I have been in Dubai since the last century (which only seems like yesterday). It is amazing how much has changed in the region but one thing that has remained the same is our ability as individuals to control our emotions when investing.
I have always been a traditionalist when it comes to investing and I am a firm believer in separating protection from investments, primarily due to cost and flexibility. Individuals will have a need for future tax planning, but this has to be coordinated with financial and investment planning.
Unfortunately, many tax planners in the UAE lack the experience and discipline when it comes to financial planning and investment management. The main difficulty to overcome is “Individual Investor Behaviour” and unfortunately these traits displayed by the client or individual are often replicated by the Investment Advisor.
Investment Management is a skill that is difficult to learn, requires a lot of experience and importantly; it demands the removal of emotion from the decision-making process.
Many Financial Advisors often take the easy route and tailor a product or investment to what they believe the client wants, as opposed to framing the solution the client needs into something they want.
Let me explain…
Much of economics forecasting and investment advice is based on the notion that human beings are rational beings who attempt to maximise wealth creation while minimising risk.
However, there is empirical evidence that the investing behaviour of individual investors, results in returns that are way below the benchmark (or average market returns).
Let’s look at the factors influencing our behaviour and harming our performance when we make our investing decisions:
Investors tend to hold a nostalgic view of their investments and remember their winners while forgetting about losses. This can create the illusion or belief that one knows more than the market and more than other people leading to too much risk being taken. Combined with a lack of knowledge this can easily cause poor investment performance.
For example, when asked about driving skills relative to other drivers, most believe themselves to be above average, it is this over estimation that leads to investment mistakes. My daughter continually tells me how well she is doing in school and what high marks she has. However, when I check the facts I often find that her marks are average compared to her peers. This overconfidence often results in people making bigger bets based upon their own judgement.
2. Excessive Trading
It is well-known that men tend to display far more confidence in investing that women and this often causes underperformance. Which seems to contradict the concept of investing being a male “thing” along with BBQ’s and cars!
This overconfidence often results in men trading more often than women and when you factor in buying/selling costs then you have to generate an even bigger return before growth can match or even beat the market.
As such excessive trading often leads to poor returns before we even consider whether the the underlying asset that has been purchased performs or not.
It makes you question why people take this route? Especially when evidence shows that passive investing generates better returns.
It was interesting to note that in a study by the Wall Street Journal, funds that had the lowest total expense ratio (total annual cost of an investment) tend to be three times more likely to beat the market than the expensive Funds (UAE investors especially should check their current investments and funds for the Total Expense Ratio and not just the Annual Management Charg
3. I Want To Be A Star
We often see people wanting to demonstrate how smart they are. This not only occurs with individuals but also with some advisors recommending unsuitable investments.
It could be investing in Bitcoin because of past performance or chasing the new Google’s of the world without fully understanding the risks. These individuals are looking for lottery wins instead of constructing a diversified portfolio based on risk and goals which target a steady but more consistent increase in wealth.
4. Hindsight Bias
Investors are heavily influenced into buying investments that have gone up in the past thus reinforcing the buying decision while avoiding investments that have lost in the past. This results in having undiversified portfolios which become more at risk to changes in the market.
The Wall Street Journal analysed 5 star Mutual Funds all the way back to 2003 and discovered that only 12% of these funds kept those stars longer than five years and on average they became a 3 star fund in 10 years,
It would appear that we should not be influenced by previous winners but to look at each investment in its own right.
Typically, if investors do not have to feel responsible for buying and selling decisions then by nature they do not start selling winners and keeping losers, hence one of the attractions for discretionary management as well other hands off investing options.
5. Selling what’s performing and holding what isn’t
One prime example is the very expensive and typical UAE offered savings plans. The redemption value is often a fraction of the money paid in, however investors who need to raise cash, would rather sell a good performing investment than liquidate this poor performing investment i.e. displaying irrational behaviour by having “regret” about the investment decision but being unwilling to do anything about it. This is a standard behaviour trait of most individual investors.
They tend to hold losing investments and sell profitable investments.
6. What’s the next hot sector? What’s in the news? What is everyone else doing?
People tend to have a limited at
tention span when it comes to investing.
They face huge choice of investments to purchase, are unable to do systematic intensive research if they even have the knowledge to do so, and as such tend to purchase what is immediately in front of them. i.e. buying today’s stock in the news or in the press. As a result, they tend to sell when fear is persuasive and buy when news is positive. This is emotional investing, and empirical evidence shows it results in underperformance.
Individuals are also influenced by the behaviour or actions of friends and colleagues around them. This type of herd mentality is a natural behaviour for individuals, but not necessarily one that results in positive outcomes for them, with people often overlooking logic for familiarity. We see regular examples of this in the UAE with individuals investing in expensive poor performing savings plans without doing any research because a colleague has recommended the advisor and done the same.
7. Familiarity, Focusing on what you know & Not Diversifying
Most investors display home bias and hold investments that are overweight in an asset class or country with which they are familiar.
It makes individuals feel safe, but they then become exposed to increased volatility through a lack of diversification and is more pronounced with investors that lack investment experience. They tend to avoid investing in foreign stocks even if these foreign stocks have a lower correlation to the domestic market and can reduce risk while giving better returns.
If you are looking to reduce unnecessary risk and still achieve the correct investment outcome, you should not be in one asset class. No matter if it is the best performing asset class, you will always have systemic risk. If the market goes down, then no matter how good your investment is, it will also go down.
Evidence shows that investors often end up holding under diversified portfolios and carry a lot of concentrated risk, despite the evidence showing the opposite is required to create wealth.
Smaller portfolios are also an ideal example, some perceive them to be too small to diversify, and concentrate the investments into a narrow asset class. However, that need not be the case. Exchange-Traded Fund’s (ETF’s) are one example of an extremely efficient way of diversifying and very inexpensive.
For individuals who are unable to overcome these influences or require the professional management, using a Financial Advisor can be the solution. However, this can create its own issues, especially in the UAE where Advisors can be high cost.
One of the biggest drags on performance is costs, and if someone is paying on average 4.5% in fees per annum as is often the case with insurance backed investment/savings accounts it is very difficult to achieve the returns required to generate positive inflation adjusted returns
Let’s be contrarians?
Investors and advisors tend to buy using a rear-view mirror instead of buying with a forward view. i.e. they buy with a hope that they believe “what will happen” (tendency bias) assuming that the past is an indication of the future. They then sell after an event has actually happened (capitulation) or they sell to lock in a gain and hope to repeat this on the next trade and not because they believe that the past winner is a future loser.
Statistical performance returns shown are purely academic, in the real world it is different. Investors and advisors trade often, incurring unnecessary costs and have poor asset selection ability and top it off, they often have a concentration of risk. The real risk adjusted returns come from well diversified low-cost portfolios.
An experienced and accomplished advisor would carefully assess the risk and return of all possible investment opportunities, create a portfolio that would suit the client’s risk profile and long term goals, rather than what the client thinks is low risk or exciting. In this instance, the most likely result will be the client’s expectations being dashed but without emotion dictating investment it should also result in a better long term investment plan for the individual.