Emotional decisions can lead to regret
Sometimes when you’re trying to achieve something that requires selfdiscipline, finding the right support mechanism makes all the difference.
Consider one of the most common New Year’s resolutions — going to the gym. You’re excited in the beginning, but by February you’re probably one of the 80 per cent who fail to deliver on their commitment.
But if you had signed an agreement with a friend committing to go to the gym together once a week (and promising that if one of you bails out, you’ll be on the hook for a dinner), the likelihood that you’d keep your pledge would be much higher.
Recent stock market volatility illustrates that investments is another area where creating a simple mechanism can help you stay disciplined and achieve your long-term goals.
When the market crashed in February, billions of investment dollars we pulled out. Between Feb 20 and March 23 the S&P/TSX 60 plunged some 37 per cent — and data from the Investment Funds Institute of Canada shows that mutual funds recorded net redemptions of $14.1 billion during the month of March.
Driven by emotion, investors decided to liquidate their mutual funds to avoid potential additional pain. But as it turns out, after the sharp decline the S&P/TSX 60 bounced back, by about 30 per cent in just six short weeks.
The market still has a long way to go — and the COVID-19 crisis isn’t over yet. But markets generally do recover and those who panic and sell during a market crash almost always miss the rebound and end up filled with regret.
So why do we sell? This is how we, as human beings, behave. We are subject to many well documented biases. One of them is herd behaviour — when everybody else is selling in a panic, we tend to do the same.
Another is loss aversion. First identified by Amos Tversky and Daniel Kahneman, loss aversion is the notion that the pain associated with losing money is
much greater than the pleasure of gaining the same amount. It has been estimated in experiments that losing, say, $5,000 is about 2.5 times more painful then gaining the same amount. Hence, when the market falls sharply, it can create strong emotions.
Dan Bortolotti, a portfolio manager with PWL Capital in Toronto, says he agrees that “the emotional part is the most difficult part of the puzzle.”
There is help though, he says. New products, such as self-balancing Exchange-Traded Funds (ETFs), can take some of the emotion out of investing. “You can easily create a welldiversified portfolio with a few ETFs, or even just one. But sticking to your plan over the long term, and not trying to outsmart the market is where it gets hard.”
Interestingly, although often presented as making only rational decisions, professionals can be subject to the same traits and biases as retail investors.
In their book, “Fund management: an emotional finance perspective,” David Tuckett and Richard Tuffler report the results of in-depth interviews with more than 50 fund managers in the United States and Europe, most of them managing fund with more than US$1 billion in assets.
One of their most interesting observations is that: “As in close personal relationships, our fund managers’ feelings about their securities are strong and volatile. Asset managers talked about liking and even loving stocks and the managements of companies that were delivering what they hoped and then hating them when they felt let down.”
Tuckett and Tuffler conclude that the highly emotional investment relationships of asset managers with their stocks has the potential to lead to problematic states of mind and dysfunctional outcomes for investors.
So, is there a trick that would guarantee that investors stick to their original investment plan? Fortunately, there is. A financial adviser — robot or human — can help solve the problem.
Robo-advisers, first introduced in Canada in 2014, offer an elegant and cost-efficient choice. These are services that use an emotionless software to determine one’s asset allocation and then execute it using six to 10 low-cost ETFs. Roboadvisers ask investors answer a set of questions to assess their risk tolerance, and then, coupled with additional inputs such as age, will come up with a proposed portfolio.
The beauty of working with a robot is that it will stick to the plan no matter what. Robo-advisers will rebalance portfolios only once they deviate significantly from their proposed asset allocation.
For example, if an investor had a target-portfolio which invests 70 per cent in stocks and 30 per cent in bonds, it will be rebalanced if the weights shift to 65 per cent stocks and 35 per cent bonds.
Another solution to avoid emotional trading would be to choose a human financial adviser. Here, trust is essential, so you need to choose your adviser carefully.
If your adviser’s style of investment is passive — investing in the broad market by following major indices, a human adviser can be as effective as a robot. The service may be a bit more expensive, but it would offer more support and advice, so you might be less likely to bail when the market gets rocky.
But if your financial adviser actively manages your portfolio, keep in mind Tuckett and Tuffler’s conclusion — he or she is also subject to emotional investing. Hence, it’s up to you to find one who consistently outperforms the market after controlling for risk and taking management fees into account.
Human or robot, finding the credible mechanism that works for you to separate your emotions from your investments can go a long away to making sure the next time the market crashes, your portfolio won’t suffer any lasting damage.
Humans have a bias to herd behaviour. When everybody else is selling in a panic, we tend to do the same