Why Emotional Decisions May Be Ruining Your Investment Return

decision_making_process

Choppy markets can lead to emotional decisions. How do you keep your actions in check when emotions are running high?

A recent J.P. Morgan Market Insight shared the following observation, “While institutional investors typically follow policy targets, which naturally enforce disciplined investing, retail investors face behavioral biases that often stand in the way of optimal decision making.  Overcoming behavioral biases requires discipline and guidance, but it may help investors generate more attractive returns in the long-run.”

In looking at the first chart below from J.P. Morgan, you will notice that retail investors (the “do-it-yourselfers”), on the whole, are acting in complete opposition to institutional investors in the markets.  The result of these opposite actions over time is that long term returns earned by the average investor are well below what actually occurred in the markets, as can be seen by the second chart below.

 

money flows

Average Investor

 

 

 

These vast differences in actual returns can be at least partially explained by the way investing decisions are made in institutional environments vs. retail investors.  Rather than following regimented guidelines, individual investors subconsciously allow behavioral biases to get in the way of rational thinking and decision-making.  It is important to recognize these biases can have a detrimental long-term effect on the growth of your assets.

Institutional investors and investors aided by professional money managers are held to strict standards and guidelines for both the allowable investments in their portfolios, as well as the circumstances under which changes and rebalancing can take place.  There are specific investment policy targets which hold a Registered Investment Advisor to a particular asset allocation, as well as boundaries to force rebalancing during market changes.  This creates discipline and structure, keeping emotion and personal biases from clouding investment decisions.

The media plays a large role in driving the average retail investor’s actions.  Heuristics, or the use of a mental shortcut to make a decision, is seen when individual investors make investment decisions based on easily recallable events, or what has been working recently.  As retail investors hear in the media that equities are getting great returns, they eventually (but often too late), gain comfort with the idea of equity investing.  Once this message is repeated enough, they move larger amounts of money into equities, but are typically buying after much of the gain has already occurred.  Rather than making the smart decision to “buy low and sell high,” the average retail investor allows recent events and media chatter to control their investment decisions. The “buy low, sell high” mantra gets turned on its ear and they end up buying near market highs.

On the flip side, the media also plays a role in driving investors out of the market during declines.  Many retail investors are highly influenced by loss aversion. Studies have shown that the memory of pain and discomfort during portfolio declines has a stronger effect than the joy experienced due to portfolio gains.  The aversion to loss, partnered with the sensationalism by the media of temporary declines, can drive an investor to cash out at precisely the wrong time and keep them sidelined in cash from fear of additional potential loss.

These investor biases, combined with the constant bombardment by the media can push individual investors to make poor decisions and ultimately rob themselves of long-term investment growth.

Many individual investors have experienced greater success by partnering with a financial advisor as they pursue their investment goals.  A professional advisor provides appropriate assessment of your goals and your tolerances for risk (your level of loss aversion), a disciplined approach to your overall allocation targets, and specific guidelines and structure around rebalancing. This takes the emotion and the personal biases out of the equation, thus bringing the individual investor’s returns much more in-line with institutional investors.

The discipline and guidance provided by a financial advisor will help limit the emotional decisions that ultimately interfere with the long term growth of your investments. The statistics prove it is difficult for retail investors to discern the best moves, when being influenced by both the media and their own emotions. Working with a financial advisor will provide structure and well-reasoned decisions to put you on a path to a stronger financial future.