment.
Developing a solid investment strategy – and then keeping your emotions in check and sticking to it – is the best thing you can do to achieve your long-term financial goals, regardless of what is happening in the markets.