How to avoid being your own worst investment enemy

This week I am going to summarize the findings of a research report by the ScotiaMcLeod Portfolio Advisory Group research team. The June report is entitled “Investment Pitfalls and Opportunities: Replacing Psychology with Discipline”

Standard economic models assume that individuals are rational and will try to maximize their benefits and minimize their costs. However, studies in behavioural finance have shown emotions and psychology do play a role in markets as investors are not always rational. There are costs of emotional decision-making and ways to avoid such behaviour.

The first behaviour is loss aversion. This relates to the idea that investors feel more pain from loss than they feel pleasure from gain. In a study conducted by behavioural scientists, Daniel Kahneman and Amos Tversky, they concluded that individuals feel the pain of a loss approximately two times more than the pleasure generated by a gain. In another behavioural scientist study by Antonio Damasio and George Loewenstein concluded that investors with an intact emotional brain chose to invest less than 60% of the time due to fear of potential loss. Furthermore, the willingness of people to gamble decreased drastically after they lost a gamble. This highlights a common pitfall caused by loss aversion. We see investors pulling out of the market when they suffer a loss and often times hesitating before re-entering. We witnessed this behaviour in the most recent market downturn as investors sold out of the market quickly and rushed into cash and cash equivalents. Another loss aversion behaviour is to realize gains quicker than losses so they tend to sell their winners too soon and hold onto their losers too long. It is irrelevant what the price is today, the question you should ask is if you had cash would you buy this stock and if it is yes, then hold onto it, and if the answer is no, then sell it.

The second behaviour is herding. This is the tendency of individuals to follow others rather than deciding independently on the basis of their own information. Keynes conceived “herding as a response to uncertainty and an individuals perception of their own ignorance; people may follow the crowd because they think the crowd is better informed.” Some symptoms of herding include: trading often, buying the latest hot stock or acting on tips from your buddies at the golf course.

The last behaviour is availability bias. This occurs when investors add more weight to more recent and readily available information so investors react to the most recent headline. Some symptoms of availability bias are choosing mutual funds that heavily advertise returns, overreacting to good/bad news or believing an “opinion” to be factual. The result is that investors chase returns on the way up and panic on the way down. According to ScotiaMcLeod PAG Fund Research analysis, “almost 75% of long-term fund redemption activity took place in the last 4 months of 2008 – near the bottom of the market.”

So how can we avoid being our own worst enemy? It all goes back to the old adage of staying invested and being disciplined. Develop an investment policy statement that allows you some flexibility within ranges. In addition, develop a discipline around buying and selling.