July 2008

Staying the Course Pays Off

As investors, our emotions often work against us. Letting our hearts rule our heads can have many unfortunate economic consequences, including poor investment returns. While irrational investor behaviour has existed for many years, it is only recently that behavioural scientists have begun to study the phenomenon to better understand how we make choices, evaluate risks versus rewards, and calculate probabilities.

One of the most damaging behaviours they have identifi ed is the herd instinct. Most investors have a strong tendency to follow the crowd, which is encouraged by ongoing media reports of market movements and trends. Have a look at the graph on this page to recall the ups and downs the Canadian market experienced in the fi rst part of this year – one day, investors were bailing out of stocks as the market appeared to collapse, the next day, sharp increases in stock prices convinced many that this was the time to invest more money. This behaviour, of course, results in buying high and selling low, the reverse of what we want to accomplish as investors.

Dalbar Inc., a leading fi nancial services research firm, conducted a study of how U.S. investors moved money in and out of mutual funds between 1984 and 2003. They found that investors tended to put money into sectors that had previously posted strong returns, a practice that caused considerable damage to their long-term investment results. In fact, the average U.S. investor earned 3.51% annually over the course of the study, while the S&P 500 returned 12.98% over the same period1.

Other researchers have looked into how investors react to the possibility of gains or losses. They have found that the fear of a loss far outweighs the joy of an equivalent gain. Fear of losing money leads many investors to avoid riskier asset classes such as stocks due to short-term volatility, even though their long-term performance will probably exceed that of more stable investments such as GICs and bonds.

Similarly, some investors don’t feel the pain of a loss until they actually sell the losing investment. This perception leads to the tendency to hold onto losing investments far longer than is prudent in the hope that the price will one day bounce back, even when research shows that this is most unlikely. Remember the Nortel scenario?

When it comes to investing, logic and emotion seldom go hand in hand. Being aware of the pitfalls of our emotional behaviour can help us to act against our instincts when these are not in our best interests. In turbulent markets, we need to stay the course and avoid emotional urges to abandon ship.

1 Dalbar Inc. 2004. Quantitative Analysis of Investor Behaviour