We like to believe that we are rational and make decisions based on facts. But it can be difficult not to let emotions govern your investment decisions – especially when you feel anxious during sell-offs and in times of market volatility. And behavioural economists have identified hundreds of psychological biases that can influence the way we make decisions about our finances.
But there are some investment mistakes that you should try to avoid making, particularly in current market conditions, as set out below. Also take time to reflect on your own temperament, and propensity to over- or underreact in times of stress, so that you can think about what mistakes you personally might be most susceptible to making.
Loss aversion bias
Investors have a hypersensitivity to losses, which can lead to bad investment decisions in times of extreme market volatility. This concept, known as loss aversion, was coined in 1984 by economists Daniel Kahneman and Amos Tversky, who carried out a series of experiments which showed that people tend to fear a loss twice as much as they would welcome an equivalent gain.
An example of a mistake that investors make as a result of loss aversion is panic selling because stocks have fallen and then missing out on gains as they recover. Despite resilience in the market over the past month, the economic outlook is still very uncertain and many stocks may still have further to fall. But when markets recover it could happen very quickly, so if you have sold out you might miss this. And because of the compounding effect as markets rise it could be a lot.
But also remain flexible and reassess the fundamentals of what you are investing in. While you should avoid crystallising losses on companies that look well placed to recover, it can be equally damaging to hold on to companies that are likely to fall further. “The obvious mistake is to sell profitable investments and keep the losers,” says Ben Yearsley, director at Shore Financial Planning. “You don’t want to admit you’re wrong so you stick with a company – even if the fundamentals have changed.”
Holding on to poor-quality stocks can also mean that you do not put the money invested in them to better use elsewhere.
But it is not easy to determine whether the prospects for a company have fundamentally changed due to the coronavirus, as it is too early to know what its long-term effects on economies and markets will be. “The uncertainty over the lasting effects [of the coronavirus] exacerbates the tendency to do the wrong thing,” says David Liddell, chief executive of online investment service IpsoFacto Investor. “It is important that people stay calm, but also take opportunities to improve the quality and diversification of their portfolios.”
So with direct shareholdings, if you still think the fundamentals for a company are good but its share price has fallen, you could buy more of its shares at a lower price. Mr Yearsley, for example, bought William Hill (WMH) about six months ago because he thought it looked quite cheap at 170p a share. However, with sports events cancelled following the coronavirus outbreak its share price fell to as low as 40p. Although Mr Yearsley's holding in William Hill had fallen sharply in value, after doing further research he decided that as it had a strong cash position and arrangements with banks, the company was well placed to survive the crisis. He was also confident that its share price was worth more than 40p, so he bought more shares in it. And William Hill's price has gone back up and was 103p a share, as of 27 April, so his original investment in it is only about 10 per cent below what he paid for it.
A decision on whether to buy or sell a stock should not be made according to a previous value. If the price of a stock you hold has fallen heavily below what you paid for it, you should ask yourself what the prospects are for that stock now, rather than holding on to it simply because selling it would lose you money. “The market doesn’t care what price you bought the stock at,” says David Miller, investment director at Quilter Cheviot Investment Management. “Don’t plan to sell a stock when it gets back to the price [at which] you bought it, because that is not related to what the shares are worth.”
The tendency of investors to base their decisions on previous market prices is common and known as ‘anchoring bias’. Many people think of their homes in this way and expect to be able to sell them for at least as much as they bought them – even just a few years later – but do not consider what the current state of the market is and what it may be like in the future. Mr Miller reiterates that just because something has dropped in price doesn’t mean it’s cheap. “The rules of life are changing because of lockdown and the likely recovery,” he says. And there will be long-term changes in how people spend money.
“Many investors may look at a stock market [such as] the S&P 500 and consider that now is a good time to buy as this index is still far below the highs of only a few months ago," adds Nicholas Hamilton, chartered financial planner at Mazars. "This previous anchor becomes an expectation of potential future returns and that markets will return to such highs. Yet further analysis demonstrates that the S&P 500 is now far more expensive than when the pandemic began – S&P 500 valuations versus expected earnings are now expensive, with a forward price to earnings ratio of 21 times compared with the 10-year average of around 16 times.”
Investors also have a tendency to look for information that supports their existing view of a company, which can lead to them making ill-informed decisions. This confirmation bias explains why bulls tend to remain bullish and bears tend to remain bearish. To help overcome this, seek opinions that challenge your point of view, and make a list of an investment’s pros and cons, reassessing it with an open mind.
Don’t try to time the market
Since this crisis broke it’s been difficult to focus on anything but the short term, amid daily newsflow and extreme market turbulence. And having seen large swings in share prices you might be tempted to try and make a quick buck by plunging in at what looks like a good moment – especially if you are stuck at home with more time on your hands.
However, it is next to impossible to time the market. “A lot of time and money can be spent undermining your own returns,” says Ryan Murphy, head of decision sciences at fund research company Morningstar. “It is not advisable to churn your portfolio – even if it is tempting when volatility increases.”
Investing is a long-term process and doing it over this timeframe should help you to avoid mistakes. Thinking about what the market will do day-to-day is speculation, but thinking about what it will do over the longer term is investing, adds Mr Murphy. And when you buy higher-risk investments such as equities you should look to hold them for at least five years.
Also don't think that there won't be further periods of market stress once we have got through the worst of the coronavirus crisis as this will take time to work its way through the system. Mr Miller says: “If you buy something that you think is good value and has a chance of thriving, you have to give that investment time to work, and not be put off by share price volatility, which is bound to continue.”
See past the hype
You might be tempted to try to explain why the market has gone up or down, but Mr Miller says that “sometimes markets move for good reasons and sometimes they just move.” And just because markets have gone up, for example, in the past two weeks doesn’t mean that everything is fine. Similarly, sharp sell-offs can present good investment opportunities.
You need to look at what is going on in the world and the economic data coming out, but make judgments based on what you think the future looks like. You should not satisfy yourself by, for example, thinking that if markets have gone up 10 per cent everything is fine. Instead, think about what impact the virus is having on company profits and dividends, and general economic activity, as this is a clearer signal about the future than short-term market movements.
As no one knows what the outcome of the pandemic will be, treat content that purports to know this with caution. Instead of certainty, “the best experts think in terms of probability,” adds Mr Murphy.
Approach your investment decisions with humility, conduct thorough research and try to avoid what is known as ‘representative bias’. Many investors don't have the time or expertise to review and analyse all the important information that will impact share prices, so short-cut this process with overly simplified rules. Mr Hamilton says this results in them placing a greater weight on particular information that may affect decision making without considering the alternative implications. For example, a quick scan of the papers recently would have informed you that oil was trading at negative prices. But without assessing the reasons for this you might have assumed that oil prices were in free fall and made poor, knee-jerk investment decisions based on this assumption.