Investors are often advised to be dispassionate when making investment decisions. But that advice might be doing their portfolios more harm than good.
Meir Statman, a finance professor and behavioural finance expert from Santa Clara University, told a recent CFA Vancouver luncheon that a narrow focus on investment returns can blind advisers to the deeper psychological desires of investing.
Some of those desires include:
- security from becoming poor;
- hope in becoming rich;
- prestige and social status; and
- the thrill of beating the market.
Those desires might seem obvious, but Statman said the finance community has largely tried to detach them from investment decisions. That, he said, doesn’t benefit investors when emotions and desires are naturally tied to investments.
“While my colleagues have focused on errors in thinking that lead to errant investment behaviour, I say that there is a need to step back and ask yourself why we commit those errors, which are led by our emotions.”
Statman noted that emotional and social desires are somewhat addressed as part of the initial discussion between investment advisers and clients. But that process tends to focus more on understanding clients’ risk tolerance than addressing their underlying desires.
By addressing the desires, advisers can better understand their clients and explain investment decision tradeoffs. Lower risk investments, for example, won’t have the same capital gain potential as growth stocks.
“You have to figure out what you really want and ask yourself if you’re willing to pay the price of what you want. There are trade-offs between what I call utilitarian benefits, like high returns, and expressive and emotional ones, like status and security.”
Statman said knowing one’s emotional tendencies could also help prevent decisions that result in investment losses. Investors with a stronger fear of poverty might also be more likely to make the cardinal mistake of selling low after buying high, especially during a severe market correction like the one that followed Bear Stearns’ collapse in late 2008.
Conversely, investors looking for strategies and opportunities to beat the market might wrongly base decisions on market patterns that might appear sound because of historical evidence, but are based on wishful hindsight analysis.
Investors should also ensure they don’t make the mistake of looking for evidence to confirm beliefs and strategies, while overlooking or discarding what doesn’t.
Advisers of ego-driven investors might also want to take greater care in helping clients understand the dangers of investing in exclusive clubs or funds.
“Think about Bernie Madoff,” Statman said. “How did he get his money? He made it an exclusive club.”
Other key investor mistakes include basing decisions on market sentiment or trying to time the market.
“Investors tend to think when the market has gone up, the market will go up. In truth, more often than not, the opposite is true. When they feel good about the future, if anything, the future is not going to be as good as they predicted.”
Ultimately, Statman said that having a diversified portfolio of investments remains a tried-and-true strategy to protect portfolio value, even during the stock market volatility of the past few years.
“Diversification is about not having your entire portfolio in the crummiest assets. In exchange, we also give up returns of the best performing assets. It’s not to prevent losses, but it can mitigate them. Diversification says you will be somewhere in the middle, and [over the past few years] it worked.”