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Avoid Emotional Investment Decisions

You are human – decisions are often influenced by the subconscious biases


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Imagine waking up on Saturday morning ready for a sip of coffee and a quick look at how your investments performed during the previous quarter. Your eyes land on your large cap growth fund. The performance numbers catch your attention, but not in a good way. The fund was down 5.49 percent in the first quarter, while the benchmark, the S&P 500 Growth Index, was up 0.53 percent. Instead of essentially breaking even with a low-cost index fund, you paid active management fees and lost about 5.5 percent, in one quarter? Surely you could have been invested in something better. You decide that you are going to call your advisor and discuss replacement options.

WHY DO I THINK THIS WAY?

You pause long enough to eat breakfast before making the call, which allows your emotion to subside a bit. Reflecting for a moment, you ask yourself:

Why the immediate, emotional reaction to last quarter’s poor performance?

Because you are human. 

Our decisions are often influenced by the subconscious biases that swirl around beneath our conscious reason. Some of those cognitive biases can help explain why it is so easy to make a snap judgment when confronted with an investment loss.

Paying Too Much Attention to Recent Pain

People tend to experience the emotional pain of negative events, including investment losses, twice as strongly as they experience positive emotions from good events, like investment gains. To state the principle conversely, a positive experience creates about half the amount of emotional impact as a negative one. Paired with human tendency to allow emotions to influence decisions, it’s a recipe for less-than-rational decisions.

These tendencies are a central feature of Kahneman and Tversky’s 1979 prospect theory, which argues people derive utility or satisfaction from changes in wealth, rather than from absolute levels. A simple example illustrates the concept:

 A person given the choice between

  1. Receiving $20
  2. Receiving $40 then immediately losing $20

 

will typically choose the former. 

That is true even though each situation results in the person having $20; the loss involved in situation two makes it much less appealing.

Another obstacle to investing rationally stems from the human tendency to give more weight to events that occurred recently as compared to events in the more distant past. Despite many past quarters outperforming most large cap growth managers, this specific fund’s recent performance had been poor, which could have resulted in our human brains judging the investment as an overall poor performer. 

These recent, painful experiences are sometimes distracting from other highly relevant data points.  Here, investors may have trouble seeing past recent poor performance despite understanding that performance is only one of many factors that should bear on selecting a mutual fund. After all, investors ought to give great weight to qualitative measures of investment process, style, and personnel, along with the fund’s historical performance. 

WHAT HAPPENS IF I ACT ON THESE TENDENCIES?

Typically, reacting to recent underperformance is a recipe for mediocre investment results. A 2008 study examined the behaviors of 3,400 retirement plan sponsors between 1994 and 2003, specifically focusing on 8,755 manager hiring decisions. The study showed that fired managers tended to outperform their replacements during the three years after the change, even when their historical returns outpaced the fired manager over the previous three years.

WHAT SHOULD I FOCUS ON INSTEAD?

First, remember every fund will underperform for periods of time. The reasons can vary from market cycle, to the fund’s investment decisions taking time to play out, to the manager’s unique style simply being out of favor. Diversification – investing in several different asset classes – typically results in a mix of investments outperforming and underperforming in all market environments. This fund diversification normally lowers the portfolio’s volatility, reducing the shock that any one market factor can have on the portfolio.

Second, consider both quantitative and qualitative measures when monitoring an investment. Pay close attention to the fund’s investment style and strategy, the manager’s experience and credentials, and the overall organization structure and governance. When an investment scores highly in these categories, it means there is conviction that the necessary pieces are in place for the investment manager to execute a thoughtful and proven strategy that will achieve the fund’s stated goals. Paired with the quantitative measures of the fund’s size, performance, and costs, these qualitative criteria provide a robust picture of an investment and its suitability for your portfolio. 

So, when should performance be an issue?

When the underperformance is inconsistent with the investment manager’s process or style, or is the result of a significant process or personnel change, an investor should closely examine the merits of changing managers.

Returning to our large cap growth fund example, the underperformance relative to the index experienced in the first half of 2016 was not inconsistent with the established investment process, was not the result of a change to fund management and was not a problem warranting manager replacement.

Changing funds would have been a mistake.

In fact, if you avoided the pitfalls described above and remained invested, you would have been rewarded with a total return of 22.77 percent, 2.27 percent in excess of the S&P 500 Growth Index return of 20.50 percent, for the period April 2016 through June 2017. Qualitatively, the same investment team has continued to employ the same investment strategy. This includes a willingness to significantly overweight sectors that the team expects to outperform.

To be clear, this example does not prove that every underperforming fund will have an incredible upswing in the following year. Nonetheless, focusing on short-term performance can distract investors from more meaningful factors and lead to suboptimal investment decisions.

Chris Meyer is vice president and Abigail Thomas is senior analyst at Innovest Portfolio Solutions.

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