Humans are emotional beings

It’s not usually a good idea to base investment decisions purely on gut instincts.

Most investors know not to panic at the first sign of market turbulence and that it’s not a good idea to buy “fashionable” stocks or products that you don’t understand. But it’s very hard to totally ignore your emotions when it comes to money issues. So although we know better, we are not immune to rash behaviour.

We see what we want to see

In earlier times, scientists claimed that investors were perfectly rational beings. But the theory of efficient markets has since been largely debunked. How else could we explain phenomena such as the tech bubble or the subprime mortgage crisis in the US? Investors are clearly prone to the influence of irrational factors and processes when taking decisions.

Emotional factors can take various forms. Investors may be influenced by friends, family or the media, and take decisions based on what they see, read and hear rather than on a rational assessment of the situation. When assessing a company’s success, they may not cover all the bases, relying purely on strong turnover figures in one business segment or a personal preference for a specific product, for example. There is a danger of taking an isolated and potentially irrelevant example/individual occurrence and drawing a general conclusion about the company’s success. That can have fatal consequences.

Bad timing

Emotional investors tend to follow the overall market as an animal follows the pack. When high spirits prevail, they buy, and when panic breaks out, they sell. Such trades are almost always made at the wrong moment. The US financial services provider Dalbar calculated that the average investor made a loss of 9.42% in 2018, versus a decline of 4.38% in the S&P 500 index. This means most investors missed selling before the year-end decline or reinvesting in time to benefit from the recovery.

It is nonsense to suggest that you can only achieve more value by trading constantly.

This is not an isolated case. Dalbar research shows that time and again investors make decisions at the wrong time and are driven by emotional factors – to put it bluntly, by fear and greed. Over a 20-year period, the S&P 500 achieved average growth of over 8% per annum. The average equity investor struggled to achieve half of this, and fixed income investors performed even worse.

Information isn’t everything

Behavioural psychologist Paul Davies offers an interesting hypothesis. He queries whether having the necessary information means that people behave more rationally. He believes it is wrong to assume that people who are well informed can be relied upon to act appropriately. According to Davies, processes are required that support reasonable behaviour and make it easier to do the right thing.

In any case, the best way to make the right financial decisions is to take as few decisions as possible. It is nonsense to suggest that you can only achieve more value by trading constantly. Regular savings transferred automatically from an account are a good example. If you have to take investment decisions from scratch every month, it becomes complicated. In this context, Davies suggests building personal “if-then” moments into financial planning. Such rules provide us with better protection against emotional decisions taken in the heat of the moment. Financial advisers also often set a maximum acceptable loss with clients. Setting a maximum loss tolerance is sensible means of preparing for potential losses, but it also provides the opportunity to plan an investment strategy away from day-to-day market developments.

Build personal “if-then” moments into financial planning.

Similar rules should be applied to asset allocation decisions. In general, most investors work with a strategic asset allocation, i.e. a long-term position configured to help achieve their financial goals. This broadly defines how high the proportion of equities, bonds and other asset classes such as real estate should be in the portfolio. Meanwhile, adjustments for differing market conditions can be made in the tactical asset allocation.

Define your goals – set limits

It’s important to keep an eye on your goals and not get caught up in short-term events. The best solution is a system of automatic reallocation, which systematically adjusts the portfolio to maintain the original asset allocation. Once again, this doesn’t mean you won’t have to take any decisions. Automatic reallocation means that investors will naturally exit expensive markets that have performed well and invest in cheaper markets that have performed badly.

Of course, there will be circumstances where short-term opportunities can be exploited and a tactical portfolio adjustment may make sense if the performance of a specific market is overly dependent on a limited number of individual shares. However, it is generally better to decide on an asset allocation and stick to it, reassessing it on a regular basis and not just when disaster strikes.

An even harder task, but one that cannot be ignored, is knowing our own limits. Investor expectations for potential investment returns are often too high. This leads to a poor assessment of the relevant risks and limits that we should set for ourselves.

In conclusion, when it comes to money, investors are easily influenced by their emotions and this often leads to poor decisions. So set up your investment strategy in a way that requires you to take as few decisions as possible. This will reduce the risk of making the wrong decisions on the basis of gut instincts.