Emotion wreaks havoc with investment return

16 September 2009 Gareth Stokes
Franco Busetti

Franco Busetti

You cannot allow sentiment and emotion to dominate your investment decisions. Pearls of stock market wisdom have been passed from generation to generation by the world’s greatest investors. From the simple ‘trend is your friend’ to the irritating ‘buy low – sell high’ and the unexpected ‘avoid the herd’ there’s more than enough advice doing the rounds. And most of it focuses on emotion – or to be more accurate – stripping emotion from your investment decision.

If you allow emotion to guide your investment decisions you’re bound to make expensive mistakes. Fear and greed are often fingered as the emotions that cause investors to mess up their market timing. Greed drives them into markets when stocks are way too high, while fear forces them to sell shares when there’s still plenty of upside.

Understanding investor psychology

Psychological traits influence individual choice. It therefore makes sense for financial intermediaries to get to grips with some of the emotional responses their clients might have where investing is involved. The topic Psychologies of Investing for Financial Advisors is covered in detail in The Effective Investor by Franco Busetti. He dedicates a chapter to the common patterns investors follow, including overconfidence, over-optimism, anchoring, hindsight and imitation.

Overconfidence, in the context of investing, is when a person believes their estimates are more accurate than they actually prove to be. Research conducted by Brad Barber and Terrance Odean shows that men trade 45% more than women, reducing their net returns by 2.7% per annum. This research suggests that women are less overconfident than men, with the result they trade less and produce higher returns! Over-optimism is overconfidence in a positive direction. Optimists have a high opinion of their talents and underestimate the likelihood of bad results. Anchoring is perhaps the most insidious of investment mistakes. We tend to take the current or starting value of, for example, a share as the status quo and anchor our expectations to this level, even though it may be totally removed from fair value.

Hindsight is the perfect science

Hindsight is often easier than foresight when investing and promotes overconfidence. It is also an unnecessary element of investor regret. You didn’t possess the knowledge you have today when you made your investment decision three weeks ago – so don’t crucify yourself with it. When an error in judgement results in a loss, learn the lesson and move on. Imitation, herding and contagion are all words that describe a person’s tendency to allow their judgement to be impaired and influenced by the opinions and actions of others. In many instances, herding behaviour by investors can be reflected in significant deviations of financial prices from their intrinsic values, which leads to volatility, bubbles and crashes. Be sure to check the latest information or research on hand regarding a decision you need to make before you follow the crowd.

Other investor psychologies include the disposition effect and cognitive dissonance. The former is the reluctance of investors to realise losses. If you need cash and must sell one of two stocks, one that has gone up and one that has gone down, you are more likely to sell the stock that went up, irrespective of the fundamentals. The trick is to have exit rules and stick to them. And the latter describes a mental conflict that is experienced when a person’s beliefs are proven to be wrong. We tend to try and reduce this by avoiding new information or displaying selective amnesia. When investing, it is important not to stick your head in the sand!

Investor questions answered

Psychology aside, The Effective Investor provides a clear and simple explanation of how the stock market works, the key principles that drive markets and how to improve your investment performance and meet your expectations in both the short and long term. It covers essential information about the South African stock market that is relevant for private investors and investment professionals alike. Other questions addressed in The Effective Investor include:

• What drives returns?

• What does ‘risk’ really mean?

• How to set realistic ‘return’ expectations

• What fatal traps are avoidable?

• How much to invest offshore?

You can use your understanding of emotive responses to market conditions to become a better investor. Whilst many of us wish we could remove emotion from the investment mindset, it is not humanly possible and would result in an inability to make any decisions at all! For a more detailed look at these characteristics and other essential information about the South African stock market ensure that The Effective Investor is on your reading list.

To win one of three copies of The Effective Investor simply send your name, address and answer to the following question to “Which American investment guru is also known as ‘The Oracle of Omaha’? We will send a book to the first three correct emails received.

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