By Ben Jang, Portfolio Manager and Ron Haik, Senior Financial Advisor
Studies show the average investor underperforms the markets.
So how is it that affluent families and high net worth investors continue to grow their portfolios?
The problem is that retail investors suffer from emotional overreactions to market activity. Instead of being objective, investors default to any number of cognitive biases that result in irrational decisions (we delve into those biases below).
Proper investment management requires an informed and methodical approach. Employing an investment philosophy allows reason to guide your investment decisions and reduces the inclination to succumb to biased motivations.
In the full article below, we explore what it takes to utilize a more calculated approach to portfolio construction and wealth building, including answering questions like:
• What makes investors so poor at making investment decisions?
• Which investor biases do you exhibit?
• What does it take to reduce risk and improve returns?
The Average Investor vs the Markets
The Quantitative Analysis of Investor Behavior (QAIB) study by research firm DALBAR includes the effects of emotions on asset allocation returns in its 2020 report and found that the average individual U.S. investor underperformed both the markets and a portfolio of professionally managed funds.
According to DALBAR, over the past twenty-years, the investors in the study earned a net return that was only 0.4% greater than inflation. Most investors need a rate of return that is significantly greater than that to meet their long-term goals.
How Does the Average Investor Fare?
Taking a look at different market environments, the average investor has fared poorly in most market environments. They have historically realized returns close to or below that of the bottom 25% U.S. balanced fund manager in both up markets and down markets.
What Makes Investors so Poor at Making Investment Decisions?
Investor behavior is not as simple as buying and selling at the right time, it includes the psychological traps, triggers and misconceptions that cause investors to act irrationally, which plays a huge part in overall investment performance. There are nine distinct behaviours that tend to plague investors based on their personal experiences and personalities, shown below.
When looking at the impact of behavior on investor return, the results are compelling. The desire to chase returns and to try to time markets without discipline has led to significant underperformance.
Many investors buy an asset after a run-up in prices because they feel “more comfortable,” but often this results in the investor buying into the market after a large rally, or selling out of the market when valuations are low – exactly the opposite of what should be done.
Stop Mixing Money and Emotions
Which investor type are you?
Behavioural finance is a field that combines cognitive psychology with economics to help explain the irrational choices that cause investors to make poor investment decisions.
Developed by Daniel Kahneman and Amos Tversky in the late 1960’s, behavioural finance has continued to gain traction as they were awarded the Nobel Prize in Economics for their research in 2002. There are many behavioural and cognitive biases that have a direct effect on investing.
The following are some of the more pervasive biases:
Anchoring occurs when a decision is based or anchored solely on a specific reason or value. Closely related to anchoring is the Gambler’s Fallacy where people focus on the reversion to the mean when in fact the mean itself could have changed.
[Ex: Late investors in Blackberry believed in a turnaround story, but as its price dropped they were anchored into their purchase price and found it difficult to sell at a loss even though Samsung and Apple continued to take market share and develop more advanced phones.]
Confirmation Bias occurs when an investor has preconceived notions and they actively seek out information that supports their beliefs. This bias is dangerous because seeking out evidence for false positives is a critical aspect of investment research and decision making.
[Ex: An investor reading about the next greatest technology such as 3D printing and then actively seeking out other articles which strengthen their view of this new revolutionary industry without considering other factors
and the anticipated hurdles.]
Status Quo Bias is the tendency to not make any changes even though rational logic would suggest taking action would be prudent. As noted by a number of studies, people have more regret of a negative outcome when they took action versus having done nothing. The status quo bias is similar to Conservatism where beliefs are insufficiently revised even when presented with new information.
Recency Bias is the opposite of the status quo bias and conservatism where a disproportionate weight is attributed to recent observations. Market observers have humorously noted that market cycles are between 5 to 7 years because of investor long term memory loss.
Loss Aversion is the tendency for people to put more weight on losses rather than gains – the discomfort of losing something is greater than the pleasure of acquiring it. This is somewhat parallel to the Endowment Effect where people will often desire a higher selling price for something they already own, compared to the price they would pay for the exact same item.
[Ex: When homeowners sell, they generally list their homes at very high prices believing that it is fair value, but acknowledge that they would not purchase their own home for the same asking price.]
Overconfidence Effect is, as the name suggests, the tendency to be overconfident. Often surveys will ask if a person thinks they did better than average to which most people will say yes, however it is not mathematically possible for the majority to be better than the average.
