Know yourself, not your investments
12 October 2017
An edited version of this article was published in the 7 October 2017 issue of TODAY.
Do you sometimes find yourself to be a tangled web of contradictions? Some of us may think nothing about bungee-jumping off a cliff, or navigating fierce rapids in white water rafting, but when it comes to investing, the same people who find enjoyment in such death-defying activities may exclaim: “Stocks? Too risky!”
What gives?
One may argue that most extreme sports enthusiasts will do their research and only go with trusted, experienced instructors to reduce the risk of something going wrong. More importantly, they would first ensure that they are physically fit and fully prepared.
Yet, when it comes to investing, few of us apply the same rigour. We neglect conducting the proper due diligence on those who would be managing our hard-earned money. More importantly, we neglect assessing our financial health to understand our own risk tolerance and how much we can afford to lose before it impacts our long term goals and psychologically devastates us.
This self-discovery process is something a good fiduciary adviser should do right at the start before even talking about solutions or products. They also need to help investors understand how markets work, especially in a crisis. Sequentially going through a simulated a crisis will give the investor a better understanding of how they are likely to react when markets eventually fall, as well as prepare them for what to expect and do when a real crash occurs – just like a practice run in extreme sports! Unfortunately, this is rarely done due to the time required and the constant pressure to close the sale.
Some investors believe all this is wholly unnecessary and prefer to do their own thing based on information gleaned from CNBC, Bloomberg or some other hot tip. To see how individual actions affect investment returns, we can refer to Dalbar’s Quantitative Analysis of Investor Behaviour (QAIB) study. (Dalbar is an independent research firm that has been measuring investor behaviour and the impact on their performance since 1994.)
They found that on average, investors underperform stock and bond benchmarks by more than half. The long run return of the US stock index is approximately 10%, but investors received less than 4% in returns, and less than 1% for bonds vs. 6% from the aggregate bond index. Even accounting for trading and fund management costs, the underperformance gap is still too large to ignore. Behavioural finance research has revealed that how much money you make from an investment depends much more on how you behave than how the investment does. In other words, when left to their own devices, investors tend to make bad investment decisions.
So, how do we prevent this from happening? Let’s look at some examples. Mr Tan owns Stock A and wanted to switch to Stock B when they were trading around the same price, because his friend told him Stock B was good. In the end, he stayed put. On the other hand, Mr Lee started out owning Stock B but switched to Stock A instead. Stock B then outperforms Stock A by nearly three times. Who would feel worse about it? Research shows that Mr Lee would feel much worse, simply because making a mistake from an action feels more painful than a mistake from inaction. Harvard Economics’ Richard Zeckhauser calls this the ‘status quo bias’. We thus avoid making any necessary changes to our investments, as we prefer to stick with our last decision and hope for the best.
Another common mistake investors make is “anchoring”; that is, we always compare the current value of a stock to historical prices. In 2006 and 2007, investors piled into Singapore Airlines stocks when it broke $15, expecting that it would go past $20 due to its excellent product and brand name. However, with the 2008 crisis, the stock suffered a sell-off, just like all equities. Investors who were convinced that the stock would recover back to its previous high went in to buy with this $15 anchor in mind. In 2010, the share price recovered and rose past $15. Subsequently, with new competition and oil prices, after a rally to $16, the stock fell back to hover around $10 to $11 – where it’s been for the past 5 years. The point of highlighting SIA stock is not to encourage the buying of individual stocks, but to illustrate how a share price can get stuck (or anchored) in our minds, and we blindly buy without remembering that a stock price is totally unrelated to its historical price.
So, here are some simple techniques to help us get around our biases. For starters, we need to be more realistic. Reading about how stock X went up 2,000% or how someone became a billionaire by betting all their money on some technology company will not help you. Knowing that the long-term return for a broadly diversified asset class is 6 to 8%, will help you broadly define the limits of achievable long term returns of most investments.
Another suggestion is to not look at your investments too often. A study done by the US stock exchange showed that on average, young investors check their investments at least once a week. This is way too often. If you are really investing for the ‘long-term’, checking annually is sufficient. Remember that most property investors check the valuations of their property only when they want to sell.
Finally, think about the bigger picture and ask yourself honestly – how much of your life would change if the stock market fell by 20% and stayed there for the next 6 years? If you have just retired and are living off your investments, there could be some impact to your financial plan. But for most people, the impact would be minimal as it is money set aside for the long term.
Many people invest just to “make money fast”, without knowing their financial targets and the time horizon needed to get there, which is based on how much risk they are prepared to take. This is why investors panic when markets fall – they had taken on too much risk and are shocked by the magnitude of the paper loss. Whereas a seasoned investor allocates his investments right at the start to be congruent with the level of loss they can handle, and then just allow time and compounding to get them there.
At the end of the day, a successful investor is defined by how well they weather market crises and remain in control of their financial goals, versus an indeterminate amount of money they can make in a lucky call. Being honest with yourself and capitalising on how markets work are key factors in ensuring success in your investing journey.
(This is part of a series of articles that we have been writing for Singaporean investors.)
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