Beginners guide to investing part 6:Impact of our behaviours on investment returns

“If you can keep your head when all about you are losing theirs…..yours is the earth and everything that’s in it

— Rudyard Kipling

INTRODUCTION

“The Behaviour Gap” is a fantastic book by Carl Richards. The premise is that despite knowing better, people continue to make the same mistakes over and over with their money. It is our emotions that get in the way of making smart financial decisions. The distance between what we SHOULD do and what we ACTUALLY do, he termed “the behaviour gap”.

In terms of investing in the sharemarket, this gap refers to the difference between what the investment returned vs what the investor made. Some of the gap is attributable to the fees of the investment, but the rest of the gap is usually contributed to by our behaviours.

For example, if the NZX50 market returned 7% for the year and we invested in a market fund at a 1% cost, our net return SHOULD be 6%. However, we may have panicked during the year and sold after a political event, but bought back in to the market when things settled down again. This may have resulted in a ACTUAL return of 5% as an example. Because of our emotion, we bought sold and bought shares at imperfect times.  Our behaviour gap in this instance was 1% in returns - 6% real returns minus 5% actual returns.

 

WHAT ARE THE BEHAVIOURS THAT IMPACT OUR INVESTMENT PERFORMANCE?

1/. Greed
W
e tend to buy shares when they are increasing in price or highly priced. We don’t want to miss out.

2/. Fear
We tend to sell shares when they are decreasing in price or low. This means we are selling shares for cheap, or less than we paid for them. This is the best time to buy shares, not sell them.

3/. Expectations
Expectations drive our behaviour but they are often wrong. Typically, expectations are based on our most recent experiences, with more distant past experiences not considered, often creating a large gap between reality and expectations. If times are good, we often push negative memories from the past aside. This is why we are reluctant to invest just after a large crash – because it is ‘hot’ in our minds. And why we are more willing to invest after a long bull run – because the crash was so long ago it is now ‘cold’ in our minds. If we don’t remember the past, we will just get hammered and hammered again. So many investors make the mistake of chasing the most recent hot stocks or hot advisers. The hotter a stock is though, the closer it is to cooling. By the time we get on board the bus, the other passengers have got to their destination and are getting off. We are too late. 

4/. Overconfidence
As markets begin to soar we tend to gain more and more confidence. Confident that we will earn a lot of money, and confident that nothing bad will happen. That confidence then feeds to more and more people, which then re-affirms our reasons for being so confident. As more people believe that stocks are GUARANTEED to make money in the long run, the market ends up overpriced.  As the level of our overconfidence increases, the costs of our mistakes increase as well. We become more blind to the risks and veer from our strategy, by taking on more risk than intended.

5/. Sunk cost
We have a tendency to become emotionally attached to certain investments. The more we invest in something, the harder it becomes to abandon it. A sunk cost is a investment that can never be recovered. For those approaching retirement or needing to sell some stocks, if it is going down below levels we are comfortable with, we may have trouble selling it when we should. This is because we tell ourselves "I have already invested so much time and money into this stock, I don’t want to lose money." But the problem is we have already spent the money. The decision should be based purely on the price level the stock has fallen to, not on what we have already contributed.

6/. Physical attachment
We tend to overvalue things that we own. Think of when you sell a house or a car. You have invested a lot of money into these and had some great experiences. The person buying though doesn’t care about all that. They just see them for what they are physically, not emotionally. When purchasing a house it is easy to become emotional by picturing the potential and all the things you can do to fill the rooms. This emotion can lead to purchasing the house for more than it is worth. Same with stocks.

7/. Fear of loss
Multiple studies have been conducted that test our brain activity when confronted with gains and losses. They show that we react more aggressively to losses than we do with gains. In other words, we feel more pain from losses, than we feel joy from gains. This fear prevents many of us from investing in stocks that may be good for our portfolio and it also causes us to sell stock when we shouldn't. 

8/. Following the herd
As much as we like to be our own individual, we have a tendency to follow the crowd and not step out on our own, figuratively exposing ourselves. The crowd does not always know best. Our decisions to investing should be based on what is best for us, not what is best for others.  

