Use your head

By Ian Davidson
Illustration: John Sapsford

A few simple strategies can help investors make rational and smart emotional investment decisions

Investors are frequently motivated more by emotion than by rational thought when they make critical decisions about their life savings — and that has a big impact on their long-term returns.

In fact, Boston-based research firm Dalbar Inc.’s 2005 quantitative analysis of investor behaviour (QAIB) revealed that investor behaviour plays a much bigger role in investment returns than does fund performance.

That means it is important for investors to develop strategies so that they invest with their heads, not just their hearts.

In recent years, an academic discipline has emerged to study the ways investors make decisions. It is called behavioural finance, and it has identified nine major emotions that can cause investors to underperform. These include:

Loss aversion: investors expect to get high returns associated with low risk.

Narrow framing: investors make decisions without taking into account all of the implications of their actions.

Anchoring: investors relate situations to familiar experiences even when this is not appropriate.

Mental accounting: investors take unnecessary risks in one area while avoiding rational risks in another.

Diversification: investors attempt to reduce risk but end up with different sources of risk.

Herding: investors mimic the behaviour of other investors even when this leads to negative outcomes.

Regret: investors focus more on errors of commission than on errors of omission.

Media response: investors react to news reports without examining and questioning them.

Optimism: investors are convinced that everything will work out for them, while bad outcomes only happen to other people.

Clients and their advisers battle the clients’ worst instincts. Investors need to understand the negative impact bad investor behaviour can have on their portfolios and how to make more objective, rational choices.

The graph (please see “Market returns vs fund sales,” above) shows that Canadian equity fund sales typically lag behind S&P/TSX composite one-year return performance. In other words, investors often get into the market too late, missing the lows that provide an opportunity to buy on sale, and then sell out their holdings just when returns are starting to improve.

QAIB provides additional evidence that investors frequently make the wrong call. Using a new “guess right ratio,” Dalbar found that people buy low and sell high only in minority cases. An astonishing 75% of the time, the average investor guesses wrong in down markets, failing to achieve a short-term gain by buying before the market rises or selling before the market falls.

Emotion plays the biggest role when markets are faring poorly. It is important for investors to realize that the times when they are feeling discouraged about their investments often represent the point of maximum financial opportunity, when markets are poised to rebound. Similarly, euphoria about investments generally means markets have reached their zenith, and that is actually the point of maximum financial risk.

When investors understand that their emotions are usually not in sync with the opportunities and risks facing their investments, they can begin to recognize the danger signs of too much despair or too much enthusiasm, and look more closely at the rational reasons to buy or sell in a particular situation.

The following are four simple investment strategies that can help investors make rational investment decisions.

1. Get expert advice and focus on the big picture. If a client wants to sell some equity investments, the client and his or her adviser should discuss why the client wishes to sell now. If there are financial obligations the client needs to meet over the short-term, there may be a better way to meet those needs without jeopardizing the potential to earn back any value lost during the bear market. Locking in losses is the only sure thing that clients achieve by choosing to sell investments at the lowest ebb of the markets.
   
   One of the biggest strengths advisers have in helping clients through all market conditions is their ability to get the clients to focus on the big picture — their overall financial well-being and the importance of their long-term goals.
   
   
2. Utilize an investment policy statement. An investment policy statement is a written document that outlines the investment process an adviser and client have agreed upon and helps to guide both as they make investment decisions. It articulates the client’s investment objectives, lists investment time horizon, income and liquidity requirements, risk tolerance and tax situation, describes the client’s investor profile and recommended portfolio and explains investment management guidelines. These guidelines may include a commitment from the adviser to recommend appropriate diversification strategies, conduct portfolio reviews, monitor and provide rebalancing advice when necessary and measure performance against specific benchmarks.
   
   By creating an investment policy statement, the adviser and client are creating a memorandum or understanding with investors that ensures they get the best possible advice for their situation.
   
   
3. Dollar-cost averaging through a systematic investment plan helps investors resist the temptation of following their gut instincts toward less favourable returns. Regular investments can keep investors focused on long-term investment goals instead of short-term emotions. And the benefits can be impressive: QAIB discovered that systematic investors who use the dollar-cost averaging strategy have the potential to realize returns that beat the average investor by 70%.
   
   
4. Consider mutual fund investing for cost effective diversification, professional portfolio management and liquidity needs. Mutual fund portfolio managers are dedicated to selecting and managing suitable investments for the fund. They make the buy and sell decisions concerning which stocks, bonds and other securities to fulfill the investment objectives of the fund.

Mutual funds also provide investors access to a diversified portfolio with a minimum investment. It would be impractical and expensive for someone with only $5,000 to select and purchase shares in 20 different securities. Assuming the investor purchases a minimum of one board lot (i.e. 100 shares) of each security at an average price of $10 plus commission, an individual would have to invest at least $20,000, calculated as [(100 x $10) x 20], in order to establish a modestly diversified portfolio.

Mutual funds are also typically very liquid investments, converted into cash by redeeming them at the daily net asset value per share.

The statements contained herein are based on material believed to be reliable but are not guaranteed to be accurate or complete. This article is not intended to provide individual financial, legal, tax or investment advice. Particular insurance, investment or trading strategies should be evaluated relative to each individual’s objectives. TD Asset Management Inc. is not liable for any errors or omissions in the information or any loss or damage suffered.

Ian Davidson, MBA, CFP, CA, RFP, is vice-president with Assante Capital. He is technical editor for Personal financial planning