According to John Bogle, founder of Vanguard, the average equity mutual fund gained 173% from 1997 to 2011. The average equity mutual fund investor earned only 110% during the same period.
Why?
One of the main reasons is that we let our emotions control the investment decisions we make. Factors such as greed, fear and loss aversion all play a part. We buy when we think things are going well and sell when things are going badly. Here, we look at this ‘behaviour gap’ and how you can change your behaviour to generate better returns.
The dotcom bubble: a perfect case study of bad investor behaviour
Back in the dotcom bubble of 1999, the NASDAQ rose by 85% in a single year. And, rather than reflecting on the huge rise in the market and where it might go next, investors continue to pile into these stocks.
Before January 2000, the record for net inflows (money going in minus money going out) in stock market mutual funds was $29 billion. In January 2000, the figure was $44.5 billion. In February, it rose to $55.6 billion. March saw a further $39.9 billion.
In just one quarter, $140 billion entered the market after it had already risen by 80%. At a time when investors should have shown some caution, their greed led them to keep on buying.
By October 2002, the market had lost 50% of its value. And, with the S&P 500 down, more than half against its previous high, investors couldn’t sell quickly enough. October 2002 was the bottom of the market and represented the fifth month in a row that investors took more money out of stock mutual funds than they invested.
Instead of buying shares at the cheapest prices in five years, investors moved their money into bonds, buying $140 billion of bonds…at a time when bonds were at 46-year highs.
On a massive scale, investors had made the mistake of buying high and selling low.
Carl Richards, author of Behavior Gap, says: “This is kind of a genetic, almost a genetic, issue. We want more of those things that are giving us pleasure or satisfaction or security, and we want less of those things that are giving us pain.
“So, we tend to pile in at the top, and we’re notorious for it, and then we bail out at the bottom, and it’s the only thing that we purchase that way. We want to buy more when it’s marked up, and we want to get rid of it when it’s on sale.”
How fear and greed affect your investment decisions
Emotion can play a big part in investing and two of the biggest are ‘fear’ and ‘greed’. If you’re nervous each time the stock market falls, you’re being led by fear. If you want to buy in a rising market, it’s greed.
It’s important to think about what sort of investor you are and develop an investment plan accordingly. If you don’t, you could end up selling at the bottom out of fear and buying at the top out of greed.
As Warren Buffett once said: “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”
Why we hate to lose more than we love to win
Another reason that emotions can get in the way of good investment decisions relates to the theory of ‘loss aversion’. As humans, we naturally view ‘not losing £100’ as better than ‘gaining £100’.
When you apply this principle to investing, it can result in bad outcomes. Since we react more strongly to loss than we do to gain, we act illogically in order to minimise our feelings of loss or regret at the expense of potential gains:
We exit profitable positions too early in order to minimise potential loss of gains
We exit losing positions too late in order to preserve our initial entry point.
To remove this behaviour, it’s important for you to set clear ‘buy’ and ‘sell’ points that reflect the actual amounts lost or gained, rather than your emotional state at those price points.
How real financial planning can help you
Over time, things change. There will be births and deaths in your family, career changes and other unexpected events. External events will also play a part: from Brexit to climate change, from new tax legislation to stock market corrections.
Real financial planning is about us helping you to achieve your life goals and ambitions; whatever happens along the way. That’s why we believe it’s vital that we regularly monitor and review your financial plan in order to keep it up to date.
While you may not think that much can change in a six or twelve-month period, we’re always reviewing and analysing a wide range of issues that may affect your plan. Marriage, children or a career change in your life can prompt a review, as can a fall in the markets.
Understanding the issues that you face, finding the right solution, and having the confidence to execute it under pressure is where real financial planners come into their own. We also add value by becoming your ‘coach’; acting as a sounding board to avoid knee-jerk reactions and short-term decisions.
If you want to find out more about how real financial planning can help you, please get in touch. Email team@tfp-fp.com or call us on 01621 851563.
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