 

TIPS, THOUGHTS AND NUGGETS OF WISDOM TO HELP OVERCOME THESE BEHAVIOURS

  • Before you invest your hard-earned money, ask yourself: Are you buying a particular investment because you think it’s a good investment? Or are you relying on a greater fool to come along and buy at an even higher price? The latter is a very risky strategy as eventually the number of fools will run dry.
     
  • Goals are very rarely achieved in a straight and expected line. The line has many troughs, borrows, dips, turns and steady rises along the way. People worry a lot about the things they cannot control. The solution is to focus on the things that matter to you and FORGET THE REST.
     
  • The more emotionally attached you are to an investment the more likely you are to make a mistake and a large one at that. FEELINGS CAN BE EXPENSIVE. Make decisions based on the product, not your attachment to the product.
     
  • A common mistake is to get stuck on the numbers of what you want to get in return for investment based on what you paid. For example, you paid for a $800,000 house and want to sell it for at least $800,000, yet the best market offer is $750,000. You don’t sell for $750,000 because you are too emotionally attached to the $800,000 number and because of this miss out on $750,000. 6 months later and you are now just hoping for any offer such as $700,000. See the costly difference? Know the market and what your investment is worth today. Getting back to even is never a good reason to hold onto an investment.
     
  • Investment decisions should be made based on what we know, not how we feel.
     
  • Uncertainty is OK. We will never be right all the time. We can control the process of making the decision, but we can’t control the outcome. We make decision’s based on available information. We’re not totally in control even when making wise decisions. We’re responsible for our own behaviour but we can’t always control the results.
     
  • Know who is giving the advice: conflicts of interest mean much greater research is required. They may be selling you a specific investment because they benefit in some way you buying it.
     
  • Friends and family may mean well but do they know best?
     
  • We may say that we want simplicity, but we often choose complexity. Solutions to important problems don’t have to be complex.  Increases in simplicity often lead to increases in effectiveness. Yet so many people prefer complex answers because simple solutions require us to change our own behaviour and accept the responsibility is ours! We would rather look for the silver bullet than simply doing the work that needs doing.
     
  • The simple options that have the largest impact on our financial success require discipline, patience and hard work. They require that we apply those basic fundamentals over and over again. It’s much easier to entertain ourselves with the fantasy of finding an investment that will give us a fantastic return than to save a little bit more money each month. But in the end, the fantasy will fail us. The work will deliver.
     
  • Saving money, avoiding speculative investments, and repeating that process over and over may not be sexy, but it gets the job done.
     
  • The more instant gratification is searched for, the more money problems you will have.
     
  • There is no secret: Spend less than you earn, set money aside for rainy day, pay down debt and steer clear of large losses. Simple. Boring. Not easy.
     
  • Slow and steady wins the race. Slow and steady however does not sell magazines or website traffic so be weary of noise.
     
  • Slow and steady investments are more concerned with avoiding large losses than with chasing the next big investment. Slow and steady means you’re willing to exchange the opportunity of making a killing for the assurance of never getting killed.
     
  • Slow and steady isn’t easy. It always seems that someone else is getting rich quick. But take the time to look behind the stories and you’ll find something else they aren't telling you.
     
  • People have short term and selective memories. Sometimes it takes only a few winning trades for people to forget the losers.
     
  • If you decide to be slow and steady, remember to take with a huge grain of salt all those stories of people getting rich quick.
     
  • Don’t shoot for the best. Shoot for good enough.
     
  • Slow and steady capital is short term boring but long-term exciting.
     
  • Decide where you want to go. Make decisions that send you in that direction and you will reach your destination. There will be bumps along the way, but if you’re clear about where you want to go and do not deviate from the plan, then it becomes a lot easier to close your behaviour gaps.
     
  • The goal isn’t to make the perfect decision about money every time, but to do the best we can and move forward. Most of the time that’s enough.

 

Next in the investing series we will focus on the different types of stocks we can invest in.

 

 

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