The fast view
- Behavioural biases can influence our judgement, leading to poor investment decisions.
- The loss aversion bias often moves investors to switch their growth investments to cash after a sharp market fall, thereby locking in losses.
- The recovery in markets following the global financial crisis and the rebound after the Covid correction, highlight the importance of staying invested during market downturns.
- A correctly structured investment portfolio requires surprisingly little attention during periods of excessive market volatility.
It is often said that we are our own worst enemy. This can be particularly true when it comes to investment decision-making. Traditional investment theory is founded on the belief that investors consider all relevant information before making rational investment decisions. However, in practice, this is often not the case given that investors are negatively influenced by any number of behavioural biases.
Behavioural biases
Researchers have identified many behavioural biases that can influence our investment judgement and lead to poor decision-making, including:
- Mental accounting errors. This refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results (taking undue risk in one area and avoiding rational risk in another).
- Overconfidence. This applies to both the quality of your information and your ability to act on said information at the right time.
- Anchoring. Here the tendency is to hone in on one piece of information, for example, a share’s current price relative to its history.
- Herd behaviour. This is where you are comforted because others are doing/investing in the same thing.
- Loss aversion. This is where investors are more concerned about avoiding unexpected losses than making unexpected gains. Simply put, investors feel the pain of loss more than the pleasure of gain.
As a result of these and other biases, investors do not necessarily act rationally, leading to suboptimal investment decisions. In fact, our 4Factor SA capability, which manages the Ninety One Equity Fund and Ninety One Worldwide Flexible Fund, seeks to exploit these biases in terms of their ‘earnings revisions at reasonable valuation’ investment philosophy and disciplined, evidence-based process.
The importance of staying invested
It is at times of increased market volatility and disappointing investment returns that the impact of these biases is more pronounced. While many growth-oriented investors profess to have a higher tolerance for risk, the loss-aversion behavioural bias often comes to the fore when the value of their investment falls by more than, say, 10%. It is often at this point, and with much higher anxiety levels, that investors feel compelled to act by selling their long-term growth investment seeking the perceived safety of cash, or a similar conservative investment. However, as difficult as it is to do nothing in market downturns, it may just be the best investment strategy.
Figure 1 illustrates the difference between staying invested in the equity market (as represented by the FTSE/JSE All Share Index) after a significant market correction (the Global Financial Crisis of 2008, when the market lost approximately 32% peak to trough), selling at the bottom and reinvesting a year later, and selling and staying in cash.
Figure 1: The power of doing nothing
Source: Morningstar and Ninety One as at 30.06.22 – the charts are for illustrative purposes only.
It comes as no surprise that even with the material market correction from earlier this year, remaining invested delivered the best outcome for investors. The worst outcome was selling out at the bottom of the market and remaining in cash, demonstrating the real risk of being too conservative. The market returned to its previous high in only 29 months, whereas investors who switched to cash and stayed there had to wait 9 years before the value of their investment returned to where it was at the peak in May 2008.
The inset chart, where we repeat the exercise for the shorter period after the Covid correction in March 2020, reinforces this key message of staying invested.
Dalbar’s Quantitative Analysis of Investor Behaviour (QAIB)
Further evidence in support of staying invested is provided by the American research company, Dalbar.1 Since 1994, Dalbar’s QAIB has measured the effects of investor decisions to buy, sell and switch into and out of mutual funds (US unit trusts or collective investment schemes) over short and long-term time frames. These effects are measured from the perspective of the investor and do not represent the performance of the investments themselves. The results consistently show that the average investor earns less – in many case much less – than fund performance reports would suggest. This is simply because of self-destructive investor behaviour – selling out of funds when their performance bottoms and buying into funds when their performance peaks. It is never a good idea to respond emotionally to market movements!
Most recently, for the calendar year 2021, the average equity fund investor return was a seemingly attractive 18.4%. However, when comparing this to the S&P 500 return of 28.7%, it reveals an alarming investor return difference of 10.3% – the third largest investor return gap since 1985, when QAIB analysis began. Dalbar further makes the point: “Historically the average investor has failed to realize the long-term benefits of asset ownership because they do not stay invested in any given investment for a long enough period of time.” Since 2000, the average investor retention rate has ranged between approximately 2.5 and 4.5 years, far below the recommended investment holding period for an equity (or growth-focused) investment.
In an earlier report, Dalbar makes a key point: “No matter the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behaviour than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market.” These words remain true today.
Being aware of these behavioural biases is the first step in overcoming their detrimental effect and improving investment outcomes.
The value of independent financial advice
While there is increased noise and media commentary surrounding the ongoing instability in financial markets, investors must not panic. They should revisit and recommit to their long-term investment goals and bear in mind that they are more likely to achieve these by ensuring time in the market than trying to time the market.
In this environment, the value of financial advice is even more pronounced. A good financial advisor can help investors understand their future cashflow requirements and ensure that investment portfolios are set up correctly to cater for these needs. A correctly structured investment portfolio requires surprisingly little attention during periods of excessive market volatility. We therefore recommend that investors seek professional investment advice, tailored to their individual circumstances.
1 Dalbar 2022 QAIB Report: Quantitative Analysis of Investor Behaviour for the period ending 31 December 2021.
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