Wednesday 26 July 2017

Following your heart instead of your head can often come at a cost

 

The stock market slid when talk surfaced about the potential impeachment of President Trump. Photo: AP
The stock market slid when talk surfaced about the potential impeachment of President Trump. Photo: AP

Pat McCormack

Many investors look at the future and naturally focus on the risks. This year, markets have understandably been preoccupied by political uncertainty across Europe, and with such volatility, there comes a risk that investors exaggerate potential threats and feel compelled to act; making decisions that could be detrimental to their portfolios.

Recently, markets were taken by surprise at the gathering momentum behind the remote potential for US president Donald Trump to be impeached. There were sharp falls in yields on higher-quality bonds, and it was the first genuine setback of the year for stocks. Such a backdrop begs the question of how investors can achieve the best anxiety-adjusted returns: the best possible returns, relative to the anxiety, discomfort and stress they are going to have to endure over their volatile investment journey.

Through times of extended market volatility, investors can deviate from good investing practice because good long-term investment decisions are invariably uncomfortable along the way. Only by having a practical system that addresses their needs for emotional comfort along the journey will investors be able to endure the ride, and get to the end with the returns they had hoped for.

Our innate need for emotional comfort is estimated to cost the average investor around 2pc to 3pc per year in foregone returns. For many, the figure is much higher. This shortfall - referred to as the "behaviour gap" - stems from the fact that the financial decisions that are optimal for the long-term are often very uncomfortable to live with in the short-term.

Failing to invest at all is another way in which we naturally purchase short-term emotional comfort at a cost to long-run returns. It provides this comfort in a very simple way: you cannot lose if you don't get involved.

The classical principles of good investing are based on the assumption that we are all perfectly calm, unemotional beings. In truth, as human beings, our emotions are the biggest driver of our investment decisions and, therefore, our returns. In turbulent times, theory often goes out the window. Depending on the market cycle and how it makes us feel, we may leave large portions of our wealth un-invested; we may be overconfident and overactive with the portion that we do invest; and, in the end, we often give in to our strong psychological tendency to buy high and sell low.

Investments are much more risky and volatile when viewed in the short-term than the long term. When we approach investment decisions with a myopic short-term perspective, despite our objectives being long-term, our perceptions of greater risk will lead to inappropriately high caution.

One year is an investor's typical evaluation horizon in calm times. In times of stress, investors' emotional horizons can be much shorter. Investing is often about growing a capital base indefinitely, so as much as 10 years may well be on the short side of when many investors actually need to withdraw their capital.

As an investor, you need to consider how you react emotionally to market movements. Constantly fretting over your portfolio on a daily basis may be jeopardising your returns.

Get your advisor to help you understand your financial personality including: how you feel about risk; your approach to financial decisions; how you react to stress and financial information and how you behave under pressure.

Pat McCormack is head of the wealth and investment management division of Barclays in Ireland

Sunday Indo Business

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