Emotional Decision Making Can Be Hazardous to Your Wealth

February 7, 2019

Unfortunately, research shows that investors time their sales and purchases of diversified equity mutual funds poorly when stock markets are under pressure.

Human emotions and the behaviors they give rise to have been shaped over hundreds of thousands of years, in environments and pursuits far removed from the modern world. As a result, the hard-wired behavioral tendencies conferred on us by natural selection sometimes work against us. The phenomenon is especially real in investing, where long-term success requires that we learn to manage our emotions and avoid panic-driven decision making.

The scarier the news or, the more severe the market’s reaction to it, the more likely investors are to panic.

The 24/7 News Cycle and Investor Emotions

People are now able to follow events around the world 24 hours a day, seven days a week, 365 days a year. This constant news flow often contains unpleasant surprises that are out of any individual’s control.

Experiencing emotional reactions to them is inevitable. When the news is related to financial markets, these reactions can be especially visceral, as nobody likes to lose money. When bad news comes out, investors are left to wonder, “How will this impact my portfolio?”

The scarier the news or, the more severe the market’s reaction to it, the more likely investors are to panic. In pre-modern settings, natural selection may have favored those who were the first to drop everything and head for the hills. Today, those instincts can undermine an investor’s ability to plan and work towards a financially secure future. Instead of buying low and selling high, emotionally-driven decision-making leads them to buy high and sell low.

Diversification is a time-tested strategy for investors seeking to achieve their long-term goals while avoiding outsized risks.

Keep Calm and Carry On

A better question for investors to ask when facing fear and uncertainty is, “What impact will panicking and abandoning my investment strategy, even temporarily, have on my chances for long-term success?”

The answer is not encouraging for those who attempt to time the market to escape periods of turmoil and discomfort. Studies have found that mutual fund investors tend to be their own worst enemies, consistently erasing a significant proportion of their returns with their trading decisions.

In its most recent annual report on investor behavior, financial research firm Dalbar found that U.S. investors timed their sales and purchases of diversified mutual funds poorly over the past twenty years (Exhibit 1).

The average equity investor under-performed the S&P 500 Index by almost 2% during the study period, while the average fixed-income investor lagged the Bloomberg Barclays U.S. Aggregate Bond Index by over 4%.

Exhibit 1: Mind the Gap

chart: Exhibit 1

Source: Dalbar (as of 12/31/2017)

It’s worth noting that the period includes both a relatively calm span marked by rising markets but also times that included the great financial crisis and a significant market selloff.

Professional Investment Strategy

Investors who utilize an investment manager (for example, in a mutual fund) should be aware that the success of a manager’s strategy is best assessed over one or more complete market cycles (defined as bull market, bear market and a second bull market). As an industry rule-of-thumb, such cycles tend to last between three and five years but often continue significantly longer. Trading in and out of the market on a shorter-term basis can, and often does, result in abandoning a diversified strategy at inopportune times, mitigating any gains that might have been created through sound portfolio management.

Our View

To be a successful investor, among other things, you have to keep your eye on an appropriate time horizon, craft an asset allocation strategy that is tailored to your personal needs and tolerance for risk and stay committed to it through thick and thin.

In normal market conditions, that is not hard to do. However, in both raging bull and snarling bear markets, remaining committed to a long-term plan takes significant skill, as our hard-wired emotional tendencies make us reluctant to sell or pare back on winning investments and buy or add to losing ones.

In other words, it’s very unnatural to buy low and sell high; to do so takes plenty of courage and self-control, but it’s the key to successful long-term investing.

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Index Definitions

Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

S&P 500 Index: The S&P 500 Index is an unmanaged, market-weighted index that consists of 500 of the largest publicly-traded U.S. companies and is considered representative of the broad U.S. stock market.

Legal Note

Important Information

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.

Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

The performance data quoted represents past performance. Past performance does not guarantee future results.