It’s not unusual for investors to experience a tug-of-war between the rational and the emotional. Until recently, investing was considered to be a largely logical activity. Find the right quantitative strategy or forecasting model, and you’re off and running. But getting the jitters and pushing the sell button at the first sign of a market downturn is, typically, a sign of someone acting on emotion.
Often, the emotional response is due, at least in part, to a behavioural bias. For example, perhaps the antsy investor sat out a previous market correction, and now regrets the inaction. Or perhaps he or she just wants to feel in control, and even a panic-driven decision to sell seems better than just sitting back and doing nothing.
Why we do what we do is a question most of us have difficulty answering for certain. As a wealth advisor, part of my job is to understand a condition known as ‘behavioural investing’ – an awareness of the human biases that can often influence a client’s investment decision-making.
While there are many examples of this propensity out there, what follows are three of the most frequent:
1. Loss aversion – where investors feel the pain of even small losses significantly more than the pleasure of equal, or even larger, gains.
Two major events in the past twenty years have increased the fear of loss aversion. 2001 and 2008 saw significant losses to an individual’s wealth. These memories stay in the minds of people usually forever. Despite recovery from both of these episodes and despite the markets and most investors sitting at all-time highs; the fear of loss remains front and centre.
2. Recency effect – when you buy an investment based on its recent performance, you could be vulnerable to the tendency when making a decision to give recent events more weight than things further in the past.
This is more evident today than ever before. The markets are sitting at all time highs. Individuals who have been sitting with large positions of cash have missed out on significant gains and are now anxious to join the parade. The saying is buy low, sell high. The unfortunate scenario for those who do not receive advice is buy high, sell low.
3. Herding – the pain of social exclusion for many clients is too great to bear, so the need to own the investment flavour of the day prevails, win or lose.
There have been many investment sectors over the years that have exploded the returns. Gold market, mining stocks, tech sector, and more recently, pot stocks. This can be very dangerous to a client’s savings and retirement plans. It is very important to stick to your financial plan, remain within your risk tolerance, and to ultimately achieve YOUR goals, not anyone elses.
All of these dispositions, and several others, can have potentially disastrous consequences for the investor. The key to neutralizing them is in the recognition of when and where they occur in the investment decision-making process, and applying a brake to precipitous action. And that’s where I come in.
Geoff Funke is a Senior Wealth Advisor at ScotiaMcLeod®, a division of Scotia Capital Inc. of Scotia Wealth Management. Tel.: 604.535.4721.