Sunday, 10 September 2017

The Emotional Investor

There is a widely held perception that investing on the stock market is very risky . I often read comments in the popular press money pages which suggest it is akin to gambling at the casino where the odds are heavily stacked in favour of the house. 

There must be a good reason for this - some will result from having a poor understanding of finance generally but others may have ventured into investing without understanding the nature of the risk they were undertaking or how they would react to a sudden fall in the markets. Many new investors are sucked in to making easy money when there has been a prolonged bull market (such as now!) but are totally unprepared for a 20% loss when the bull run ends and fear grips the market.

A little while back I set out some of the elements to becoming a successful investor. For me, this would include :

·                     having a simple plan - a good idea of what you want to achieve & how you will get there;
·                     an understanding of compound returns and the importance of patience/time; 
·                     the importance of keeping costs low; 
·                     maintaining a diverse portfolio and balanced allocation of assets; 
·                     understanding market volatility and mean reversion; 

We may spend a great deal of time researching our investments, maybe looking into some individual shares, comparing funds to ETFs, the costs of active funds v passive etc. without a thought on whether we possess the right emotional attributes to carry through a long term project.

Whilst all the above are important, the end result of a carefully researched plan may fall short without some understanding of your emotional/psychological make-up and ensuring this is a close match with your chosen investing strategy.

Emotions will play a large part in our lives - work, relationships etc. and it would be surprising if they did not come into play during the investing process. At times, the markets can be a rollercoaster ride - it can be just as challenging to stay with the plan during the upswings as when the markets head south. We may be driven by greed to maximise returns from our portfolio when markets are rising and then gripped by fear at the prospect of losing any gains during a bear market which seems to appear from nowhere.

Get to Know Yourself

"We have seen much more money made and kept by 'ordinary people' who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock market lore"  Warren Buffett.

We therefore need a plan which takes into account our personal capacity and reaction to loss and then put in place a realistic allocation of assets to closely match the degree of risk and volatility we are prepared to take. Some people are natural risk takers and may be temperamentally well suited to a higher exposure to equities, whilst others are naturally cautious and require a more balanced allocation which may include a higher percentage of bonds, fixed interest and property.


However, staying calm when the markets take a tumble will present a challenge for the most relaxed investor. It is therefore important to have a robust plan for the long term so that your strategy does not collapse during the rough seas of market volatility.

Your Personality

We all possess unique personality traits and preferences combined with a range of emotional and cognitive biases which all impact on the way we invest - or even prevent us from engaging in the investing process completely. There are many academic studies of this aspect of investing known as behavioural finance.

An assessment of our emotional make-up does not need to be complicated. Most people will know whether they are naturally cautious/reserved or carefree/outgoing. Some people are natural risk-takers, others prefer the slow & steady option.

Knowing these basic types will help to select the most appropriate asset mix. You can use an online tool such as Vanguard's AssetMixer to show how various allocations of equities/bonds/cash perform over a set period.

(click to enlarge)

As a general rule, the anxious/cautious personality will be more suited to a steady, low volatility portfolio with a higher percentage of bonds and cash in the overall mix and correspondingly lower proportion of equities.

Wealth managers can try to understand their clients personality type by identifying four basic profiles - Preservers, Accumulators, Followers and Independents.

Preservers place more emphasis on preserving what they already have and do not feel comfortable taking risks to accumulate more wealth. They will keep a close eye on short term performance and will become anxious about losses. They may even have difficulty taking action for fear of making a wrong call...making no decision is better than making the wrong decision.

On the other hand Accumulators are confident risk takers who typically believe the path they have chosen is correct. They may have been successful with business ventures and believe they will also make a success of investing. The over-confident type typically believe they have an edge over others and will be attracted to active management and stock picking which are higher risk strategies.

Followers will typically latch on to the latest investing trend or pick up investing tips from friends or discussion boards. They do not work out their own plans and may follow the bandwagon without any real understanding of the financial markets or risks involved.

Independents take great interest in the process and can analyse a situation and then trust their own judgment to make confident and informed decisions. Independent thinking and having confidence in what you believe is much more important than being the smartest person in the market.
 

So, are you naturally cautious or do you like the thrills and spills?

Do you seek instant gratification or are you patient?

Are you more skilful than the average investor?

Can you accurately predict the direction of the markets?

Are you overly influenced by the so-called experts or do you do your own thing?

How would you react to losing 10% of your portfolio value?…25%?…40%….?

Stay the Course

Having a little insight on how you may react in certain situations will be a big advantage in the process of investing. It could make the difference between reaching your long term objective or falling at the second hurdle.

Personally, it has taken some time for me to understand the links between my investing strategy and behavioural biases and psychological temperament. I can well understand the whole process intellectually, but implementing a well-thought out plan for the longer term has involved coming to terms with my tendency towards over confidence and under-estimating of the risks involved.

I also have a tendency to over-activity which leads to tinkering. I am slowly coming to terms with the concept that doing nothing 9 times out of 10 is probably the correct course.

As a result of this increased awareness, I have made a few adjustments to my strategy in recent years. These include the moving away from the constant monitoring of my portfolio; deciding a basket of individual shares was no longer suitable; a gradual move from actively managed to passives;  simplifying the strategy by incorporating Vanguard Lifestrategy as a core holding.

There is no perfect strategy. Different plans will suit different investors with different circumstances. I suspect the best plan is one which is more likely to ‘fit’ with the individuals psychological make-up and is therefore most likely to keep them in the game and get them to their destination.

…the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness. (Warren Buffett)


What emotional aspects of investing cause difficulties to you? Feel free to leave a comment and share your thoughts and experience with others.

4 comments:

  1. Ciao DIY,
    Very nice article, I am also getting to the conclusion that not acting, 9 times out of 10, is the best choice. I do not consider myself a "trader", I am more of an investor, and this means that sometimes I can just let time do it's job. A small portion of my portfolio is dedicated to more "aggressive" trades today, I can get my thrill from that if I need it, but the rest has a more patient approach. This realization got me to modify my option strategies for example. It might not give me stellar returns but it's good enough for me! :)
    Ciao ciao
    Stal

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    1. Stal,

      Good to hear from you...I hope you are enjoying your 'sabatical'.

      Yes, getting to a position where you accept the returns are 'good enough' and not being unduly concerned about your portfolio sounds like a good position. I understand the 'buzz' from having a small percentage of your portfolio for more exciting options will help to maintain the larger, more boring element. The situation is similar with my small holding of Scottish Mortgage and core holding of Lifestrategy 60.

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  2. I'm heavily invested in equities (>85%) and consider myself a higher than average risk taker. My profile is probably closest to Independent.

    I am convinced that I will not panic and do something daft when the bull market comes to an end - whether I'll be able to sleep at night is a different matter, haha!

    Doing my monthly updates when the market has crashed won't be easy - it would be far easier to cope by not even look at the numbers, ie like that tortoise hiding in its shell!

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    Replies
    1. weenie,

      I guess none of us know precisely what level of risk to take until the markets head south and we see our portfolio value drop by 20% in the blink of an eye.

      It is now 9 years since I lost 35% in the space of around 3 months and at times it felt like capitalism was about to collapse. Fortunately I was able to see it through and was back in profit the following year with a 40% recovery but it was a testing time.

      Some years later and am now more at ease with my 60/40 Lifestrategy balance and moving towards 40/60.

      You seem to have a good sense of your psychology and I am sure you will be well prepared for bears when they appear!

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