Why investors need to keep their emotions under control in this volatile market
The human brain is poorly adapted to investing, as it is inclined to make irrational rather than rational decisions
What is the single biggest threat facing investors right now? Forget volatile stock markets, crashing economies, social unrest, trade wars or even Covid-19, and take a look in the mirror instead.
The greatest obstacle standing in the way of building long-term investment wealth for your retirement is you. The human brain is poorly adapted to investing, as it is apt to make emotional decisions, rather than rational ones.
Fear is a major threat to your wealth. It can take over during a stock market crash, persuading you to sell shares at the bottom of the market. Investors who panicked and sold during the March collapse lost out as share prices recovered almost as quickly.
Primal responses can overwhelm rational thinking, making markets prone to bubbles and runaway crashes.
Fabian Chui, ADSS
Greed can be just as dangerous. It can trick you into gambling on high-risk investments such as Bitcoin in the hope of getting wealthy overnight, or lure you into get-rich-quick schemes designed to swallow your money.
Fabian Chui, global head of front office and risk at Abu Dhabi-based financial services firm ADSS, says entire stock markets can be swayed by emotional extremes. "Primal responses can overwhelm rational thinking, making markets prone to bubbles and runaway crashes," he says.
Exuberance, overconfidence and greed combine to fuel asset bubbles, while fear creates self-fulfilling crashes, Mr Chui says. “In both cases, investors lose all objectivity. The ability to determine the fair value of an asset gives way to emotions,” he adds.
Justin Waring, investment strategist at UBS Global Wealth Management, says despite thousands of years of evolution, humans still haven't outgrown our "fight or flight" response, and overreact to short-term market threats and opportunities. “As a result, investors buy high and sell low, sometimes with disastrous consequences,” he says.
Professor Stephen Thomas, associate dean, MBA Programmes at Cass Business School in Dubai and London, says a study by investor behaviour specialists Dalbar found that between 1986 and 2015, the US S&P 500 produced an average annual return of 10.35 per cent, but the average investor generated just 3.66 per cent a year.
He blames the discrepancy on investors making emotionally driven decisions in volatile markets. “At the height of the financial crisis in October 2008, the S&P500 dropped 16.8 per cent but the average investor lost more than 24 per cent as they panicked and bailed out, missing the recovery towards the end of the month,” he says.
Private investors respond the same way every time markets crash, Mr Thomas says. “They are prone to selling too late, in other words after share prices have crashed, then buying too late, after the recovery. Ultimately it culminates in yet another very human emotion. Regret.”
Demos Kyprianou, a board member of SimplyFI, a non-profit community of personal finance and investing enthusiasts in Dubai, says pride and overconfidence are also deadly: “Too many investors think they are cleverer than other people, and have the skills to beat the market. In the vast majority of cases, they are kidding themselves.”
Overconfident investors typically trade too often, buying and selling shares in a bid to beat the market, when history shows that almost nobody can reliably do that for long periods. In 2019, more than 70 per cent of large-cap fund managers underperformed the S&P 500. The longer they invest, the worse they perform, according to the Spiva scorecard, which measures actively managed funds against their relevant index benchmarks worldwide. Measured over five years, 80 per cent underperformed, the scorecard found. So, if the experts cannot reliably beat the market, then what chance do you have?
You also have to overcome your own apathy and fear of the unknown, which deters many from investing until it is too late to accumulate the wealth they need to retire in comfort, Mr Kyprianou says. “Too many people think it is too difficult, when in fact it is surprisingly simple, provided you keep your emotions out of it.”
So how do you master your emotions? Mr Kyprianou recommends investing in passive exchange traded funds (ETFs) that simply track the performance of global stock markets.
That way you are not trying to beat the market, which means your ego is not on the line.
He says you can build a diversified range of shares through a one-stop global equity ETF such as the Vanguard FTSE All-World UCITS ETF (VWRL). “You will never beat the market but you will never underperform, either, while keeping fees and other trading charges to a minimum, so you keep more of the growth for yourself,” he says.
Mr Kyprianou suggests balancing it with a bond ETF, to reduce the overall volatility of your portfolio when share prices crash. A popular option is the iShares Global Govt Bond UCITS ETF (IGLA), which invests in government bonds from G7 countries Canada, France, Germany, Italy, Japan, UK and the US.
Mr Chui says o avoid becoming prey to your own emotions you need to set clear investment objectives from the outset, then remember them when markets go haywire. "Ask whether you are buying a dip because of fear of missing out, or because you really see value from oversold conditions,” Mr Chui says.
Holding a diversified spread of investments can also help, by limiting your losses in a crash. If you invest purely in shares, your portfolio will be more volatile than if you balance this out with other asset classes such as bonds, gold, property and cash.
Taking a long-term view can also help soothe your emotions. If you are investing over 30 or 40 years, as you should be, then a short-term crash is nothing to panic about.
In fact, it is an opportunity to buy shares at a reduced price with the aim of holding for the long term, as markets always recover if you can stay calm and give them enough time.
Mr Waring says another way to keep your emotions in check is to "quarantine" your decisions, by thinking them over for a week or two as "this can help you filter out decisions driven by emotions".
Automating your portfolio can also help, he says. “Commit to an asset allocation strategy, say, investing 60 per cent in stocks and 40 per cent in bonds, with an automatic rebalancing system to keep your portfolio in line with this strategy,” Mr Waring says.
So if shares rise, you take your profits and buy bonds, or vice versa. This has the further advantage of selling high and buying low.
Mr Waring says beware of another dangerous emotion – loss aversion – because "people feel the pain of losses about twice as powerfully, as they feel the pleasure from making gains".
As we saw in March, most losses happen over short periods, and you need to hold your nerve to give them time to recover. To help you stand firm, Mr Waring recommends setting aside a pool of safer investments to meet everyday spending, so you do not have to sell shares during a short-term crash. "As we have seen this year, being forced to sell risk assets in a dip means you can miss out on powerful gains when markets recover,” he adds.
You will never be able to completely curb your emotions, but the more you can control them, the wealthier you should ultimately become. If you can do that, your overriding emotion should be happiness.
Updated: June 14, 2020 10:29 AM