We are all brought up with the notion that good behaviour should be rewarded. This is instilled in us from a very young age both at home and at school – Isobel (my 7 year old daughter) is always beaming when she has received a merit from her teacher for doing something well.
What is termed “behavioural finance” involves studying the emotional side of financial decision making and the impact it can have on investment returns. Psychology has found that humans tend to have an inflated view of our abilities in most aspects of our lives – for example, with driving a car, most people rate themselves in the top third of the population when of course half of us are below average. Such overconfidence can be dangerous when it comes to making judgements on investments.
Research shows that we tend to be over-confident about making gains and over-sensitive about making losses. Some estimates show that the pain of an investment loss is more than twice as strong as the joy of an equivalent gain. For example, if you invested £100,000 and it grew to £125,000, rate on a 1 to 10 scale how pleased you’re feeling with yourself. Now, let’s go the other way, and the investment fell in value to £75,000 – how do you feel now and how strong is that emotion compared to the corresponding gain?
What is at risk here is that our behaviour can lead to making irrational decisions which destroy rather than create future wealth, such as; selling investments too early because we want to lock-in the profit, panicking unnecessarily when a specific investment falls in value or even holding onto a poorly performing investment for too long to avoid the pain of accepting a loss.
So, what difference can “bad behaviour” make to your personal balance sheet? Probably the best known study in this area is from US based research company, Dalbar. This showed that over a 20 year period investors in managed funds investing in the US stockmarket achieved an average annual return of 4.3% when the overall market grew by 8.2%. Now part of that difference will be down to the costs of a “managed” fund and that most managed funds don’t beat the market (perhaps a topic for a future article!), but the other part, and to quote the author here, is that investors “move their money in and out of the market at the wrong time – they get excited or they panic and they hurt themselves.”
Also, when the power of compound interest gets involved, a lot of money can be at stake. An investment of £100,000 over a 20 year period and annual growth of 4.3% gets you to £232,000. However, an annual return of 6.7% (the “good behaviour” return less 1.5% costs) gets you to £366,000 – a whopping difference of £134,000 and, reverting to my earlier driving analogy, according to today’s Auto Trader listings, more than enough to buy a very nice Porsche 911 GT3.
So what can you learn from behavioural finance in helping you develop a successful long term investment strategy:
- Work out what you want to achieve and develop some investment goals in terms of the trade-off between risk and return.
- Diversify your investments across a range of assets – in other words, don’t put all your eggs in the same basket.
- Control costs – all investments have costs attached to them, so understand them and take them into account.
- Maintain perspective and long-term discipline – “good behaviour”.
Sounds boring? It is – but, just think about the Porsche.