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We need to talk about…
the emotional investor

25 November 2019

As we approach 2020, the investment environment feels unsettled, with stories like the demise of Woodford, Brexit, the UK General Election and the US-China trade war looming large on the news agenda.

Understanding the human factor

Confidence and uncertainty play a big role in investment decisions, and not always in a positive way. It’s often said that markets are driven largely by two particularly strong emotions - fear and greed.1

When the news headlines are warning of a possible stock market crash, reporting on an investment scandal or speculating on what impact certain political events might have on the economy, it’s only natural for investors to start wondering how it could affect them. Just the sheer ‘noise’ of it all can make it difficult for clients to think clearly about their own investment goals.

Human emotions are well recognised as a risk to successful investing. Investment guru Benjamin Graham summed it up in his book, The Intelligent Investor - "the investor's chief problem - and even his worst enemy - is likely to be himself".2

When emotions bite

When markets are riding high, for example, there can be a tendency towards overconfidence, leading investors into investment decisions that might not be completely rational. Yet being too cautious can be a risk too, bringing potentially negative long-term investment implications.

Investors are also likely to be influenced by previous experiences. If they suffered heavy losses in a down-turn they might later decide to steer clear of market investments entirely, despite evidence showing that equities typically produce positive returns over the long term.3

That supports the idea behind Prospect Theory, set out in 1979 by Daniel Kahneman and Amos Tversky. Their research found that investors usually felt the pain of losses more intensely than the pleasure of gains of the same size, with the outcome that investors will typically be risk averse to a degree that is out of proportion to the expected outcome.4

Getting ahead of bad news

Such behavioural and emotional factors can be at play, regardless of market conditions. But it’s when things feel more fraught and there’s more bad news than good, that those emotions can become overwhelming.

Here, we highlight three ways you could consider getting ahead of bad news:

Get back to basics

Reminding clients of the basic principles of long-term investing in all market conditions is probably a good place to start. For instance, talking around the importance of diversification and explaining why spreading their money across different assets and investments can help mitigate risk while still allowing them to take advantage of any opportunities that do arise.

These points can be supported by hard evidence. For example, several different studies have shown that asset allocation is the biggest single driver of portfolio returns over time, as opposed to approaches such as market timing or stock picking.5

Discuss positive strategies

A discussion on the potential benefits of regular, drip-feed investing and the pound-cost averaging effect, as a way to manage the timing risk otherwise associated with one-off investments may also be helpful. The same goes for highlighting the potential ‘snowball’ growth effect through compounding that might be achieved – where appropriate - by reinvesting investment income on an ongoing basis.

Highlight lessons from history

It’s always important to be clear that past performance is not necessarily a guide to future performance, and care has to be taken with presenting theoretical scenarios, but you might also use investment history to counter the potentially disproportionate loss-aversion highlighted by Prospect Theory.

Research showing the effect of selling out at the wrong times can help here by supporting a rational response when clients are spooked by market falls. As one example, Fidelity found that total returns for an investor who stayed invested in the FTSE 100 index from the period September 1992 to the end of September 2018 would have been 559%. But missing the five best days over that period saw their returns cut to 343% and missing the best 30 days cut to just 48%.6

Other research by Tilney7 has shown that the longer a client can hold their nerve and stay invested the more likely they are to see positive returns. Based on annualised returns across calendar years for the MSCI World index from 1970 to 2019 it calculated the minimum and maximum annualised returns that you could have received by investing in the global stock market for every single 1, 3, 5 or 10-year period since 1970. These were the results.

Keeping the bigger picture in mind

If you have an understanding of your clients’ possible cognitive biases and how they respond to external events, you will be well placed when investors are looking for reassurance. For many of those investors, turning to a professional adviser who helps them see the bigger picture and block out the noise when emotions are running high will be the best investment decision they make.

Important information

Please remember the value of your clients investments and any income from them can go down as well as up and your client may get back less than the amount they originally invested. Past performance is not a guide to future performance.

1 Investopedia - Financial Markets: When Fear & Greed Take Over - 25 June 2019

2 Quoteswise.com - Benjamin Graham Quotes - n/a

3 Nerdwallet.com - What Is the Average Stock Market Return? - 22 Oct 2019

4 Investopedia - Prospect Theory - 9 July 2019

5 Studies by Brinson, Hood and Beebower in 1986; Brinson, Beebower and Singer in 1991; and Ibbotson and Kaplan in 1999. As summarised by Larry Elkin in 1999.

6 Fidelity – The perils of market timing – 27 December 2018

7 Tilney – It’s about time in the markets, not timing the markets – 17 October 2019

Support for your clients

You may find our ‘Investing and your emotions’ guide a helpful resource to use with your clients. It’s aimed at reminding clients why they invest and how you can help them on their investment journey.