Looking at the psychology of investing behaviour
IT is well established that sensible long-term investing requires you to spread your money across different types of stocks and bonds (and perhaps other asset types), as well as different geographies and sectors.
This is based on the understanding that we need to hedge our bets about the always uncertain path of the future, whilst seeking to benefit from mankind's collective innovation and ingenuity, which could come from any corner or sector of the world economy.
As a result, investment managers put a lot of effort into their asset allocation process, ensuring the right mix and balance across types of investments, over the long and short term.
For the thrill-seekers, the bad news is that dependable long-term investing is, by its very nature, quite a dull pursuit. Putting your money into a well-diversified investment portfolio hardly sets the endorphins coursing through the veins. George Soros, a well-known successful investor, once said: “If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring.”
For many investors, especially those who are focused on protecting what they have, this is not a problem. However, for many, the very appeal of investing is the excitement and emotional rewards it can offer: the highs and – perhaps inevitably – the lows.
It's interesting to look at the psychology of investing behaviour – why are some investors prepared to take bigger risks in the safe and sure knowledge that the losses could be real and potentially painful? There's a mental battle between risk and reward. Surely, the greater potential for significant returns (reward) tempts us to over-ride the rational part of our brain telling us to avoid risk: take the pain to make the gain?
Lotteries, with their potential for out-sized gains, are a perfect example of this mental debate, making them more appealing than they mathematically should be it could be YOU! I mean, it could, but the chances are microscopic. However, on the other hand, your brain is already telling you that if you're not in, you can't win. The investment can be minimal and the potential gains are life-changing. Go figure!
This isn't to say that less risk-averse investors want to go ‘all in' on black, but the draw of the gains easily masks the risks, making concentrated investments feel less speculative. There is a certain sense of achievement from having invested in a company that goes on to increase in value. Getting a better return than ‘others' can also be powerful, and we should not underestimate the simple fear of missing out (good old FOMO) for driving conviction in individual investments.
It would seem, therefore, that holding a significant proportion of your money in a well-diversified ‘boring' investment, combined with allowing yourself to have a small ‘pot' for being more speculative, would be a good compromise.
This approach, often called a ‘core-satellite strategy' is very popular among investors. This limited risk-taking can prevent you from de-railing any wider objectives, whilst also providing the desired emotional thrills. Although more manageable, once invested, we still need to be aware of some of the potential pitfalls.
Investors have a tendency to hold on to stocks that are making a loss for too long, and for selling investments in profit too early. This aptly named ‘disposition effect' has been well documented and can have a serious impact on long-term returns. While this applies to all investments, it is more likely to occur when holding direct stocks.
This is because, quite often, a sentimental attachment to a company or its concept or innovation can make us reluctant to pull out. There's an emotional balance to be achieved between the passion and commitment to a big idea and the dispassion of knowing when to cut your losses.
There is also strange psychology around possession and ownership: we are more likely to want to hold on to something we already have. We value things we own more than we would if we didn't currently own them.
A good way to counter these effects is to imagine a hypothetical situation in which, overnight, you have been forced to sell the investment. The next morning, forgetting you ever owed it, ask yourself ‘would I buy that investment now?' This forces you to create a rationale for buying the investment, rather than one for keeping it – which we seem to be better at doing objectively.
Good awareness of these psychological tricks and some mental tools to cunningly short-circuit our emotional wiring, are among the best weapons an investor can have.
:: Cahir Gilheaney is a wealth manager with Barclays Wealth & Investment Management team in Belfast.