As you recently read, Warren Buffett knows a thing or two about investing. One of his most famous quotes is that “the most important quality for an investor is temperament, not intellect”.
Over recent decades, a wealth of research has revealed how behavioural biases affect our human decision-making, and how this can lead to damaging financial outcomes.
In their landmark 2016 research, shared by Schroders, Professors Jin and Taffler looked at a sample of more than 3,000 fund managers over the period 2003 to 2013.
They found that, on aggregate, buying decisions added 1.4% a year to performance, while selling decisions detracted -1.8% annually in underperformance.
What this shows is that fund managers – and investors – do show some skill when it comes to entering the market. However, what it also shows is that investors also managed to lose significant sums with their ill-timed selling decisions.
Modern studies show that the emotion of fear is processed very differently in the brain from the opposite feeling of joy. As a result, you’ll likely think of financial losses very differently to how you think about gains – and this can lead to suboptimal decision-making.
Here are three reasons that investors are often bad at selling, and how working with an expert like Black Swan can help you to avoid emotional and knee-jerk financial decisions.
1. You likely spend more time on “buying” than “selling”
When you’re thinking about investing money, the chances are that you do lots of research before you take the plunge.
You may spend hours researching funds or companies, poring over share price charts and performance history. Or, more likely, you seek out professional advice and engage the help of an expert.
Whatever your method, the decision to invest will be a carefully considered one.
On the flipside, the determination to sell often happens much faster. In a volatile market, when you see the value of your investment decrease it’s easy for your emotions to kick in. Indeed, the theory of “loss aversion” tells us that humans feel the pain of losses twice as strongly as the pleasure of gains.
Your decision to sell may be made much more quickly, based on little other than your emotional reaction to markets.
So, one way to ensure better outcomes could be to shift a more meaningful portion of your time budget towards sell decisions.
Working with a financial planner can help you to avoid knee-jerk decisions that result in long-term damage. We can be a sounding board in difficult times, providing you with reassurance that markets typically recover in the long term, and that patience can often be a virtue when investing.
2. Recent performance can shape how you feel about an investment
If the value of your home fell by 20%, what would you do?
Would you immediately panic and sell it, worried that the value might fall further? Or would you ride out the storm, in the knowledge that the value would likely recover in time?
The answer is almost certainly that you’d stay put. So, the same should apply to your investments.
Many investors allow very recent performance history to shape their risk assessment of an investment. This has been termed “myopic loss aversion”.
If an investment has recently declined in value, it can trigger a fear response in your brain, which can lead you to conclude that the investment is much riskier than a comparable investment that made a gain.
Of course, holding on to an underperforming investment for longer than you should can leave you in a worse position. However, it’s worth remembering the adage “it’s time in the markets, not timing the markets” that counts.
If you are investing for the long term, and your plans haven’t changed, it’s unlikely that your investment strategy needs to change either.
3. You believe what you want to believe
While optimism is a great trait, it can negatively affect your rational decision-making.
As a rule, you believe you are generally right. So, once you have made an investment decision, you have bought into its merits and are committed to it.
Unfortunately, this means that you will likely interpret subsequent data in a way that is favourable to your original premise. You look for information that reaffirms your original decision.
This “confirmation bias” makes it highly likely that you will miss important information that runs counter to your beliefs and could lead you to poor decision-making.
Indeed, Schwab Asset Management say that financial advisers cite confirmation bias as one of the top behavioural biases affecting their clients’ investment decisions.
As an example, if you are committed to owning shares of a particular company, you may ignore unfavourable news about that company. Confirmation bias may also see you focus on some expert opinions while ignoring others. This can potentially lead to decisions based on incomplete information.
Working with a financial planner – a neutral observer – can help you to overcome this bias. We can help you create a well-diversified portfolio aligned with your tolerance for risk and provide regular reviews to ensure you remain on track to reach your goals.
Get in touch
If you’d like to find out how we can help you to make better investment decisions, please get in touch. Email us at email@example.com or contact your adviser on 020 3828 8100.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.