While we all like to think that we are capable of making rational decisions, it appears that when it comes to investing, a switch inside even the most sensible person seems to flick, and rationality disappears in a cloud of emotion!
Being an investor is not easy. We have to contend not only with the erratic and unpredictable nature of markets but also with the sometimes erratic and irrational ways in which we are tempted to think and behave.
All investors should try their best to make rational decisions and to make their head rule their hearts. Yet, for many, while understanding that being rational makes sense, putting it into practice can be exceedingly difficult. Benjamin Graham, one of the great investment minds of the twentieth century, famously stated:
‘The investor’s chief problem – and even his worst enemy – is likely to be himself.’
Irrational investing manifests itself in many different ways: chopping and changing one’s investment plan influenced by what has just happened to the markets; trading shares in an online brokerage account; trying to pick market turning points, i.e. when to be in or out of different markets; being tempted into buying flavour of the month investment ideas or products; or chasing fund performance.
The list of irrational decision-making opportunities is long and undistinguished. John Bogle summed this up perfectly in an address to the Investment Analysts Society of Chicago (2003):
‘If I have learned anything in my 52 years in this marvellous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns than the economics of investing have ever dreamed of destroying.’
At times, the ’emotional cost’ of investing can be extremely large. By emotional costs, we mean the impact on returns caused by our own actions or inactions (i.e., our behaviour) rather than the markets.
The temptation to try to get in (or out) at the right time is huge. Imagine if you could have avoided the 50% market fall during the global financial crisis of 07/08 or the blink-and-you’ve-missed-it COVID crash in early 2020 and bought in again at the bottom.
Investors have a woeful track record of determining when to jump in and out of markets. When market timing, it’s worth remembering that you have to get two decisions right: the first is when to get out, and the second is when to get back in again.
The problem is that markets work pretty efficiently at reflecting new information into prices (e.g. company shares and bonds) quickly, and thus every decision you make is a bet against the aggregate view of all investors trading in the markets.
Markets move on the release of new information, which is, by its very nature, random.
The returns that a fund delivers are known as time-weighted returns. The return an investor in a fund actually receives is known as the money-weighted return and will be impacted by the magnitude and timing of cash flows into or out of the fund that they make.
A well-known piece of research from Morningstar’s ‘Mind The Gap (2023)’ report estimates this ‘behaviour gap’ to be around -1.7% per year on a large sample of US funds.
In other words, the cost of trying to guess the future direction of the markets costs the average investor 1.7% every year in missed returns – that’s a lot!
Figure 1: The emotional costs of investing in theory
Let us look at an example of the ‘behaviour gap’ in action. The chart below shows the fund flows of the largest index fund in the world—the Vanguard Total Stock Index Fund—plotted against the fund’s rolling quarterly returns (in GBP terms).
Following the COVID drawdown, investors continued to sell funds, spooked by what had recently happened. Yet the market bounced back and was up 22% by the end of June 20 whilst these investors sat in cash
This is the behaviour gap in action.
Figure 2: The emotional costs of investing in practice (3/2019-12/2020)
The solution? Own a sensibly diversified portfolio with sufficient higher-quality, shorter-dated bonds to provide protection from portfolio falls, allowing you to stay invested throughout these inevitable episodes of market turmoil that arise from time to time.
This is exactly how we manage your portfolio and help you achieve investment returns to support your goals and objectives.
During short-term market declines, it’s wise to remember the words of John Bogle, the founder of Vanguard, who always said, ‘ This too shall pass!’
Graham McCulley
Investment Director
