Shares are one of the best long-term investments around. No other investment offers the tax benefits of shares, or the ability to sell quickly in whole or in part. However, this flexibility has a downside – it gives “investors” the ability to get out quickly if they don’t stay the course when the market has one of its normal downturns. Our stock market plunged to 4546 on 23rd of March, and many inexperienced investors ran for the hills. Since then, our market has had a strong rebound and is up 43% in just seven months.
This week’s report from behavioural finance experts Oxford Risk claims that on an average year, the decisions retail investors make for ‘emotional comfort’ typically costs them 3% a year in returns. Worse still, thanks to Covid, bad decisions may cost even more.
Oxford Risk says many investors have increased their allocation to cash during these volatile times, and the cost of this ‘reluctance’ to invest may be around 4% to 5% a year over the long-term. In addition, it estimates that the cost of the ‘Behaviour Gap’ – losses due to timing decisions caused by investing more money when times are good for stock markets and less when they are not – i.e. buy high and sell low – is on average around 1.5% to 2% a year over time.
In my new book Retirement Made Simple I discuss a report by Barclays Wealth in Britain based on interviews with thousands of wealthy investors, which explores how they overcame their inbuilt cognitive biases.
Trying to time the market is one of the main problems. There is extensive research that people who try to time entry and exit into the market end up with a 20% drop in returns over a ten-year period. Despite the fact that a majority of investors acknowledged this to be true, they still confessed that it didn’t stop them having a go.
Younger wealthy investors admitted to needing more self-discipline than older investors, but those who made joint decisions with a partner generally achieved better returns, as two people were involved in the decision-making.
Barclays identified several strategies that were helpful in taking emotions out of the investment process. These included :
1. Avoiding the trap of being involved in day-to-day gossip about the markets, to lessen the chance of being distracted.
2. Delegating to fund managers who would be responsible for investment decisions.
3. Conferring with other people, such as financial advisers or stockbrokers, for input.
4. Setting financial deadlines to create accountability and overcome inertia.
5. Cooling off — waiting a few days before implementing a major financial decision once it has been made.
6. Establishing strict rules, such as re-balancing the portfolio twice a year, and setting up and down price limits.
According to Dr Greg Davies, head of behavioural and quantitative finance at Barclays Wealth, a key reason why individual investors systematically underperform professional investors is not that they are inherently worse investors, but simply that “professional investors are aided by a strong set of institutional rules that ensure greater control of their knee-jerk reactions.”
The report points out that humans did not evolve to be good long term investors, but to be great short term risk avoiders. The impulse to avoid risk is apparently more than twice as strong as the impulse to seek reward. And to make it worse, we instinctively want to follow the herd for protection.
Just remember, the major factor that determines how much you will have in your portfolio when you retire is the rate of return you can achieve on your assets. A long-term reduction of 3% per annum could cost you hundreds of thousands of dollars over the long-term. Adopting smart strategies, can be a life changer.