Our emotions cost us dearly

Overconfident traders’ decisions ‘mostly wrong’

Take the emotion out of your investing.

I often say we are physical beings run by our emotions: the way we feel affects our actions. That’s certainly true when it comes to investing.

For the 20 years up to December 2021, the MSCI World Index, which tracks large and mid-size companies across 23 developed countries, averaged 9% a year. You could simply leave your money to follow the combined ups and downs of those companies and it would double in value every eight years or so.

It’s been fairly consistent over the years; the past 10 years have averaged 14.9% pa, 15 years 10.7% pa and 50 years have averaged 11.5% pa.

But this isn’t what most investors achieved. In the past 20 years, the average equity fund investor returned only around 5% per year.

Why? Behaviour. How we behave when investing is often illogical, based on emotion not facts. Let’s highlight that with a couple of examples of typical money-losing moves that average investors make.

Study after study shows when the stock market rises, 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, and then returning your purchases 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 news and get fearful. Logic can easily go out of the window.

This tendency to overreact can become even greater during times of personal uncertainty, such as when we near retirement, or when the economy is slumping – like now.

There’s an entire field of study which researches our tendency to make illogical

We’re human and so we overreact to good news and then we get greedy

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, aiming to ascertain if frequent trading led to higher returns.

The stocks bought under performed the stocks sold by 5% over one year, and 8.6% over two years. In other words: the more active the investor, the less money they made.

This study was repeated in multiple markets and the results were the same. The authors concluded that traders are “basically paying fees to lose money”. Overconfidence causes investors to exaggerate their ability to predict future events. They are quick to use past data, and to think they have above-average abilities that enable them to predict market movements into the future.

Almost invariably, they are wrong. One of the best things you can do to protect yourself from your own natural tendency to make emotional decisions is to seek professional guidance and hire a certified financial planner (see how at warrenshute.com).

A CFP can serve as an intermediary between you and your emotions, which can make a serious difference to your returns.

Learn more about successful investment at The Money Planner podcast.