Keep the Emotion out of Investments

The response by investors to the current volatility in global stock markets highlights the dangerous tendency for investors to make decisions based o­n emotion, rather than reason.

Globally, $487bn moved into money market funds in the first quarter of 2008 compared to the $250bn in the last three months of 2007. The majority of this came out of equity funds. In South Africa, the Association of Collective Investments (ACI) reported at the end of the June 2008 quarter that money-market accounts gained popularity with net quarterly sales of R10.2bn.

“Unfortunately, the decision to move from high equity products to very conservative investments is emotion driven and is not a good strategy for investors, particularly those with a long-term investment horizon,” says Megan Butler, head of research at Old Mutual Actuaries and Consultants. “This is due to the fact that when markets recover, cautious investors miss out o­n the often substantial recoveries in share prices.”

She adds that similarly, rocketing share prices not supported by fundamentals are caused by herd mentality, when investors derive comfort from investing with the herd. “Unfortunately, these so called bubbles can have devastating consequences for investors when sanity prevails.”

Gary Hartwig, an actuary at Old Mutual Actuaries and Consultants, says a study of behavioural finance shows us investors are often driven by emotion, rather than facts, allowing for irrational behaviour when making investment decisions.

“To illustrate the point, with children in your home, would you consider a swimming pool or gun more dangerous? Just as swimming pool drownings are 100 times more likely gun-related accidents, the markets are likely to rise more often than fall o­n any given day,” Hartwig says. “Unfortunately, shocking negative events tend to receive far higher volumes of media coverage and stick in people’s minds.”

“In an investment context, investors should avoid looking at short-term performance to make long-term decisions as they are more likely to see unusual events and may not get a true reflection of the actual performance,” Hartwig comments. “For example, judging a particular asset manager over a short-term time period will not necessarily give you an accurate picture of ability over the long term which may lead to serious errors when allocating assets.”

‘Heat-of-the-moment’ decisions can have far-reaching negative consequences for investors,” says Megan. “Investment decisions are complex and should be thoroughly examined. I encourage investors to consult an expert in the field who is able to view markets objectively. They will make short-term or tactical calls o­n exposure to equity markets in order to lock in returns when markets do poorly, and to maximise returns when markets recover.”

Investors should be spend time focussing their investment strategy, taking a 20 to 30-year view and not making decisions based o­n the last 2 or 3 years of performance. “Investors should not be influenced by the fear of regret, but strip out emotions to provide an objective viewpoint based o­n common sense,” Hartwig concludes.