Our last post introduced the concept of emotion-driven decision-making as the central reason investors statistically underperform market benchmarks.
The question remains, how and why does this happen, and what can we do about it?
The Dalbar study1 defined several biases that lead investors to make poor or off-plan investment decisions. The most influential of the fallacies listed were “the herding effect” and “loss aversion.”
Buying High and Selling Low
Herding is what happens when you follow the crowd. Everyone is buying, the market is climbing, and you start to believe that it will continue to rise indefinitely and so you buy in, too.
Loss aversion is what happens in a declining market. Stock prices have been dropping for some time, your initial denial is replaced with anxiety, and out of the fear of assuming a larger loss, you sell.
At the end of the cycle, the investor has bought in when most comfortable, at the high point of the market, and sold out of panic, at the low point of the market. Despite the fact that over a longer period the indexes have seen overall growth, the investor has sustained losses.
Hindsight may be 20/20, but when you’ve invested hard-earned money and you’re facing a market event, these decisions seem reasonable at the time you make them. So it’s not enough to say, “be rational,” or “be disciplined” — you have to have a different approach to investing altogether if you want to avoid situations where behavioural mistakes happen. Here are some features of that approach:
- Your return expectations and investment goals are based on your personal needs, time frames and emotional risk tolerance — not on beating market indexes.
- Similarly, you invest with a plan. This is how you break the buy-high-sell-low cycle, and resist reactionary moves.
- You invest with the understanding that forecasts are probabilities and present events are occurring among a different set of circumstances than previous ones. The future does not equal the past.
- You have all the information you need to make rational decisions about the situation at hand. This excludes a lot of media coverage, as news outlets tend to be rife with bias.
Those who are successful invest with a plan, a methodical process for analyzing opportunities, and a framework for making decisions. These are the practices that you need to emulate in order to take control over your emotions and see the results you want from your portfolio.
1Dalbar, Inc. Quantitative Analysis of Investor Behavior 2017.