Golden rule number two – maintain discipline
The second in our series of golden investment rules looks at discipline and how important it is to maintain, when all our natural instincts are telling us to behave differently.
At this time of year, people generally tend to make their grand plans and resolutions for the coming months, whether that be diet, lifestyle or financial planning. However, very often these plans have been forgotten within a few weeks.
The same applies to finance, where even the best laid plans can be destroyed simply by people’s behaviour – typically because of greed and fear. Research has shown that real life investor returns consistently fall behind the long term returns of the very same funds those individuals are invested in!
Numerous academic studies have shown that investment funds will typically return 1-2% p.a. behind the markets they invest in due, predominantly, to charges. However, what is even more concerning is that when the in-flows and out-flows of these funds were analysed, the investors in those same investment funds were some 2% p.a. lower again, reducing actual investors’ return by a total of 63.35% over a 21 year period . This has been seen time and time again throughout many academic studies all over the world, and often occurs as a result of short-term market timing strategies or emotional investors who let fear and greed ruin their longer term investment experience.
There is an interesting facet of economics known as 'behavioural finance', which seeks to explain how certain biases effect responses to situations and contribute towards wealth destroying behaviour. We have explained a few of the phenomenon and suggested some techniques to help combat them in the second of our golden investment rules, maintain discipline.
This is a trait which persists across most areas of peoples' lives, an example being that most people rate their driving ability to be in the top third of the population, whereas (obviously) 50% are below average. This trait can be valuable in life, as it helps you recover more quickly from disappointments, but it can cause problems when making financial decisions.
Investors have been shown to overestimate their own influence on their investment selections and to overlook wider aspects influencing their returns. It means people misattribute luck and skill, so when an investment performs well, it is put down to their skilful selection but when something goes wrong, it is put down to bad luck.
In practice, this leads to investors trading too much, increasing costs and eroding returns. More worryingly, it also leads to investors believing that diversification is unnecessary.
Inertia and loss aversion
People are generally more influenced by the thought of possible losses than possible gains. Indeed, studies have shown that losses are felt twice as much as gains. This combines with peoples' natural aversion to stressful situations and can lead to procrastination and deferring difficult decisions.
One way to combat this is by employing an ‘auto pilot system’. For example, by setting up regular investment payments or selecting a set date to rebalance your portfolio, to remove the emotions from investment decisions.
People can take too much store in too few observations. An example being judging an investment or fund by too short a time period, or expecting a short term piece of information to affect investments disproportionally. A recent example is where US employment figures were released that were better than expected. Logic would suggest this would have a positive affect on the markets, however they dipped due to the increased likelihood of interest rate increases.
To combat this, investors should accept that markets can be very unpredictable in the short term and construct portfolios which accurately reflect their time horizons.
Hopefully, being aware of these biases will help you follow our second golden rule of investing – maintain discipline, in finance, if not in the diet and gym membership!
Look out for our next Intelligent Investor bulletin, where we will highlight our third golden rule.