Emotions cost investors dear, research finds

Knee-jerk reactions and short-term thinking lead to significant losses according to research by Oxford Risk (as reported in the Financial Times – Madison Darbyshire, October 24, 2020). 

Investors lose an average of 3 per cent a year in returns to emotionally-driven investment decisions, a gap that widens significantly in times of steep volatility such as the current pandemic, research found. Oxford Risk reached its conclusions about the role of emotions in losses by analysis incorporating two decades of academic studies and economic data on investment.

“Losses are amplified when markets perform more badly because inevitably that’s when our emotional response is at its strongest,” said James Norton, an adviser at Vanguard UK.

During periods of high stress, investor losses can rise to about 6 or 7 per cent a year from emotionally-guided investment decisions, according to investment risk adviser Oxford Risk. That number rises significantly if someone fully invested in equities were to have sold out at the bottom of the March downturn.

“Recency bias” is the assumption that because an investment is underperforming it will continue to underperform,
or that when an asset is outperforming, it will continue to rise in value. This causes investors to sell underperforming assets when they are down, crystallising losses. A compulsion to buy high and sell low costs investors 1.5 to 2 per cent a year, compared with a buy and hold strategy.

A desire to back products and services that feel familiar during times of uncertainty can lead to overexposure and under-investment, or investing in things that are widely popular and likely to be overpriced e.g. AfterPay.

Marcus Quierin, chief executive of Oxford Risk, said: “Retail investors should avoid watching the markets day-to-day as this will only increase anxiety to no useful end, and make you feel like you should be doing something, without any useful guidance to what that should be.”

Investors increasing their cash holdings due to uncertainty is costing them 4 to 5 per cent a year over the long term, Oxford Risk said. By sitting in cash, investors “are buying themselves the ability to sleep better at night”, Mr Davies says. But getting back into a volatile market is a particular challenge, he added. “People have money that they’re not deploying because they’re worried about Covid, as well as markets being high . . . Investors fail to deploy their cash because in the short term it’s easy to find an excuse not to.” 

Advisers recommend those who have come out of the market reinvest in tranches over time, to avoid losses that come from mistiming their re-entry. The most important thing is to have a plan and stick to it, in order to ensure that investors have both enough financial liquidity — such as cash on hand to ride out an uncertain time — as well as “emotional liquidity” to avoid emotional decision making.

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Sofie Korac is an Authorised Representative (No. 400164) of Prudentia Financial Planning Pty Ltd, AFSL 544118 and a member of the Association of Financial Advisers.

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