By: Lehani Marais, Director at Stonehage Fleming Investment Management South Africa
Stonehage Fleming warns against investors letting emotions drive their investment decisions
The market selloff in March as a result of the Covid-19 outbreak resulted in three different investor reactions. According to Lehani Marais, Director at Stonehage Fleming Investment Management South Africa, some investors wanted to increase exposure at the lower market levels, whereas others wanted to sell their holdings. The third reaction was to wait for markets to stabilise before investing again.
It is in times like these, says Marais, that investors risk destroying their wealth due to decision making that is overly influenced by emotional and/or cognitive biases. “It is important for investors to stay focussed on their long-term investment strategy and to not fall prey to typical behavioural biases that may drive their investment decisions.”
As the market spiralled downwards in March 2020, Stonehage Fleming observed clients becoming more focussed on the winners than the losers in their portfolios. Fearing they would decline, some investors wanted to sell the profitable positions and ‘lock in’ the gains. In contrast, they wanted to hold onto their losers in the hope that they would recover the losses.
“Whether it is losing out on a bargain in the shop or witnessing investment portfolios decline, we as humans hate to lose,” remarks Marais. “Investors tend to feel the pain of losses significantly more than the joy of gains. Research by Tversky and Kahneman (1992) showed that we feel the emotional impact of a loss more than double a gain of the same amount. This behavioural bias, known as loss aversion, is exacerbated by the fact that equity market gains occur over a longer time period rendering them less satisfying, whereas losses are typically experienced over a short and sudden period, making the experience much more painful. Regardless, the long-term result from selling winners and holding losers is ultimately a portfolio of losers.”
The human tendency to have too much confidence in our own abilities is known as overconfidence bias. Following the -34% decline of the S&P 500 in March, some investors hoped they could accurately time the market. Accordingly, they preferred a strategy of cutting their equity exposure when the market was down and reinvesting once the markets had stabilised.
“While selling high and buying low makes logical sense, the reality is that it is very difficult to predict short term market movements particularly in highly volatile times. In this case, an overconfidence in predicting how the market would perform would have yielded negative results as, against most investors’ expectations, the market went on to recover almost all the losses two months later.”
Herding bias refers to doing something because others are doing it. As fears of the spread of the virus crippled financial markets, investors began running for the hills, prompting others to follow suit. “Going against the herd can be extremely difficult, especially in a severe market decline, but for every seller there is a buyer. One could therefore argue that there are two herds moving in opposite directions and it is best to be following the herd that are buying bargains.”
Looking ahead to the outcome of the Covid-19 pandemic, there are currently two polar views – optimistic or pessimistic. Marais says that investors typically look for information that confirms their current belief – known as confirmation bias – and as a result they seek views that confirm what they already know, rather than looking for views that contradict theirs. “As an investor, it is important to recognise whether you tend to have a glass half full or half empty view, because this itself is a behavioural bias. Instead of focussing on news that supports your view, you should remember that there are a range of possible outcomes.”
“Now more than ever, it is important for investors to be aware of their emotions, and to make sure that these emotions are not driving their investment decisions. As a firm, we have witnessed how behavioural biases can impact family wealth and in our experience, clients tend to ultimately achieve better investment results when they remain focussed on a long-term investment strategy.”