Psychological traps investors should be wary of

It has been a rollercoaster year for investors. If you resisted the urge to sell in March as global markets plunged, then you probably benefited from the subsequent bounce — but you may now be fearing that worse is to come.

The hangers-on are likely to have seen their dividend income dry up, whereas those who retreated to the safety of cash have been watching share prices detach from the reality as an influx of day traders enter the market.

As the markets swing, investors are all wondering the same thing: what should I do now?

“When something is broken, you want to fix it,” says James Norton, senior investment adviser at Vanguard UK. “It goes back to our very, very basic need to protect ourselves.”

The desire to act in a crisis is deeply embedded in our psychology. But investment behaviour experts warn that this instinct is our own worst enemy when it comes to money.

Wanting to remove discomfort is a natural response to feelings of anxiety or powerlessness. “You see your portfolio falling in value and the natural thing to want to do is to protect it,” says Mr Norton. “You sell that asset that is falling in value and you feel better — almost immediately.”

But over the long term, more frequent activity can actually lead to worse outcomes. Research shows investors who trade more frequently have worse long-term outcomes than those who trade infrequently or not at all. Investors who retreat from the market in a downturn rarely time their re-entry correctly, missing out on the recovery.

The human brain relies on millions of shortcuts to function everyday. These are mostly helpful, but when it comes to investing, they can create unhelpful bias causing investors to internalise trends, say Steve Wendel and Sam Lamas of the behavioural science team at investment research firm Morningstar. “When the market is crashing, investors behave like it’s always going to go down,” says Ms Lamas.

Investors are also psychologically inclined to fall into the trap of overestimating their investing abilities, or assigning too much weight to their intuition, something Mr Wendel calls “overconfidence bias”.

“Investors follow the same behaviour again and again in market sell-offs,” agrees Mr Norton. “They need some kind of emotional circuit breaker.”

So how can investors protect themselves from themselves?

In times of crisis, there is no shortage of advice from pundits urging investors to “buy the dip” or “find the bottom”. As markets plunged in March, online trading platforms reported seeing their busiest ever trading days.

The sophistication of apps and online trading means that retail investors can buy or sell in a few clicks — and can instantly see any bad news reflected in their portfolio valuation.

Twenty per cent of investors say that they check their portfolios at least once a day, according to a survey this week by asset manager BMO. “The more people check their portfolios, the worse the decisions they’ll make,” says Mr Wendel. Experts call this fixation on the short term “myopic loss behaviour”.

Yet investing is supposed to feel uncomfortable. “The right thing for your long-term goals is always emotionally uncomfortable for the present self,” says Greg Davies, head of behavioural science at Oxford Risk, a consultancy. “This gets dramatically exacerbated during times of crisis.”

The more connected you are to the daily, or hourly, market swings, the more you will be focused on the short term, and the more likely you are to make impulsive choices.

“We don’t feel comfortable doing nothing, though, often, that is exactly the right thing to do if you’re an investor,” he adds.

One of the reasons investors tend to make poor trading decisions in a downturn is because they are trying to exercise control in a powerless situation. Experts recommend finding a ‘displacement activity’, or another way to feel in control of your money, such as doing some financial admin. Checking your statements, cutting back on spending, or making sure your accounts are organised could be enough to help you feel in control.

If investors do feel like they have to make a trade, experts say, it is helpful to implement strict rules. Investment platforms on mobile phones are designed to make it easier for you to trade, not more difficult (and the more you trade, the more money the platforms collect). So investors need to build in their own backstops, or ‘pause points’ to avoid making impulsive decisions.

Call a friend for another perspective, or sleep on a trade before making it, Mr Davies advises. Limits might also mean setting restrictions on when you will look at your account or make trades. Mr Davies says he only looks at his investments on Saturdays. This provides him a longer backstop, since he knows whatever trade he puts through on Saturday will not go through until markets reopen again.

Ms Lamas recommends a three-day wait rule to execute any trade, “giving you time to use the analytical side of your brain,” rather than the emotional side. Ms Lamas also looks up what the tax consequences will be of any trade she makes to avoid decisions she will regret later. “A lot of people, including me, hate paying taxes more than they hate losses in a downturn,” she says.

Mr Norton recommends pen and paper. “Ask yourself why you think that trade will put you in a better position than you were already,” he said, “Writing it down is incredibly powerful.”

Plus, he adds: “If you write down reasons for trades and revisit that list every time you want to make a trade, you’ll get a sense of whether your history of decision making is any good.”

Little and often

Investors with a lump sum to put to work in the markets often spend a lot of time worrying when is the right time to invest. The easiest way around this is to divide your investable cash into tranches, and spread your re-entry over time. That way, you will benefit from pound (or dollar) cost averaging. By deciding to invest on a fixed date in the future, such as the first of the month, investors can average out the market swings.

Importantly, says Mr Davies, “you take away the need for your future self to make any of those decisions.”

Experts say that retail investors should not feel bad if they struggle with setting rules around their investments. Even professional investors are vulnerable to behavioural traps.

Mr Davies notes that even if investors are feeling remorse about decisions made earlier in the year, they should try and think about this as one crisis among many they will live through. Plan for the next one, he advises.

“A big downside of a crisis is that all this good advice is difficult to put in place during a crisis. You want to draft these rules so when you need them, they’re already there.”