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In general, we all prefer to do something at times of stress and uncertainty rather than doing nothing. In behavioural finance, they've dubbed this the “action bias”. A great example of this can be seen in football games. Imagine you are the goalkeeper facing a penalty kick. What do you do? Dive right? Dive left? Stand still?
A 2007 study looking at how goalkeepers react in the face of a penalty kick found an “action bias”. They jump to the left or to the right an overwhelming 94% of the time – meaning they stay in the middle only 6% of the time. In comparison, the shot went towards the centre 29% of the time.
The key here is that the goalkeeper is motivated by the fear of regret rather than the fear of failure.
To have dived and failed feels better than standing still and failing. Diving isn't reducing the potential for actual loss (i.e. the goal is scored) but does reduce the emotional loss to the goalkeeper.
Investors now find themselves in a similar position. Do you trade or do you hold your positions? Would trading now make you feel better?
Action bias might lead us to make some radical changes in investment strategy either by shifting funds between investments or by sitting in 100% cash for fear of losing more. Both would be a mistake in our opinion: essentially the risks of short-term attempts to time the market outweigh the expected long-term benefits.
The action bias tends to be asymmetric – we feel a strong desire to jump ship to avoid losses, but typically find it very difficult to get back into the market once we're out, particularly after a drop, when it would be most beneficial.
In investing, if we're to achieve returns, we need to take risks – fact. If we're going to take risks, then periods of loss are not a danger, they're a certainty– fact. But these certain losses are not a problem in the long run ... selling when you have a loss is. The action bias tends to lead to frequent, short-term, emotional trades, the benefits of which seldom outweigh the risk.
The bias leads us to want to do something but doesn't lead us to anything specific. So if you feel compelled to do something, as most of us do, look for actions that are constructive.
We know that investors tend to make serious behavioural mistakes at this time and this is when they require sound advice and reassurance. We at Investec Wealth & Investment maintain as a core philosophy of wealth management that staying the path of a well-constructed and diversified investment portfolio will ultimately lead to real risk-adjusted returns through market cycles.
It's okay to ignore volatility—that's part of the plan. Don’t just do something, stand there!
Rules to help you through a feverish market
Rule #1: Recognise that volatility and periodic corrections are common in equity
The key to getting through unexpected turbulence is to understand that swings in the financial market are normal—and relatively insignificant over the long haul. The best approach to protect portfolios is to diversify among a broad mix of asset classes so that you are better poised to buffer the declines in the equity market.
Rule #2: Tune out the noise, and remove emotion from investing.
According to Dalbar & Lipper in a study done from 1995 to 2014 the “investor behaviour penalty” (investors propensity to buy and sell their investments at the wrong times) amounted to 3.9% p.a. On a R1m initial investment this translated in to a difference of R2.95m growth over a 20 year period (R5.7m vs R2.8m). (Source: Quantitative Analysis of Investor Behaviour by Dalbar Inc. & Lipper)
Seeing the same story at the top of every news site you visit, as well as seeing related portfolio fluctuations, is likely to worry you more than it should.
If you're a long-term investor, resist the urge to make drastic changes to your investment plans in reaction to market moves. You may find what's driving the overreaction in markets is nothing more than speculation.
Making shifts to your portfolio in the hopes of avoiding a loss or finding gain rarely works long-term. Investors who panicked and dumped equity holdings n 2008 and 2009, believing they could get back in when "the coast was clear," likely suffered equity losses without the benefit of fully participating in the recovery.
Also, try not to look at your accounts every day. It's unnecessary and may do more harm than good. Remember that portfolio changes, aside from routine rebalancing, can result in significant capital gains. And don't forget you need to know when to jump out of the market and then get back in—decisions few investors can and should tackle.
Rule #3: Make volatility work for you.
Save more and continue to invest regularly. Boosting savings is important to your long-term financial goals. We believe market returns may well be muted over the next few years; therefore, stick to your investing principles and avoid getting caught up in the market.
If you invest regularly you're putting the market's natural volatility to work for you. Continue making contributions to take advantage of rand-cost averaging. Buying a fixed rand amount on a regular schedule offers opportunities to buy low during market dips. Over time, regular contributions can help reduce the average price you pay for your investments.
If your portfolio is broadly diversified and has the appropriate balance for your financial goals, time horizon, and risk comfort level, sticking with it is a wise move. Because no one knows what the future holds, a diversified strategy can be more advantageous than shifting too much in any direction. You can resist the temptation and save yourself the stress by tuning out the noise.
About the author
Wealth manager: Investec Wealth & Investment
Patrick is a senior private client wealth manager with Investec Wealth & Investment, specialising in providing holistic investment planning advice to some of South Africa’s high net worth and ultra-high net worth individuals, families and their associated entities.