Future Focus: Market returns are secondary to this return driver
Want to be a successful investor? You’re focusing on the wrong thing.
In my investment strategy, I focus on what I can control.
I can control the amount of risk I take in my portfolio. I can minimise my transaction costs and fees. I can control my behaviour. Controlling my behaviour leads to lower transaction costs and better tax outcomes. It is a virtuous cycle.
In an article I wrote on long-term equity market returns, poor behaviour was one of the largest detractors of total returns for investors. For this week’s column, I look at some of the most common behaviours that puts investors on the back foot and how you can reduce the likelihood of falling prey.
Overcoming FOMO
Part of human nature is our desire to avoid missing out on the returns that others are getting. When markets are going up, we want those same gains in our portfolio. On our recent Investing Compass episode, we spoke about the top holdings of the best performing superfunds.
We acknowledged that looking at these top performing superfunds is common behaviour for investors, and often these funds see inflows when they make the top of the list. People want the best for themselves and that’s not something to be ashamed of. However, often this behaviour can lead to poorer outcomes.
My own experience with FOMO
It’s easy to write these articles and preach that you shouldn’t partake in poor behaviour. It is harder in practice. I’ll speak about myself for a moment.
Although overcoming FOMO when markets are rising is more common, it isn’t just trying to partake in the upside. When markets fall, I tend to get anxious about missing out on an opportunity when shares are cheap. If prices are temporarily depressed, I start to get itchy fingers and want to put more money in the market.
This is an ongoing battle. My last trade out of my regular cycle was in mid-April, as I saw US markets dropping, sometimes over 5% a day. I struggled to watch the markets and not invest, fearing I’d miss out on entering at an attractive price. I took funds out of my emergency fund to put money into the market. This is not my investment strategy, and it is not a sustainable way to invest. I let the fear of missing out get to me.
I have realised that the best way for me to achieve success with my investment strategy is to set clear guidelines, and intervals for when to invest. I’m trying to mimic what happens with my superannuation account. My employer contributions are blind to how markets are moving. Lucy from our Finance team at Morningstar isn’t sitting there watching real-time data and waiting for a dip before she sends my employer contributions to my superfund.
I am not a tactical allocator because I’ve found that that is not how I will maximise my outcomes. I automate my additional investments and try to maximise my contributions. I limit costs as much as possible. Engaging in tactical allocations means that I would have cash sitting there waiting to be invested all the time. With my long-time horizon, it’s in my best interest that I invest and give my funds the most time in the market as possible.
In mid-April during the market volatility, I was a tactical allocator. This behaviour was similar to how I acted when I first started investing. For the most part I’ve been able to avoid this behaviour by setting up a proper strategy. There are still slip ups as April demonstrated but these slips have gotten less common.
This is important. The data says the more I can control my behaviour the better I will do.
Morningstar’s Mind the Gap study shows that investors realised a return of 6.3% a year over a decade to 31st December 2023. The investments they purchased and sold had a total return of 7.3%. This is a gap of 1.1% a year, or about 15% of the total return that is lost by poor behaviour.
This is purely because of decisions that investors have made to enter and exit funds at certain times.
How to fight back against FOMO:
- Write an investment strategy that aligns to your goals and stipulates when you can and can’t invest.
- Automate your contributions so it invests based on a schedule. Not having spare cash laying around means that you are less likely to try to time it so you get in the market at a good price.
- Compare your portfolio turnover year on year. If it is higher, understand the underlying reason behind an increase and whether it is tied to chasing performance.
Loss aversion
Loss aversion is simply the concept that a loss feels much worse than a corresponding gain. Morningstar’s Behavioural Research team has found that losses can feel about twice as painful as an equivalent gain.
This asymmetry of emotional responses can drive poor decisions from investors.
It means that investors can often:
- Sell positions that still have the potential to grow. They’re worried about experiencing a potential loss in the future that has not been realised.
- Stay in positions that they shouldn’t stay in. Investors will sit in positions that they own, not wanting to realise the loss. In doing so, they are holding positions that are freezing up capital that could be used for another investment, overcomplicating their portfolio and not efficiently realising their losses.
How to fight back against loss aversion:
- Coming up to tax time, it’s important to have an honest review of your portfolio. Are you holding onto positions that no longer have potential, or align with your investment strategy? There may be gains that these losses could be offset against.
- During your portfolio reviews, be transparent and honest with yourself about your holdings. Investing is an art where you will never be correct 100% of the time. It is inevitable as an investor that you are going to have some bad outcomes. Even the most successful investors have poorly performing investments.
- Establish a strong decision-making framework which ensures that you will not sell out of positions early. Specify when you will sell and stick your plan when your investments appreciate.
- If it suits your goals and portfolio, incorporate rebalancing at set intervals to cut from allocations and add to others.
Analysis Paralysis
Have you ever been in a supermarket and looked at the 12 different tasty cheese blocks that they offer and been immobilised by the choice? This is capitalism. But it’s also analysis paralysis.
Analysis paralysis is also known as choice overload. It often means that investors end up defaulting to the easiest option that might not be the best for them.
When we look at equity markets there are approximately 56,000 listed companies globally. There are over 12,000 ETFs listed globally. There are 3,700 managed funds in Australia. The US market alone has 500,000 corporate bonds. Then there’s private markets and more exotic investments.
Investors have a lot of choice about where to put their money.
A common place we see this analysis paralysis is with superannuation. A large proportion of Aussies stick with their default funds. Many people find it overwhelming to change a superfund. The fees, performance, fund options, and sheer number of superannuation providers all contribute to this reluctance to change funds. And that’s assuming that all of this information is easily accessible and not jargon-filled. It isn’t hard to see why people don’t engage with their superannuation or change it.
I’ve written an article before about why it’s important to engage early and take your super seriously.
Morningstar research from 2019 (Bigger is Better, Blanchett & Finke) looked at the US market but the results are relevant to Aussies as well. They looked at 500 defined contribution plans with over 500,000 participants. When the core menu of options grew from 10 to 30 funds, they saw that the members that stuck with the default option leapt from 74% to 84%. People are simply overwhelmed by choice.
How to fight back against loss aversion:
- Again, a lot of this behaviour can be prevented through an Investment Policy Statement (IPS), which is another name for a written down investment strategy. Narrowing down the types of investments that will help you achieve your goals means that you can exclude the others.
Final thoughts
Poor behaviour has a large impact on your total return outcomes. Market returns are going to be out of your control. To a large extent, the taxes that you pay and the transaction costs that you incur are inevitable. Although, they can be limited through smart choices. Your behaviour is entirely within your control.
Investors are not perfect. There will be times where you deviate from your plan or make poor decisions. However, having a clear strategy and being transparent with yourself will mean that you can limit this behaviour. This includes reflecting on past behaviour and understanding the decisions and conditions that make you susceptible to deviating from your plan.
The best behaviour that you can adopt is to let your investments supply the returns and not get in the way.
