SIMPLE BUT NOT EASY
For many of us, investing appears to be a complex field of study with mathematical formulas resembling hieroglyphics. This may be true for a Masters of Finance textbook, but there is another, arguably more important, side to investing. KAREN DU TOIT explores the fuzzy, less mathematical, human behavioural aspect of investing.
The study of investor behaviour or investor psychology is a field that has become increasingly prominent over the last decade. It examines not only finance but also how people behave with money. Behaviour is the way we respond to a particular situation or stimulus. How we behave is in turn affected by our past, our generation, where we live, our personality and circumstances. It is usually emotional and therefore no less complex than the numeric side of investing.
Warren Buffet famously said that investing is simple, but not easy. This may be true if you remove emotions and behavioural biases as the best investors can do. To the rest of us, yoked by fear and greed, there appears to be nothing simple about investing.
When going through times of volatility or underperformance it’s very difficult for the lay person to remain disciplined and stick to their investment plan. We are hard wired to eschew immediate pain. We want to escape it, even when rational, objective thinking suggests we are better off in the long term by waiting for the cycle to turn.
We can study investor behaviour by discerning patterns in industry savings statistics. There is a clear pattern of investors switching from the worst performing funds to the best performing funds based on past performance. This is evidence of backward-looking biases and extrapolation of the past into the future. In behavioural finance jargon, this is called extrapolation bias, which is the tendency to overweight recent events when making decisions about the future.
For example, while balanced funds have investment horizons of five or more years, investors often judge these funds on one-year performance compared to their peers. The assumption is that the one-year returns can successfully predict the performance over the next five years. By chasing last year’s winner, investors could well be selling the following year’s top performing fund. It’s a vicious cycle.
We see the same value destroying behaviour between different categories of funds. For example, investors switching their retirement savings from long-term, growth-oriented strategies to short-term, money market or income funds. This is partly explained by extrapolation bias but partly by market timing.
Trying to accurately predict a market inflection point is almost always unsuccessful due to behavioural biases. Greed keeps investors in growth assets too long and fear keeps them in cash assets too long. This “sell low, buy high” phenomenon explains why most investors’ long-term returns are way below the average of the funds in which they invest. Churning managers comes at great long-term cost.
The most successful long-term investment strategy for lay investors is to set an investment objective that is realistic and within your budget and emotional range; invest regularly to harness the benefits of rand cost averaging and stay invested through market cycles.