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Irrational, but predictable, investor behaviour comes at a cost

By Paul Resnik – Co-founder and Director at FinaMetrica

Many investors trade actively and speculatively to their detriment according to ‘The Behavior of Individual Investors’, a research paper by Brad M Barber from the University of California, Davis, and Terrance Odean from the University of California, Berkeley.

If your portfolio is inconsistent with your risk tolerance, you're more likely to make emotional investment decisions when markets are volatile. The risk averse may sell down in a market correction; risk seekers may buy in during a market boom. Both add transaction costs, and generate profits and losses to manage for accounting and tax purposes. They also leave the challenging question of when to re-enter or exit the market. Both are highly likely to diminish long-term portfolio returns. Your life choices will be reduced because there's less or even insufficient money available to meet your needs as they fall due.

So what are some of the factors that can so negatively influence your decision-making? According to the research paper, investors are influenced by the media. “They tend to buy, rather than sell, stocks when those stocks are in the news. This attention-based buying can lead investors to trade too speculatively and has the potential to influence the pricing of stocks," the research paper says.

In addition, “investors are influenced by where they live and work. They tend to hold stocks of companies close to where they live and invest, at least in the USA, in the stock of their employer. These behaviours arguably expose investors to unnecessarily high levels of idiosyncratic risk,” the paper says.

Predictable, indeed!  Investors often select companies based on what they read, rather than on what they research and analyse. So much so that they even prefer businesses located close by rather than ones with sound business plans and robust earnings growth and potential.

This leads to another downside of random investing: overtrading. “Transaction costs are an unambiguous drag on the returns earned by individual investors. More surprisingly, many studies document that individual investors earn poor returns even before costs. Put another way, many individual investors seem to have a desire to trade actively coupled with perverse security selection ability,” the paper says.

“Real investors tend to sell winning investments while holding on to their losing investments—a behavior dubbed the ‘disposition effect.’”

The researchers found that the disposition effect tends to increase, rather than decrease, with an investor’s tax bill since in many markets selling winners generates a tax liability that might be deferred simply by selling a losing, rather than winning, investment.”

So what does this all mean? Investors' portfolios generally underperform the markets in which they invest. Such inefficient trading could leave retirees without sufficient funds on which to live during retirement.

At FinaMetrica, we’ve estimated that investing within your risk tolerance could add $5000/year to performance for every $1 million you have invested.

How so? Let's be conservative and assume that emotional trading decisions (buying high, selling low) causes equity underperformance of 1% pa. That’s a very conservative measure; Research firm DALBAR argues that the difference in equity performance has been as much as 4.6% p.a. over the last 20 years. Morningstar has the number closer to 2.0% p.a.

In a 50:50 growth asset and defensive portfolio, (typically growth assets include shares and property and defensive assets include term deposits and savings accounts balances) the performance advantage of investing consistently within your risk tolerance is likely to be at least 0.5% p.a. That is, for a $1 million portfolio, that's $5,000 p.a. to performance. No small amount!

The chart below highlights that people’s trading activity (reflected in the flow of money into or out of equity funds) follows market movements and what’s being reported in the newspapers. News is typically beaten up – as it is at the moment about China’s apparently dire economy and the drop in the oil price – but too often, what’s being reported doesn’t eventuate (in this case, China won’t stop growing). Emotions are driving investment decisions rather than a person’s long-term financial plan. And this is costing them money.

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