At Salvo Capital we are constantly trying to improve communication with our clients. For us to do this effectively we need to understand the psyche of our clients and to accommodate and manage the potential risk that an investor might pose to his/her own investment due to investor behaviour.

The intent of this document is to explain the mistakes that an investor can make if investment decisions are driven by emotion. After this has been identified we will explain practical steps that can be taken to ensure investment decisions are made at the correct times in the correct circumstances.

Investor Behaviour

Since 1984, a company called Dalbar has been measuring the effects of investor decisions to buy, sell and switch into and out of investments. The conclusion has always been the same, namely that returns are far more dependent on investor behaviour than on fund performance and fund investors who hold their investments are more successful than those that time the market. This is illustrated below:

Average Return 1994 – 2014

S&P 500 9.85% pa
Average Equity Investor 5.19% pa
Return Deficit (Investor Behaviour) -4.66% pa

Behavioural finance holds that investors fall into predictable patterns of destructive behaviour, especially in times of short-term volatility. In the same study, psychologists estimated the negative effect for an average loss to be 2.5 times the magnitude of a positive one. Because of this it is extremely easy to let emotion take hold and to make an irrational decisions.

We will identify 5 common faults in investors’ behaviour that destroy capital and cripple investment returns.

Following the Herd

Herd behaviour occurs when investors mimic the actions (rational or irrational) of a larger group. Individually these investors would not necessarily make the same decision. Herd behaviour often occurs when an investor feels that a large group is less likely of being wrong. The investor believes that they know something he/she doesn’t. This is a very dangerous behaviour because acting in such a way will increase the frequency of investment’s, which increases the chance of “buying high” and “selling low”. Therefore avoid the noise in the market. If you are feeling unsure about your investment, contact your advisor and discuss the strategy that was implemented. Don’t follow the irrational herd.

Recency Bias

This occurs when investors overemphasise recent events when making decisions. Example: People tend to like stocks after the market has had a strong upward trend and dislike them after a downturn. This often leads to “buying high and selling low,” which is contrary to the mantra for successful investing. Therefore, looking at the last 6 year bull market will only show you how your portfolio did in good times, however analysing your portfolio in the last 10 years, which included the 2008 credit crisis, will show whether you are comfortable with a tail-risk event.

Short-term Thinking

Short-term thinking is very dangerous for any investment. Chopping and changing your investment strategy actively correlates with “Greed” as discussed below. It is thus very important to match the term of the investment with the risk-profile that an investor has. An advisor plays a very important role of ensuring that you invest in a way that suits your needs. Both patience and discipline is needed so that the initial investment strategy has time to reach the investment goal.

Fear & Greed

Fear (loss aversion) refers to the fear of losing capital. This fear leads to a withdrawal of capital at the worst possible time. This is known as “panic selling”. This often occurs when short-term volatility increases. As markets revert to the long-term average many investors panic and see the correction is the market as a “crash” and exit all their positions, thereby realising (monetising) a negative return instead of sticking to the long term strategy. After an investor realises this drawdown, fear is high and instead of reinvesting at a discounted price in the market (buying low), investors wait until a trend forms and re-enters the market too late (buying high).

Greed (over-optimism) occurs when markets are rising and an investor builds confidence in the market. As the investor sees prices rise even more, more confidence rises until he eventually buys into the market. So instead of “buying low” the investor is in fact buying high. The investor is confident that the trend will continue to rise, however the higher that market deviates from its long-term intrinsic value, the higher the probability of a correction (mean reversion).

As described above it is clear that “fear” and “greed” are two big risks that may be present in an investors’ behaviour. Instead of buying low and selling high, investors may make the mistake of buying low and selling high which leads to a negative return for the investor.

Conclusion

It is clear that investor behaviour determines the success of an investment. Markets are volatile, investments are volatile, and we can’t change that; however what we can change is “investor volatility”. If the investor is emotionally volatile along with the volatile markets success will never be achieved. The incorrect behaviour is therefore the biggest risk in an investment. Ensuring you have the correct behaviour as an investor as well as having a long-term view will help you become successful. We have found that the applying the following steps will encourage the correct investor behaviour.

• Have an investment strategy that you are comfortable with and stick to it

Ensure that the risk profile of the portfolio is what you expect from day one.

• Don’t only focus on past returns

Ensure that the past returns of the investment are risk-adjusted to put those returns in perspective.

• Don’t let fear lead to irrational decisions

When you experience short-term volatility and feel uncomfortable, communicate with your advisor and find out what measures are in place to manage that volatility. Review,

• Avoid the noise

Hear what is happening in the world, but relate that to the way your portfolio is structured. If you are diversified rest assured that there will be uncorrelated returns within your portfolio. Once again communicate with your advisor before you make decisions that can damage your portfolio (buying high, selling low)

At Salvo Capital, the way in which we construct portfolios is to reduce the variability of returns (being more consistent) as that should cause more consistent positive investor behaviour and in the process reduces the risk of negative investor behaviour.

To read more about investor behaviour please click here.