How emotions get in the way of smart investing

Why do investors fail?

It’s really pretty simple – emotions are the main reasons the average investor fails. Investors fail because they panic in down markets and are overconfident in rising markets. More simply put, too many investors sell when the market has already fallen and buy when the market has already risen. Two typical behavioral patterns are loss aversion and herding:

• Loss aversion: The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as "panic selling."
• Herding: Following what everyone else is doing. Leads to "buy high/sell low."

It sounds simple to fix, but is actually quite complex—we’re talking about human behavior and psychology, after all.

With media pushing a 24/7 news cycle, it’s little wonder emotions, and not sound research, drives too many investors’ behaviors. Forbes had it right; “investors, avidly glued to the financial press, will follow the words of a reporter or market ‘guru’, in order to avoid ‘missing’ an opportunity”.

What is the impact of such behavior? According to one study, if an investor missed only 10 of the best days of nearly 15 years of trading, her return would drop from 8.2 percent to 4.5 percent. Miss the 30 best days, return drops to 0.0 percent. One month in 15 years and your return goes to zero.

Taking it a step further, over a 30-year period through 2014, the average equity mutual fund investor underperformed the S&P 500 by 8.19 percent. During the same period, the fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by 4.81 percent.* This “performance gap” can be attributed to investor behavior, i.e. buying and selling at the wrong times.

Solutions

So what is the solution to avoid this type of behavior? It partially lies in the type of investor, as well as an understanding of a few things about your own behavior. For example, if you prefer to invest on your own, you’ll be much more likely to fall into investor behavioral traps.

 For the do-it-yourselfer, you’ll want to ensure you have a process in place to not allow emotions to overtake reason. One way to do this is through a trusted “advisor;” someone with whom to discuss your research and ideas before making any final decisions. This person could be your spouse, a relative, or a professional, such as a financial advisor or CPA.

For those that do not want to take on investing for themselves, or at least recognizes their behavioral realities, it’s prudent to hire an advisor. There are many types, so to find a good fit, ask yourself a few questions before you engage in your search for a qualified investment advisor.

Do you want someone to assist with more than just investments, i.e. wealth planning, investment strategies, etc.?

Do you prefer being involved in the investment decisions, or would you like to be hands-off and trust that everything is handled properly?

How often, if at all, would you like to meet with your advisor?

Are you okay paying an annual fee, or would you prefer fees that are bundled with investment expense ratios so they’re not as readily seen?

This last quesion provides an important distinction. The compensation and the standard of care are very different for each scenario. For example, if an advisor is someone to whom you pay an annual fee, typically as a percentage of assets, the advisor should be a fiduciary, meaning that they must act in your best interest.

On the other hand, if the advisor takes commissions from the products he or she sells you, they are under a suitability standard of care and must only concern themselves with making sure that any investments you purchase are “suitable” for your situation.

For example, a 65-year-old woman asks her advisor for recommendations on proper investments. If the advisor is under a suitability standard, he could sell the woman high-yield bonds under the premise that the coupon rate and yield will be higher than other investments offered. On the other hand, if a fiduciary advisor were to invest the woman’s money in high- yield bonds, it most likely will be part of a larger allocation to other investments.

The logical question is, how can this be? Since the advisor under the suitability relationship only has to worry about suitability standards, he can argue that bonds are suitable for a woman of her age. By contrast, the fiduciary advisor must look out for the woman’s best interest, and only use the bonds as part of a larger strategy.

For investors, developing investment goals and plans, monitoring and adjusting as needed, and sticking with it is perhaps the most effective way to weather the market’s ups and downs, and keep emotions in check. It’s the best way to turn investing failure into long-term success.