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Emotions - bad for an investor’s wealth?

July 7th 2015

Life comes with plenty of decisions. And you only need to look at history to know that us human beings don’t always get it right. Take Lehman Brothers. The firm’s strategy to dramatically increase the amount it borrowed was not the smartest decision known to man.

Humans make bad investment decisions

Whether we recognise it or not, most of us are notoriously poor at making investment decisions. This is because our life experience makes us filter information in a certain way. We are not aware that we make many false assumptions, for example, based on our cognitive and emotional biases - and this stands in front of every decision we make.

For a start, the weight we place on certain information impacts our ability to analyse things objectively. Negativity bias illustrates this well. It means we often put more weight on negative news over good news, and this can lead to us being too cautious when things are going well, such as during a bull market, and so we end up missing out. No doubt this sounds familiar to most investors.

Other common inhibiting cognitive tendencies include confirmation bias, where we only listen to the information that suits us best. We also have an innate tendency to see patterns in a series of random events, which can lead us to draw incorrect conclusions and make misplaced predictions.

It’s not just our own decisions that are affected by these human behaviours though - the whole financial market is based on them. Just think about self-fulfilling prophecy. If enough of us believe something is going to happen, then, true to form, it often does. This impacts the financial markets on a daily basis, as the beliefs of both individuals and collective groups filter through into what we read in the news - where most of us go to make our independent investment decisions in the first place.

That leads us on to another commonly quoted investment bias - chasing past winners. We all know this is unprofitable behaviour, yet if we were truthful most of us would have to admit to being guilty of it at some point. It’s an inborn emotion that kicks in because of our default need for security. To prove its influence on investor’s decisions, studies have shown that around 40% of new money invested into mutual funds goes into the top ten performing funds from the previous year.

So these are just a few of the things that can divert us from the path to good returns. It’s no coincidence that investor Benjamin Graham famously said, “The investor’s chief problem - even his worst enemy - is likely to be himself.”

Too much trading can be hazardous to your wealth

Here’s something that shocks many investors: trying to anticipate investment opportunities leads most of us to underperform the market. Carl Richards refers to the gap between market return and the average investor’s underperformance as the ‘Behaviour Gap’. It’s not that we are dumb, he says. It’s just that we let these cognitive and emotional biases described above stand in the way of good investment decisions.

What’s more, not only are the actions we take likely to be the wrong ones, but we are more inclined to act too regularly. Overconfidence - or an urge to believe that the information we have is superior to that of the market - leads many investors to underperform due to a high frequency of trading.

In a comprehensive analysis of trading, a University of California professor proved that when an investor sold one stock and bought another, the one they sold on average outperformed the purchased stock by 3.3%. So, taking action might not always be the right thing to do.

Using an automated investment service can take the emotion out of investing

Technology may have the answer. Using an automated investment service, for example, can help an investor overcome these inbuilt human biases. By making the investment process far more disciplined, a good automated investment service can promote efficiency by eradicating all of the emotional noise.

But simply taking the emotion out - by automating your investment decisions - is not enough on its own.

Firstly, there needs to be a solid strategy in place to start with. So, at ETFmatic, we will work with you to define your investment strategy - addressing your risk tolerance, investment style and time to respond to market changes.

Then, with this investment strategy driving it, asset allocation is automated using Exchange Traded Funds (ETFs), as ETFs are proven to be to be far more cost-effective than both active funds and other types of index funds.

ETFmatic’s automated investment service forces investors to stick to a discipline, using cost-effective instruments, that will help you achieve your predefined investment goals.