Why controlling your emotions can be critical to investment success

Aviva recently spoke to Greg Davies, an expert in investor psychology – with a Ph.D. in behavioural finance – at the behavioural fintech Oxford Risk. We wanted to find out how investors can control their emotions and successfully navigate markets, particularly during periods of turbulence.

Greg believes investors should follow four simple foundational rules:

• Build a safety net equal to around four months of spending, a buffer against illness or unemployment, for example.
• Put the rest of your money to work, instead of leaving it in a bank account “often failing to keep pace with inflation over time”. That Greg believes is for most investors “the most behaviourally costly” mistake of all.
• Diversify “because any one thing you invest in can go to zero forever, but if you’re well diversified, that should not happen”.
• Leave your investment alone.

The trouble is that applying each of these rules is emotionally challenging yet not following them can prove very costly.

Greg explains:

“Everyone knows the benefits of a healthy diet and regular exercise — it’s sticking to the routine that’s hard.”

Why cash is not always king

Leaving money in cash in the belief that this is the safer option is the single most costly emotional trap, says Greg. He explains “Sitting on cash might feel safe, but that emotional comfort comes at a high cost—lost returns, year after year.”

Diversification can also prove challenging. That’s because it involves “buying a little bit of lots of things you know nothing about and, as humans, we gain comfort through stories and narratives”. Greg argues, for example, that investors would rather “back a company their brother-in-law works for because he’s a nice bloke and they like their products.” Despite lacking a sound investment rationale, it is “an emotionally comfortable approach”.

Many people end up with concentrated portfolios of good stories rather than owning a diversified portfolio of good investments, concludes Greg.

Why benign neglect can pay off

Leaving your investments alone, particularly during periods of market volatility, is probably the most difficult rule to follow emotionally. That’s because “once you’ve put your hard-earned money into an investment, it is only natural to monitor it, and, if you see it going down, try to rectify”.

The urge to act explains why many investors make the mistake of buying when markets are performing well, and prices are relatively high, and selling when markets are falling.

Greg argues that:

“We invest for the long term, but our emotions are wired for the short term. That disconnect leads us to chase comfort over sense—buying high and selling low.”

Yet paradoxically, says Greg, individual investors have a huge advantage over professional investors in terms of time. He points out that:

“Professional investors are under pressure to perform every month or every quarter or every year, whereas retail investors, if they have set aside a safety net, can weather downturns. The only reason they do sell is due to the need for emotional, rather than financial, liquidity.”

It is particularly hard to remain emotionally level-headed given that the media tends to hype up any market turbulence, with powerful headlines saying markets are “collapsing” or “surging”, when they may have only moved by a percentage point or two.

Greg says some individuals are simply “much better at taking a long-term view than the others because they are less emotionally-engaged with the journey”.

He adds that:

“When markets drop, people tend to dig their heels in because they hate selling at a loss. So, they hold on and on. But as the market downturn deepens, the pain of selling at a loss grows, and eventually investors run out of emotional liquidity, and capitulate. Once you’ve sold after you’ve lost 30% of your investible wealth, it is immensely difficult to recover your poise and reinvest. So, investors also tend to miss out on most of the gains when markets rally.”

Greg adds that much of his time is spent helping investors avoid trying to time the market and helping them identify the investment solution that meets their needs, circumstances, and financial personality. Oxford Risk has developed software that delivers “hyper-personalised” messages to investors to help overcome the emotional challenges discussed earlier. It is also working with financial advisors to assess which clients they should be talking to and what messages they should be sending.

Greg concludes: “We are really just scratching the surface, but ultimately we think that helping people manage their emotional states is a bigger part of the solution than simply identifying the right investment for them.”