Anybody who has been in the markets for any length of time knows that returns do not come in a straight line. We are constantly faced with the ups and downs of market cycles.
Yet even though this is the reality everybody expects, we still don’t deal with it very well. Often, we are more influenced by how our investments behave on the way to reaching a specific point, than what that point actually is.
Consider two individuals who both invest R100 000 in different unit trusts at the same time. Over a period of three years, they perform as follows:
Rationally, at the end of this period, both investors should be equally happy with how their money has performed. They have, after all, achieved the same outcome.
Intuitively, however, we suspect that if these two individuals had been tracking their investments closely, they would not be feeling the same level of satisfaction. As Greg Davies, head of behavioural finance at Oxford Risk explained to the Momentum Investment roadshow:“We feel that the journey we have been on matters.”
The next step counts
The reason this is important is not because your money cares how you are feeling, but because how you are feeling has implications for what you do next.
“At the end, how happy you are is not really that important,” says Davies. “Except
that your emotional state changes the next investment decision you make.”
In the above example, both investors have gained 35% from where they started. Investor A, however, is 31% down from the highest level they achieved. Investor B, on the other hand, is up 57% from their low.
It would be quite reasonable for Investor A to feel disappointed and even apprehensive about where the investment is going. It would be equally reasonable for Investor B to feel positive about how things are going.
Regardless of the fundamentals underpinning these investments, it would be far more likely for Investor A to capitulate and exit the investment at this point than for Investor B to do so. Similarly, if they were each given another R100 000 to invest, Investor B would be far more likely to add it to their current investment. Investor A, on the other hand, would find that a lot harder to do.
Trusting your gut
It is important to remember that, financially, these two investors are in exactly the same
position. Yet the decisions they might make are potentially completely different due to their recent past experience.
As Davies explains: “As much as we might like to think that we make every investmentdecision by rationally weighing up the risk-and-return trade-off, the fact is an awful lot of our investment decision is based on the simple question: How do I feel about this right now; whatdoes my gut tell me?”
This is one of the great challenges in investing – that we are predisposed to making decisions based on what makes us feel better.
This is why many investors sell out and lock in their losses during a market crash: they can no longer take the discomfort of seeing the value of their investments falling.
It is equally why investors were flooding into bitcoin in the second half of 2017 – it was too uncomfortable for them to sit on the sidelines when they were hearing about others making a killing in the cryptocurrency.
Convincing ourselves
These are not unreasonable behaviours. It is understandable to want to avoid discomfort.
In fact, we want to avoid it so much that we can even come up with what seem like rational reasons for doing so. Davies uses the example of the DotCom bubble in the late 1990s to illustrate that we can produce apparently sound arguments for anything when we really want to believe it.
“There were books coming out at the time saying the Dow [Jones Industrial Average] is going to 60 000, or 80 000, even 100 000,” he says. “Now we all know that the whole internet bubblewas based on vapours, so you would think that these books would just be nonsense. Except that they’re not.
“Actually they are fairly well written, well-reasoned, articulate, complex, sophisticated arguments for complete nonsense.
“Because, as humans, if we have decided that we want to believe something, we are capable of constructing incredibly sophisticated arguments as to why we are right.”
This is not because we are foolish. It is because we need to justify the way we feel.
The problem for investors, however, is that this can be seriously detrimental to our long-term objectives. That is because the comfortable decision in the moment and the right decision for securing the best long-term outcomes are often at odds.
“We need to find ways of meeting the great tension in financial decision-making – between the right thing to do and the comfortable thing to do,” says Davies.
“At every single point, regardless of what the markets are doing, humans are deviating from the right answer in the direction of the comfortable answer. We buy for ourselves emotional comfort at the cost of long-term returns, because in the moment we always want to feelcomfortable.”
Patrick Cairns is one of South Africa's most respected commentators on the investment industry. He also covers economics issues and business news.