Invest with your head, not heart
How fear, joy and over-confidence lead us astray
Take the emotion out of your investing
I frequently expound that we are physical beings run by our emotions – the way we feel affects our actions.
That’s certainly true when it comes to investing, as historical data shows.
For the 20 years up to December 2015, the shares of the largest 500 companies in the US averaged returns of 9.85 per cent a year.
You could simply leave your money to follow the combined ups and downs of those firms and it would double in value every eight years or so.
In the same period, the average equity fund investor returned only 5.19 per cent a year.
Why? Behaviour. How we behave when investing is often illogical, based on emotion not facts. Let’s highlight that with a couple of typical money-losing moves that investors make.
Buying high
Study after study shows that when the stock market goes up, investors put more money into it. And when it goes down, they pull money out.
This is like going to the shops every time the price of something goes up, then returning your purchase when there’s a sale on, at a store that only gives you the sale price back.
We are human, so we overreact to good news and get greedy. We do the same with bad, and get fearful.
This tendency to overreact can be even greater in times of personal uncertainty such as when we near retirement, or when the economy slumps – like in a pandemic.
Analysing effects
There’s an entire field of study into our tendency to make illogical financial decisions, called behavioural finance. It labels our money-losing mind tricks with terms like “recency bias” and “overconfidence”. One study analysed trades from 10,000 clients at a brokerage firm, to see if frequent trading led to higher returns. The results? The stocks purchased underperformed the stocks sold by 5 per cent over one year, and 8.6 per cent over two years.
In other words, the more active the investor, the less money they made.
This study was repeated numerous times in multiple markets and the results were always the same.
The authors concluded traders are
“basically paying fees to lose money”. Overconfidence leads them to exaggerate their ability to predict events.
They are quick to use past data, and think they have an above-average ability to know how markets will move. Almost invariably, they are wrong.
One of the best things you can do to protect yourself from emotional decisions is to seek professional guidance and hire a Certified Financial Planner (see how at warrenshute.com).
A CFP gets between you and your emotions – and that can make a serious difference to your returns.
They think they have an above-average ability to see how markets will move…