More often than not, our fears are unjustified, or not supported by statistics. Riccardo Cervellin, Country Head Italy, and Carlo Benetti, Head of Market Research & Business Innovation, look at how fear can make investors their own worst enemies.
Do you know anyone who is scared stiff of flying?
Nervous flyers are torn between a rational side, which tells them just how safe air travel is, and an emotional side, which inevitably ends up winning; 20 drops of benzodiazepine help a lot more than statistics, facts and incontrovertible evidence.
Fear is a primitive mechanism, an emotion designed to avoid danger. Thanks to fear, our ancestors, when faced with danger, ran away very quickly – if they hadn’t, our species would have become extinct in a very short time.
But, when it comes to savings and investments, fear stops being a helpful emotion and starts to trick us.
When under the influence of their emotions, investors become their own worst enemies. Experimental psychologists have demonstrated that bullish periods on the stock market are accompanied by euphoria and optimism. On the other hand, bearish conditions cause investors to suffer fear and panic. The upshot is that an excess of optimism causes investors to increase the proportion of high-risk assets they hold, while fear leads them to eliminate the reasons for the fear ... by selling the high-risk assets!
This is a portfolio disaster: investors enter the market when it is close to the top and tend to offload their investments when the market is close to the bottom.
As a general rule in financial markets, fears arise from things that have happened in the past, with the pain of past losses overshadowing expectations for the future, which are in fact the only things that actually matter when it comes to capital growth.
More often than not, our fears are unjustified, or not supported by statistics.
Perceived and real risk
The graphic above shows the discrepancy between scenarios we are scared of and scenarios that are actually dangerous. The risk of dying in a given year as a result of an aviation accident for an American is about 1 in 11 million. The chances of dying in a road accident, however, are considerably higher, estimated to be around 1 in 5,000 (source: Susanna Hertrich, figure based on the work of Dr Peter M. Sandman).
Imagining the future on the basis of past experience leads to fears that are not rationally justifiable. However, we rarely have sufficient information about the future. There is a risk of ending up like Bertrand Russell and Karl Popper's famous Inductivist Turkey.
Russell presented the example of a turkey that was very well cared for, receiving food and water every day. The turkey got used to this comfortable situation, feeling increasingly secure and confident. The turkey's trust grew every day before being broken suddenly (and tragically, at least from the point of view of the turkey) on Thanksgiving Day!
Russell used the poor turkey to demonstrate the inductivist trap: the risk of believing that the past contains all the useful information we need on the future. We run the same risk when making predictions about the financial markets.
In short, while our species is perfectly evolved to make it in the natural world, it is considerably less adapted to the artificial and complex world of the financial markets.
So here are a few rules that might help you survive in the financial markets.
The seven golden rules
Do not think you are always right. Confidence is the driving force that encourages us to take risks, and the secret of great entrepreneurs and all successful men and women. But when it comes to investments, it is best not to overdo it. History is littered with experts who made gross errors. The director of Metro Goldwin Mayer predicted that "Gone with the Wind" would be a complete disaster, while the artistic director at Decca declared in 1962 that "guitar bands (including the Beatles) were on their way out.” For investors, an excess of confidence in their own choices results in the concentration of risk, a mortal sin if your objective is to reduce reasons for panic.
Do not look for confirmation of your choices. We were born with powerful systems designed to protect our self-esteem. If, after we have taken a decision, we come across information that raises doubts about that decision, we feel stupid, and no one wants to feel stupid. But, in fact, we should try to be "laymen", and to put our convictions to the test. There are no certainties on the markets, and looking for information to confirm our ideas leads us to pay scant attention to the truthfulness and quality of that information, and in particular to ignore other information that goes against what we believe! A healthy doubt is better than an unhealthy certainty.
Do not follow the herd. There are only a few times when it is sensible to follow the majority, for example on holiday when you are not sure which restaurant to choose, but you should never follow the crowd when it comes to savings. It may turn out that the "others" made their choice by copying others. Resist the temptation to feel safe just because "everyone is doing it.”
Do not look at your portfolio too often. Look at your portfolio occasionally, and avoid spasmodic checking and comparing with financial news and market trends. Bad news leads to panic selling, while good news leads to increasing risk on the back of euphoria, and both cases compromise the creation of long-term value. Portfolios take a long time to mature. Managing your savings is like baking a cake: if you open the oven too often to check how it's going, the cake will collapse on itself, and the end result will be very disappointing.
Do not buy stocks because their value is going up. This is the worst possible investment strategy, as summed up very wisely by Warren Buffett: “The dumbest reason in the world to buy a stock is because it’s going up.” Stocks and indexes go up for a range of different reasons, and not least because everyone believes they are going to go up. The financial markets are the natural ecosystem for self-fulfilling prophecies. The value of a stock may go up and up and up simply because everyone thinks it's going to keep doing so. This is how speculative bubbles are created. Buy a stock only if its essential features suggest further increases in value.
Diversify, diversify, diversify. This is the golden rule of every respectable anti-panic manual. In the words of Mark Twain: "It cannot rain all the time and it cannot rain everywhere.” Those who are still feeling the pain from when the tech bubble burst are those who focused too much on tech companies or small cap stock. A well-diversified portfolio is better equipped to withstand a financial environment characterized by modest returns and high volatility. “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas,” said Paul Samuelson.
Get advice. Scientific literature has demonstrated that, on average, portfolios of individual investors entrusted to an adviser achieve better results than self-managed portfolios. It's not difficult to understand why. Advisers know the markets, but above all their emotional distance enables them to take more considered decisions. This is normally true when the level of euphoria is very high, and when ordinary investors feel dejected and risk missing out on buying opportunities.
GAM is a long term supporter of the Center for Experimental Research in Management and Economics (CERME) which is part of a large collaborative network, including the Departments of Economics, Management and Philosophy and Cultural Heritage of the Ca’ Foscari University in Venice, Italy. The partnership between GAM and CERME intends to provide a better understanding of behavioural finance and to develop a useful application of the experimental method to relevant management issues. The Center addresses several important research areas in Behavioural and Experimental economics, such as strategic choices, probability and ambiguity, information processing, behavioral finance and public choices.
Nothing contained herein constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions are those of the author at the time of publication and may not reflect his/her views thereafter. Reference to a security is not a recommendation to buy or sell that security. The companies included are not necessarily held by any portfolio. Past performance is not indicative of future performance. No liability shall be accepted for the accuracy and completeness of the information.