The emotional journey of the (not so) smart investor
To be a successful investor, you must buy low and sell high. Unfortunately, most people allow their emotions to get the better of them and instead, they buy high and sell low, as shown in the illustration below from Fairstone Private Wealth. It shows how an emotional investor would have responded to stock market ups and downs from 2007 to 2014.
Why do we do this? Behavioural finance experts, such as billionaire investor Ken Fisher, chief executive of Fisher Investments, take us back to the Stone Age, when the battle for survival programmed humans to hate losses more than they love gains.
Stone Age hunters had to exert more effort to avoid pain (broken leg = inability to defend or feed family for two months) than to make a gain (kill gazelle). But it also paid to take big risks – one big kill could mean a month’s protein for the tribe. Our ingrained survival instincts urge us to take risks – we frequently choose ‘fight’ over ‘flight’ when facing insurmountable odds.
Investors, by definition, are overconfident when assuming they know more than they do or when overestimating their skill level.
We are also influenced by what behaviouralists term ‘regret shunning’ and ‘pride accumulation’. If the hunters didn’t accumulate pride and shun regret, they would have become despondent over failure. They would have given up hunting giant beasts as a fool’s errand.
Stone Age hunter = It is my particular skill with the spear that led me to kill the gazelle.
Investor = I bought shares in Apple in 2002 after my 12-year-old asked for an iPod. I’m an investment genius.
Stone Age hunter = I had some bad luck today because lions frightened the gazelles away. It’s not my fault.
Investor = I bought an investment today and its price fell. I had a row with my wife this morning, so I wasn’t concentrating properly.
So what's the solution?
Most investors, and particularly beginners, will find that they get better results and more peace of mind by drip- feeding their money on a regular monthly basis into the stock market. This means their investments will also benefit from ‘pound-cost averaging’, which allows you to buy units more cheaply on average. By investing the same amount at regular intervals more shares are purchased when share prices are low and fewer shares are purchased when prices are high.
How investors got it wrong
In 1999, investors bought technology stocks at the top of the market and were badly burnt when the market crashed in 2000. It happened again at the market peak in 2007, and for similar reasons.
A 2010 study by Andrew Clare and Dr Nick Motson of Cass Business School, entitled Do UK Retail Investors Buy at the Top and Sell at the Bottom?, examined data on investment into UK funds from 1992 to the end of 2009 collated by the Investment Association. It found: “On average, the investment timing decisions of retail investors with regard to equity mutual funds has cost them performance of just under 1.2% per year over the 18-year period of our study.
Although 1.2% may not sound very high, compounded over 18 years it represents a cumulated underperformance of 20%, compared with a simple buy and hold strategy.”
The emotional journey (click to enlarge):
How experts got it wrong
At the world stock market peak in 2007, the International Monetary Fund (IMF) said in its World Economic Outlook (WEO): “The strong global expansion is continuing, and projections for growth both in 2007 and 2008 have been revised up to 5. 2%.”
At the bottom of the market in 2009, the IMF’s WEO was: “The IMF expects global growth to slow below zero this year, the worst performance in most of our lifetimes.”World stock markets went on to have a five-year run of rising prices.
A 2014 study by Andriy Bodnaruk of the University of Notre Dame and Andrei Simonov of Michigan State University, entitled Do Financial Experts Make Better Investment Decisions? examined the effect of financial expertise on investment outcomes by analysing private portfolios of mutual fund managers.
It found no evidence that financial experts make better investment decisions than their peers: they do not outperform, do not diversify their risks better, and do not exhibit lower behavioural biases.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.