Lessons from the Real WorldThe following article is excerpted, with permission, from the book Investor Behavior: The Psychology of Financial Planning, by H. Kent Baker and Victor Ricciardi. This chapter, published here, was contributed to the book by Gregg S. Fisher, founder of Gerstein Fisher, an independent investment advisory firm based in New York City
U.S. President Franklin Delano Roosevelt, during his first inaugural address in 1933, stated that “The only thing we have to fear is fear itself.” He made this statement when the country was in the throes of the Great Depression. More than 80 years later, academic research in the field of behavioral finance demonstrates that this celebrated line applies equally to investing. Investors are often their own worst enemies because they are susceptible to mental mistakes and emotional responses. These biases often lead to poor decision-making and, ultimately, inferior financial outcomes.
One of the greatest services a financial advisor can provide to clients is helping to ensure that in times of market turbulence, reason, discipline, and objectivity triumph over emotions such as fear, greed, and regret. This chapter explores some reasons for which overcoming emotional and cognitive biases in investing is both vital to individuals’ long-term wealth creation and also a perennial challenge for financial advisors. It explains common emotional biases and how these impact the development of investment strategy and, ultimately, investment results. Additionally, this chapter draws on both academic theories in the area of behavioral finance and the real-life manifestations of behavioral and cognitive biases on investors’ long-term wealth.
The chapter is organized as follows: The first section examines the complex relationship among risk, return, and the investor. Next, the chapter outlines several common emotional biases that can jeopardize an investor’s prospects for long-term wealth creation. The next section discusses the impact of investor behavior on portfolios, including why investors tend to underperform the asset classes and funds in which they invest. The chapter then details approaches financial advisors can use to help investors avoid emotionally driven decision-making and stay on track to meet their long-term goals. Finally, the chapter explores strategies that seek to turn predictable, common investor behavioral biases into profit opportunities.
Risk, Return, and the Investor: A Complex Relationship
Consistent opportunities for excess returns with zero extra risk relative to a market index simply do not exist because market participants arbitrage them away. In other words, there is no free lunch in investing because investors must incur risk in order to earn return. The fact that equities have historically outperformed fixed income stems largely from the fact that equities are inherently riskier. That is, investors must be compensated for that additional risk in the form of additional return. Otherwise, why would they incur it?
A Premium for Stock Risk
Normally, investors are compensated for the additional risk that equities entail over so-called riskless assets such as short-term Treasuries in the form of the equity risk premium (ERP). Equation 15.1 shows a simple calculation of the ERP: MKT – RFR = ERP (15.1) where MKT is the equity market return and RFR is the risk-free rate, commonly measured as the one-month Treasury bill.
The ERP is not supposed to be negative (recall that it is referred to as a premium). Yet, investors have actually been penalized instead of rewarded for taking on risk during some multiyear periods. During the Great Depression between 1930 and 1939, the ERP averaged –0.60 percent a year, using the S&P 500 Index to measure MKT and the one-month U.S. Treasury bill to represent RFR. For the decade starting
in January 2000 and ending in December 2009, the ERP was –3.7 percent a year.
Over the long term, however, the ERP has been positive: more than 6 percent annualized over the period between January 1926 and December 2012, which makes intuitive sense given the “normal” relationship between risk and return. Investors will not realize the longer-term ERP if they panic and sell their equity holdings based on short-term, negative market events. In fact, weakening prices can
represent buying opportunities from which long-term investments have the potential to gain great value. When price volatility or an increase in uncertainty about the future value of assets occurs, opportunities are available for investors to be rewarded for placing or keeping assets in the stock market.
The Sentiment Roller Coaster
Unfortunately, even prudent risks that investors objectively know should pay off are often psychologically difficult to incur. Hence, the advisor’s challenge is to keep clients who are nervous and fearful in the market after a protracted downturn. While most investors understand the concept of market cycles, when the economy has been stuck in a trough for an extended period they often have difficulty
believing that stock markets will eventually recover. This is when investors should be reminded that one of the greatest long-term wealth hazards they face is having no or minimal ownership in stocks when the cycle turns up because they panicked, sold their equity holdings, and moved into cash when stocks were in a severe downturn.
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