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Beware the Bemuda Triangle of investing

Published: October 19, 2015 by Rob Macdonald, Fundhouse

Market fluctuations are interesting to watch, but not necessarily to act upon

The dramatic fall of the Rand and the gyrating fluctuations in the South African and international share markets over over the past year have undoubtedly unsettled many investors. From a financial planning perspective, these fluctuations are interesting to observe, but are very dangerous to act upon. Simply because we don’t know what the market is going to be doing next week, next month, next quarter or even next year. If anyone tells you they know, they are lying.

An investor’s behaviour is a bigger obstacle to investment success than market movements

So if you shouldn’t be worrying about the level of the share market, what should you be worrying about? There is much research to demonstrate that an investor’s own behaviour is the biggest obstacle to their investment success, and this should be of primary concern to investors and their financial planners. The field of Behavioural Finance is becoming an increasingly influential source of insights about how financial planners can effectively manage the relationships with their clients. It is a field in which much energy and resources is now devoted to studying investor behaviour, and from this work many insights about investors have emerged.

The Bermuda Triangle of investing is a lethal cocktail of: peer pressure, cognitive mistakes and emotion

At the heart of the constant challenge that faces investors, is what I like to describe as the “Bermuda Triangle of Investor Behaviour”. There are three core influences on investor behaviour, hence the three sides of this particular Triangle. Failure to heed these influences will undermine your client’s financial plan, encourage inappropriate investment decision-making and raise the chances of hard-earned savings and good planner-client relationships disappearing into the Triangle. As we know, once something enters the Bermuda Triangle, it simply disappears.

The three sides of the Triangle, are firstly, our responses to peer pressure; secondly, cognitive or mental mistakes we make; and thirdly, allowing our emotions to influence our decisions. These three elements can be a lethal cocktail of influence on investor behaviour and can undo the best-laid financial plans.

Peer pressure leads to herding behaviour – the problem is we always compare up

Peer pressure is at the heart of why investors demonstrate herding behaviour. Psychologists tell us that we adapt our behaviour to our circumstances or context, and as a consequence we are continually comparing ourselves to others. This is not necessarily a bad thing, but unfortunately we usually compare up rather than down.

For example, assume your client was invested in a unit trust fund, and it was ranked as the 30th best performing unit trust. Research shows that your client is more likely to compare that fund to the 29 funds that have outperformed it, rather than the over 1000 funds that have underperformed it. Particularly if they know somebody who has a better performing fund! Unfortunately this behaviour doesn’t just end at comparison, but very often leads to decisions on this basis. The influence of social pressure is central to why we have bubbles in investment markets. People herd together for fear of missing out on a boom, or being caught out in a decline. The challenge for financial planners to prevent their clients from giving into peer pressure is immense.

Cognitive mistakes happen because we are mentally lazy

Cognitive or mental mistakes are very simply errors of judgment that we make primarily because we are lazy when using our brains. A simple example of this when investing, is that we tend to attach too much importance to recent performance and do not apply our minds to long-run statistics. This happens frequently in the share market, where it is much easier to say “the trend is your friend”, than to consider what has happened over the long-term historically.

What we do know is that over time the South African share market has delivered a real return to investors over about 7% above inflation. The problem is that at times, the share market may deliver a real return of 20%, and this can raise unrealistic expectations about what the share market can deliver over time, and tempts clients into action that may be inappropriate. Educating clients about long-term market behaviour is a great way for financial planners to protect their clients from themselves.

Greed and fear are the key emotions that drive us when markets move

The third side of the triangle is allowing emotions to influence investment decisions. Greed and fear are emotions we all experience.  Few of us are immune to the allure of hitting the jackpot, or the fear of losing our money. As a consequence our emotions tempt us into believing that we can time our or our clients’ entry into, or exit out of investment markets. Unfortunately the outcome of this belief is that there is much research to show that investors tend to buy when markets are near the top, and sell when markets are near the bottom. Our emotions lead us into the wealth-destroying behaviour of buying high and selling low. The ability to manage client emotions is key to the role of the financial planner, and probably more important than any technical ability they may have. If their emotions mean a client can’t effectively implement and stick to the most technically well-prepared plan, then that plan is worthless.

Educating your clients about the Bermuda Triangle of Investing is one way of managing against poor investor behaviour

An investment strategy is a critical part of your client’s financial plan. If the strategy is based on sound, realistic objectives, then the strategy and your client’s objectives should be the only reference point for decision-making. Allowing these decisions to be influenced by social pressure; cognitive mistakes or emotions will very likely derail what you and your clients are trying to achieve. Educating your clients about the Bermuda Triangle of investor behaviour may be a useful way to help you manage their behaviour, particularly when there is talk of a storm brewing.