It is often said that we are our own worst enemies. This can be especially true when it comes to investing.
Traditional investment theory is based on the belief that investors consider all relevant information before making rational investment decisions. However, in practice, this is often not the case, as investors are adversely affected by numerous behavioral biases.
Behavioral biases
Researchers have identified several behavioral biases that include:
- Mental accounting errors: This refers to the different values ​​people attach to the same amount of money based on subjective criteria. This can lead to undue risk in one area and rational risk avoidance in another
- Overconfidence: Can apply to both the quality of information and the ability to act on it at the right time.
- Anchoring: The tendency to highlight one piece of information, such as a stock’s current price, relative to its history.
- Herd Behavior: Taking comfort because others are investing in the same assets.
- Loss Aversion: When investors are more concerned with avoiding unexpected losses than making unexpected gains. Simply put, investors experience losses more than the satisfaction of gains.
It’s important to stay invested
During times of increased market volatility, these biases may be more pronounced. While many growth-oriented investors claim to have a higher tolerance for risk, a behavioral bias toward losses often becomes apparent when the value of an investment falls by more than about 10%. At that point, investors can sell their long-term growth investments and seek the perceived safety of cash. However, as difficult as it may seem, the best investment strategy may be to do nothing in a bearish market.
The graph below shows the difference between three scenarios (as per the FTSE/JSE All Share Index) following a major market correction (the 2008 Global Financial Crisis, when the market lost approximately 32% from peak to trough): continued equity investment; selling at the bottom and reinvesting a year later; and selling and being in cash.
Source: Morningstar and Ninety One as of 06/30/22 – Charts are for illustration purposes only
The worst outcome was selling at the bottom of the market and holding cash, which demonstrates the risk of conservatism. The market returned to its previous high in just 29 months. Investors who switched to cash had to wait nine years before the value of their investments returned to their May 2008 peak. Unsurprisingly, staying invested has done best for investors, even as the market corrected earlier this year.
The inset chart, in which we repeat the exercise for a shorter period after the March 2020 Covid correction, confirms that staying invested remains the best option in volatile markets.
Dalbar Quantitative Analysis of Investor Behavior (QAIB)
Additional evidence to confirm the remaining investments is presented by the American research company Dalbar*. Since 1994, Dalbara’s QAIB has been measuring investors’ decisions to buy, sell and move into and out of US mutual funds over short and long-term time periods. The results consistently show that the average investor earns less than fund performance reports suggest. This is simply due to self-destructive behavior – selling when performance declines and buying when it peaks.
For example, in the calendar year 2021, the average return on equity funds was a seemingly attractive 18.4%. However, when this is compared to the S&P 500’s return of 28.7%, there is a worrying return gap of 10.3% – the third largest gap in investor returns since 1985, when QAIB’s analysis began.
According to Dalbar, the average investor has failed to realize the long-term benefits of owning assets because they don’t stay invested long enough. Since 2000, average investor holdings have ranged from about 2.5 to 4.5 years, well below the recommended holding period for equity investments of at least seven years. Being aware of these behavioral biases is the first step to overcoming their harmful effects and improving your investment results.
The importance of independent financial advice
Although there is a growing buzz around volatility in financial markets, investors should not panic. They would be better off re-examining their long-term investment goals and commitments, and keeping in mind that they are more likely to achieve them by timing the market than by trying to time the market.
In this environment, financial advice is even more important. A good financial advisor can help investors understand their future cash flow needs and ensure that investment portfolios are structured correctly to meet those needs, which then require surprisingly little attention during periods of excessive market volatility.
Paul Hutchinson is the Sales Manager at Ninety One’s South African team.
*Dalbar 2022 QAIB Report: Quantitative Analysis of Investor Behavior for the Period Ended 31 December 2021
