APPLYING INVESTMENT RULES INCREASE RETURNS AND SATISFACTION

July 2011

Behavioral economics and finance use social and emotional factors to understand the limits of rationality in making economic decisions. A recent survey by Barclays addressed techniques used by wealthy investors to increase both investment returns and their personal satisfaction. The survey covered over 2000 net worth individuals across the world, all of whom had at least £1 million of investable assets, including over 200 who have over £10 million of investable assets. The survey also interviewed numerous academics, entrepreneurs and other experts about the meaning and reasons for the results.

The study provides an excellent summary of the conclusions of behavioral economics applied to personal investing, as follows:

“One of the difficulties we have as investors is what we might call “failures of rationality,” which makes it very difficult for investors to do the right thing as prescribed by classical finance. Failures of rationality in investing behavior can perhaps be best divided into four categories, as follows.

 Failing to see the big picture

We are all subject to what psychologists call “narrow framing” — we consider decisions in isolation, without looking at the big picture. We therefore tend to focus on investment decisions one by one, without considering the impact on our overall portfolio. This could mean we miss out on diversification opportunities, make new investments that cancel out existing ones, or decline opportunities that look too risky on their own, but would be a good addition to the overall portfolio.

Using a short-term decision horizon

We also consider and make decisions narrowly based in time. We base our decisions on anticipated performance over short time periods, when what matters is growing our wealth in the long term. … All humans are prone to loss aversion – the tendency to feel the pain of a loss about twice as strongly as we feel pleasure from an equivalent gain. Since the proportion of losses we observe increases when we use shorter time periods, loss aversion means our willingness to accept risk is much lower when we focus on the short term than it should be. This common feature of investor behavior is known as ‘myopic loss aversion.’”

Buying high, selling low

The issue here is comfort, we all tend to take more risks when we are comfortable, and fewer when we are not. The problem is that we tend to be comfortable when markets have been rising for a while and when we have been surrounded by good news. We are uncomfortable when we have been through times of stress and chaos. Unfortunately this means we are likely to take on more risk when markets are high, and less when they are low. In fact, we would be better off to buy and hold.

Action bias (trading too frequently)

Several of the biases discussed above lead to an action bias. Our failure to focus on the big picture leads us to make small, frequent decisions. If market conditions are volatile, we will trade to feel like we are doing something about the market deviations (buying high and selling low, and focusing on the short term). The more you trade, the higher your costs, and the higher the chance of making decisions that are emotionally driven or based on market noise. Most of the time the best advice is simply to do less than you are inclined to.”

Our online interactive tool provides an opportunity to see the impact of longer time horizons on investment returns. The tool demonstrates how a long-term perspective allows an investor to earn greater returns without getting rattled by shorter-term volatility that occurs with the higher-yielding stocks (vs. bonds). The study summarized the dangers of a short-term perspective as follows:

 “Short-term preferences and emotions can also lead to a number of more specific investment failures. Some examples of the ways this can manifest itself in an investment context include:

 • Anxiety about potential short-term losses without recognizing that if you take a long-term view of your portfolio, there is an increasing probability of investment gains. This may prevent people from entering or staying in the market during times of poor market conditions.

• Trying to strategically time the market and ending up paying for it. Instead of buying low and selling high, our emotions tempt us to do exactly the reverse.

• A tendency to buy asset classes that we feel more familiar with. Emotions make us feel safer in asset classes we are more comfortable with; for example, many have a preference to invest in their home markets even though we thereby lose many benefits of diversification

• After losses people often stay out of the market for too long — being burned in the past leads us to be more cautious in the future.”

The use of rules was correlated with both higher wealth, and higher satisfaction. The ability to control one’s emotions using rules such as these has a big impact on the investment returns one achieves. According to the study:

“One key reason why individual investors systematically underperform professional investors is not that they’re inherently worse investors, but simply that professional investors are aided by a strong set of institutional rules that ensure greater control of their knee-jerk reactions. …

Whilst many high net worth individuals in this study are able to identify that financial strategies are effective, another of our key findings is that for particular personality types, these strategies are associated with increased financial satisfaction. Not only do strategies bring this hidden emotional benefit, but our study also found these strategies were associated with higher wealth levels. …

This lack of control over our emotions is not an abstract problem; in fact, it can have tangible, detrimental effects on both investor satisfaction and performance. A recent Dalbar study into investor behavior found that over 20 years, ending December 31, 2010, the average equity investor earned 3.8% a year, while the S&P 500 index returned 9.1% annually — a considerable difference. This effect was also found in a study commissioned by Barclays Wealth at the Cass Business School from 1992 to 2009, though the results were more conservative. The total return of UK equity funds was 6.5% but the average investor earned only 5.3%. Compounded over 10 years, this difference is significant – it is a sacrifice of nearly 20% of one’s return.”

One might think that older investors might be more nervous about risk because of a lack of options to correct or overcome large mistakes. However, older investors were characterized by greater calm, acceptance and satisfaction. This impact was independent of security caused by greater wealth. The report summarized:

“An analysis of older investors’ personality and desire for financial discipline showed a “Zen of Ageing” effect where older investors gained more composure, were less prevention focused and had a lower desire for self-control. We see this translate into a reduced use of self-control strategies in general as we get older.”

 Imitating wealthy investors in these areas is also a good idea for those with fewer resources. Fulcrum Inquiry performs economics consulting and business valuations.

Fulcrum Inquiry performs economics consulting and business valuations.