Herding Behavior is a phenomenon that creates irrational market bubbles and stems from people’s desire to ‘not miss out’ or ‘seek the safety of others’. A wise Chinese proverb says “follow the herd to the slaughterhouse.” Sometimes trends last much longer than initially thought possible, so one should not be a contrarian for the sake of being a contrarian; having the skills to “lean against the wind” and be open-minded is a key success factor.
[Ex: When people piled into internet companies during the dot-com bubble and felt safety because others were doing so; over exuberance and speculation drove the Nasdaq up quickly. Investors eventually suffered large losses as they did not focus on the fundamentals and valuations that drive long-term stock performance.]
Mental Accounting is the cognitive process where people split items, such as investment assets, based on specific end-uses, rather than viewing all of the investment assets as being integrated and this creates inefficient asset allocation and diversification decisions.
[Ex: Investors often segregate their registered accounts as safety capital and cash accounts as risk capital whereas investors should consider all their investments as a whole and focus on the liquidity and tax efficiency of their various accounts.]
Proper investment planning requires the ability to recognize the impact of irrational investor behavior and build a strategy that takes them directly into account.
A wise man should have money in his head, but not in his heart.
Jonathan Swift, Satirist & Essayist
Jonathan Swift, an influential writer during the Age of Enlightenment, was a very astute observer of human nature and behavior. Many of his observations centuries ago can be seen in the behavioral and cognitive biases that drive investor sentiment today, clouding judgment and leading to ill-advised decisions even when there are well laid out plans.
When investors make emotional decisions under stress, publicly traded markets become volatile, which then creates more stress – irrationality begets volatility, and on and on. People rarely exhibit the logical “Spock-like” behavior ideally suited to investing and make mistakes that become very expensive over time.
Using Investment Strategy to Combat Investor Bias
At Nicola Wealth, we adhere to an investment strategy that is designed to mitigate investor emotion and ensure that our clients’ portfolios are truly diversified.
We believe portfolios need to improve diversification by adding non-traditional assets such as private equity, infrastructure, physical real estate and other alternative strategies in order to get the best possible expected return for the level of risk.
Too often, investors assume that a portfolio is diversified because it has a number of different assets, but upon closer examination, many of these assets move in tandem and are more correlated than what is ideal to achieve a reasonable level of protection.
Put another way, traditional bond and equity portfolios use assets that tend to be more correlated, meaning the whole portfolio tends to be more volatile during market cycles.
Not only have global equities and other asset classes moved more closely in tandem over the long-term, but correlations between securities within an index itself have also experienced significant increases, especially during downturns.
Non-traditional and alternative asset classes decrease correlation, reduce volatility, and, as a result, help control the emotions – the “behavioural and cognitive biases” (ex: greed and fear) – that cause us to make ill-advised investment decisions.
Beyond Stocks and Bonds: Reduced Risk, Better Return
For the individual investor, the ability to access alternative investments has been limited. This is frustrating, particularly for high net worth investors who have the ability and willingness to invest in alternative assets, but are unable to find a solution associated with investing in alternative assets. In contrast to the traditional 60/40 equities/fixed income portfolio, to create a truly diversified portfolio, we take an institutional approach to private wealth management. Consider the various types of asset classes that are the basis for our Nicola Core Portfolio Fund:
In this global market environment where investments are bought and sold not only based on each asset’s intrinsic qualities, but also based on market environments and investor bias, a more robust approach to diversification is needed.
To achieve this, an investor needs to take a multi-dimensional approach to diversification where:
- Asset classes are not highly correlated with each other.
- Portfolios include non-traditional asset classes such as private equity, real estate, infrastructure, insurance,
This last point is one that is critical in mitigating risk in a portfolio however is often overlooked or cannot be achieved with a simple stock and bond allocation. If your target return is 7% for example and your portfolio can generate stable cash flow of 4-5%, then you are less reliant on price appreciation to achieve your desired outcome. Cash flow is far more predictable than price appreciation and in some cases can be more tax efficient such as return of capital from real estate investments.
With the impact of globalization, there is an increased interdependence on global capital markets, which means that prudent risk management is more important than ever. For individual investors this means:
- Understanding traditional market and asset risks.
- Recognizing the increase in correlations amongst asset classes (less diversification).
- Acknowledging less tangible risks such as investor behavioral and cognitive biases.
Addressing practical risks such as outliving one’s retirement assets or not leaving the size of estate required to fulfill one’s desires for a legacy (either for future generations, philanthropy or both).
In order to properly address all of the real risks, we recommend a comprehensive and integrated approach combining financial planning, insurance and portfolio management. This coupled with effective portfolio construction to reduce taxes and get better after tax returns are the key ingredients for controlling and overcoming the emotional biases that humans are all susceptible to.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions