The Psychology of Investing

If you’ve ever walked away from a property auction shaking your head in disbelief, you will know that emotions can get the better of investors. As rational as we may be, greed and fear are a powerful force that can hijack even the best-laid plans - “I won’t pay more than $800,000 for that house,” you told your friend, but you find yourself putting your hand up for the tenth time to bid $895,000.

Take a look at Mike’s full presentation on investor psychology, or check out the five-minute read below.  

A million-dollar flower

The first well-documented “speculative mania” took place in 1636-37 in Holland. The Tulip Craze, as it is now known, saw the relatively conservative Protestant Dutch society bid up the price of tulip bulbs in a short time to eye-watering levels. At the peak, some rare bulbs fetched as much at 5550 florins, which is more than $1 million in today’s money. However, when the bubble burst, prices collapsed within months to their true value, leaving many in ruin. Over the centuries, there are plenty of instances where emotions have disrupted normal functioning markets, and irrational behaviour has taken over.

Psychology matters

Most investment professionals would argue that greed and fear are the only two psychological factors that influence markets. However, this is a very narrow view as there are several other factors that play havoc with an investor’s decision-making process.

Common Behaviour

1. Anchoring: This is a trait where an investor will “anchor” to a price that is important to them but may have no relevance at all to the market they are investing in. For example, being focused on doubling your money, and only selling an asset if or when the price reaches this point.
2. Loss aversion: Recognising a loss is uncomfortable for most people and investors will try to avoid it where possible. That means that if an asset is below the price the investor paid for it, they are prepared to wait in the hope they will get back to break-even. This can prove disastrous if the asset is in terminal decline. At best, it means your capital is stuck in a poorly performing asset when it could be reallocated elsewhere.
3. Herd behaviour: From a young age, we learn to succumb to peer pressure as the path of least resistance. When it comes to investing, we take comfort if everyone else is doing the same thing. For example, if everyone is buying over-priced internet shares, even if your rational brain tells you this is madness, you justify your decision because “all my friends are doing it and they are making money, so it must be OK”.

Investing in managed funds

When Peter Lynch, one of the greatest investors of all time, was annualising 29%, he conducted a study. He wanted to know what the average investor in his mutual fund, Magellan, had earned. He found that the average investor had made 5% and many had lost money, this despite the fact he was annualising 29%. This happened because his investors were succumbing to their emotions. When Lynch had a big run, those investors gave him money. When his fund pulled back, they withdrew. While this might seem like an illogical move for investors, it happens, and I’ve seen this behaviour first-hand with some of our own investors.

Investing is a partnership

I like to tell clients that we are in a partnership – Pie Funds is a “tool in your toolbox”. But if you give me money after things have gone up, and you withdraw after things haven’t gone so well, then together we’re going to produce a really poor result, and you’re probably not going to like me very much. The investor has some responsibility in this. You could invest with the best manager in the world, but if you can’t control yourself and are constantly putting in money at the wrong times and pulling out money at the wrong time, then you will have poor returns.

How to beat the experts

Developing your emotional intelligence and learning to understand your emotions can allow you to outperform even the best. As an investor, you can beat Peter Lynch, Warren Buffett or Pie Funds – the concept is simple. If you invest more money when things dip, then arithmetically, you will get a better return than the experts. For example, say you tracked Berkshire Hathaway shares over the last 20 years. Every time Berkshire Hathaway shares went down, you bought more. Using this simple strategy, you would have achieved a better return than what Warren Buffett has done. Similarly, if you bought shares in the global index at the top of the market in December 2007, you would have received around 1.4% per annum today. But if you bought shares in March 2009, you would have achieved around 11% per annum. *

This can be applied to our funds as well. Pie Growth has achieved 17.5% per annum over the same period. But as an investor, if you bought into the Growth Fund in March 2009, you would have achieved 27% per annum. *

Rational over irrational

This shows that if you want to do better, you must use the rational part of your brain to understand the feelings you experience when things go down. Lots of emotions will get thrown at you as an investor, but if you’re panicked and stressed, you are not going to make good financial decisions. The good news is that if you recognise what you’re feeling and why you are feeling that way, you can make better financial decisions. You can do this from the comfort of your own home, and you don’t have to make these decisions very often – it may be only every two years, or every 12 months when things have gone down, and you want to improve your returns. If you don’t understand the psychology of investing, then you are doomed to make very average financial decisions. At a worst-case scenario, you might have total financial ruin. But once you are aware of these mental biases, you can become a better investor.

*Data as at 16.03.17