Why do so many investors do exactly the wrong thing at the wrong time?
Why did so many investors take money out of the equity markets in the last quarter of 2008 and the first quarter of 2009, when the market was at its lowest point?
Why were many investors reluctant to add money to their equity mutual fund RRSP in January and February 2009 when the market was offering discounts of 40 to 50 percent?
Why did a large percentage of investors miss the significant market rally in 2009?
Why are thousands of investors still sitting on the side- lines in Money Market funds waiting for a “sign” that it is time to get back into the market?
Why will thousands of investors jump back into the market again after it has increased in price by 20 percent or more?
Why do people clamor for sales when they buy everything except investments?
Why do investors repeatedly sell what has decreased in price and buy what has increased in price?
Why do most investors receive a fraction of the market returns?
Why is this investing stuff so difficult to get right?
Why? Because we are hardwired to fail at investing.
Before I go any further, I want to acknowledge that there is a small percentage of the investing public that these comments do not apply to. These individuals have managed to override the hard-wiring affecting most of us, and consistently make sound, objective decisions about their investments. They don’t always make the right calls, but their batting average is good enough to produce positive long-term results.
O.K., let’s get back to why investors behave badly. Behavior scientists have identified many reasons to explain investor behavior, but the two biggest emotional culprits which sabotage our decision making are fear and greed. It isn’t simply that these emotions are so powerful, but that they unfortunately they have an unequal effect on us.
The fear of loss is estimated to be two to three times stronger than the euphoria of gain or profit. Consequently, the emotional effect of a 10% loss is not equal to a 10% gain. The loss feels like a 20 or 30%, so panic sets in. The 10% gain satisfies our greed motive but does not have enough staying power to offset the panic when it sets in.
To compound the problem there is “free” advice from colleagues and family, plus the media, focused on sensational negative events. It is no wonder that investors start selling low and buying high and wonder why they can’t make any money!
I have long ago given up trying to change this emotional hard-wiring. Instead, I have accepted that investors behave irrationally, and developed an investment-planning process which recognizes as a central theme that investor behavior will have the largest bearing on the success of the investment program. Unlike many investment planning processes, mine does not start with researching rates of return, MER (management expense ratios), volatility, investing styles, market trends, interest rates, etc. Instead, I focus on the investor—not the investment. First we have to know why an individual is in- vesting. It sounds straightforward, but this is often overlooked, or it is assumed that every- one wants to invest in the market.
Many years ago I asked a client who had several hundred thousand dollars invested in GICs why he wasn’t taking advantage of higher potential returns and better tax treatment of the returns by investing in equities. His answer: “Because I don’t have to. I can’t spend the money I’m making now, so why should I complicate things?”
If investors are going to stick with an investment plan, they have to have a strong underlying reason for doing so. If they do not, the first sign of adversity, i.e., a bear market, will make them question their plan.
Our process is called Blue Sky Planning. It involves an optimistic visualization of an individual’s financial future as it pertains to his or her family, career/business, retirement and estate. One or all of these areas will answer the question “Why are you investing?” This discussion will also tell us how much the investor will need, which in turn tells us what kind of a return he or she needs to receive.
Once we understand why an individual is investing, we move on to the next question:
“What kind of investment strategy will give you the best chance of avoiding the typical investor mistakes caused by fear and greed?”
For some investors, simply recognizing the un- equal power of these emotions, along with coaching from their advisor, is enough to provide a framework to keep the plan on track. Often, having a diversified portfolio with automatic re- balancing minimizes the emotional extremes. Others are willing to pay for guarantees and downside protection. For some, having part of their investments in safe, simple products allows them to invest some of their money in the market and deal with the volatility.
We always emphasize that there are no right or wrong products, but there are products that are right for the investor.
Just because most of us are hardwired to fail at investing does not mean our investment strategy has to fail. If we know why we are investing, and have created an environment conducive to good investor behavior, we can enjoy not only reaching our investment targets but also the journey along the way.