Do we listen to our natural instincts or do we have the confidence to stick to a long-term plan?
While how much we invest, what we invest in and when we invest has an impact on the wealth we generate, how we behave is often the biggest driver of how much wealth we create. Behavioural biases are critical in finance. There is nothing like a market downturn to test and check our typical behavioural biases – after all they are ingrained in all of us.
Behavioural biases and trying to time the market are believed to cost the average investor 3-4% per annum in lost returns. In times of extreme market volatility, it is important to remember to remain calm. Short term market moves (both up or down) are not a reason to change that plan.
In this blog post, we have set out some of the scientific reasons for our behavioural biases and how they tie back to investing.
1. The fix and improve mentality
As humans, we are hard-wired to fix problems. Our instinct to fix things, especially in a crisis goes back to our hunting days. So therefore when markets are falling we desperately try to fix it, and unfortunately, the only way we know how to fix it is to move to a lower risk option.
However, what you are really doing here is locking in losses that would otherwise be recovered when the market goes back up, as it always does. Not only that, by sticking with your original plan your portfolio may even make a profit as you have essentially continued investing when the stock market was “on-sale”.
2. I know best
We have to rely on our intuition for a lot of things in life and so it’s understandable that most of us overestimate our abilities. But, overconfidence when investing can be dangerous for your wealth.
Research has shown that overconfident investors not only take on more risk but also trade more frequently, with a subsequent reduction in their returns. Research out of the US shows that highly confident, frequent traders achieved significantly lower returns. This also explains why women tend to get better returns on their investments – they simply trade less frequently than their male counterparts and are often more conservative.
In KiwiSaver speak, the most common form of overconfidence is when a person stays in a growth fund for longer than advised. This is great until there is a downturn in the market and you need to take your money out locking in losses.
3. Losses always loom larger than gains
Fact – we hate losing money. Think back to the last time you spoke about your investment to someone. If it’s doing well, we generally talk about it in percentage terms. However, if markets or shares are down, we talk about the money we have ‘lost’ in absolute dollar terms. Does this matter? When investing decisions are driven by how we feel, more mistakes are likely to be made.
The biggest way that this plays out is – you will review your KiwiSaver carefully if you make a slight loss, but won’t notice if you make a profit. Set out below are two scenarios with how most people behave:
- The average KiwiSaver fund might have lost 10% in a 12 month period. If your KiwiSaver fund suffers a 5% loss, you are unhappy and will more than likely get angry at your KiwiSaver provider – despite the fact they have done better than everyone else.
- The average KiwiSaver fund delivers a 20% profit in a 12 month period, your KiwiSaver fund only returns 10%. You do not notice this as you are happy with a 10% return – though you haven’t noticed that your KiwiSaver provider has effectively lost you 10% in profits.
Another aspect of this bias is that our fear of ‘losing’ can potentially make us take less investment risk than we should be able to tolerate or is suitable given our age and investment goals. People are scared of suffering a short term loss even if it means they will end up with a higher balance over time.
4. Beware of your memory
We tend to think of our memories as holders of accurate information that happened in the past. In fact, we all suffer from something called ‘availability bias’, a mental shortcut that relies on the most recent examples that come to a given person's mind when evaluating a decision.
In investing, this bias plays out both when the market is booming and then also when its crashing. When markets are rising, we look at our rapidly rising portfolio values and keep buying more risky assets even when this may not suit our investment horizon. On the flip side, during times of volatility when stock markets are in the news every day, many investors will assume the downward trend will keep continuing and will sell out. This is the precise reason that all financial providers keep reminding us that past performance is not an indicator of future performance.
Managing your Instincts:
Whether it comes down to being overconfident, thinking only about losses or finding facts to confirm what we already think, biases can be dangerous for our wealth (and our KiwiSaver). Being aware of them is a great starting point so that you can check yourself the next time you’re making an investment decision.
It’s also important to remember why you’re investing. When it comes to KiwiSaver, it’s about patience, not short term gains. Using your long-term goal to frame your current decision will help you stay on track. And finally, have a process. Decide how often you will review and rebalance your portfolio. If this is too much work, get an adviser or invest with someone like kōura where your portfolio is rebalanced automatically for you.
For most of us, contributing as much as we can to our KiwiSaver and then checking annually that you’re still in the right fund type is good enough. If you have ticked both these boxes, the best course of action is probably no action.