The cost of Emotional Investing

By Morningstar |  02-03-20 | 

Everyone looks at potential returns when analyzing an investment. But we completely underestimate the impact of our own decisions based on emotions.

STEVE WENDEL, Morningstar's head of behavioural science, digs into this subject. 

In a Journal of Financial Planning article, I analysed the costs and implications of selling investments during downturns. By my estimates, and others in the field, the cost to everyday investors is on the order of 100 to 150 basis points, annualized. Even if you aren't likely to panic during a downturn yourself, though, the potential for panic by others affects your investment environment because of how the risk of emotional selling is built into common practice in asset allocation. Let's take a look at that research, and what it means for investors and investing.

By focusing one's asset allocation squarely on ones goals and what is needed to achieve them, and using behavioural tools to mitigate emotional challenges, we can find a more effective answer than current risk-preference based allocations.

How bad is it?

We've all heard horror stories of people who panicked during a downturn, went to cash, and then lost out when the market recovered. Or of people who simply became uncomfortable with a sector- or investment-specific dip and dumped an existing investment only to see it promptly recover (and outperform the "new" investment they chased after).

In this research, I start by analysing the baseline: What would emotional selling do to a sample set of investors? I developed a simulation model of investing over time, similar to one in my paper on easing the retirement crisis, and explicitly modeled the probability of selling during downturns due to emotional triggers. Depending on each person's risk preferences, they had a threshold at which they would sell; those with lower risk preferences panicked more quickly than those higher preferences. I then put them though a range of historical scenarios to see how they would behave over a 10-year period.

These baseline results came back as a loss of between 100 and 150 basis points, which aligns the range of estimates other researchers have found. The most well-established estimates look at the costs of unwisely trying to time the market, of which emotional selling during a downturn is believed to be the most pernicious part. Researchers Friesen and Sapp (2007), for example, estimate that it decreases investor returns by about 150 basis points per year. Vanguard also places it at about 150 basis points (Bennyhoff and Kinniry 2013). Morningstar's own Russ Kinnel, in his annual Mind the Gap study has shown how it has varied considerably from sector to sector and year to year, from over 150 to a current average of 26 basis points.

That's what happens to people who panic. But what about everyone else?

Emotional Investing shapes asset allocation

One of the key lessons from the analysis is that the manner in which investments are often matched to individuals (often using a risk-tolerance questionnaire) is shaped by the potential for emotional selling. When one develops a long-term financial plan, at least two competing demands are placed on the asset allocation: taking on risk to help you reach your financial goals and avoiding excessive risk, in part to avoid discomfort and negative emotional reactions that might lead you to abandon the plan.

To manage these competing demands, the field of financial planning generally applies two approaches: a risk capacity approach which focuses on goals and generating the required returns, and/or a risk preference approach that seeks to avoid panic. Unfortunately, in isolation or in combination these two approaches can fail to meet either of the two demands--failing to help investors effectively reach their goals because the portfolio was positioned too meekly, and failing to forestall panic because the portfolio was intolerably volatile.

In this paper for example, I found that using a risk-preference approach to place more sensitive investors into lower volatility investments reduced the damage from emotion-based selling only modestly, decreasing the losses for investors from 100 to 150 basis points to roughly 80 to 130 basis points. The problem is that when a downturn hits, even lower volatility investments can drop enough to trigger emotional selling among risk-intolerant investors (and similarly for risk-tolerant investors in higher volatility investments).

To mitigate this problem, one needs to address the behavioral challenge head-on.

A different approach

Yet it's also possible to address the risk of emotional selling without changing the asset allocation. Investors and, as appropriate, their advisors can use behavioural tools to help prepare for and respond to volatility when it comes. For example, potential techniques from the literature include:

  • To alleviate loss aversion, investors (and advisors) can avoid frequent price updates (Larson et al. 2016).
  • To decrease the likelihood of selling low, one can look for long-term investments that are explicitly "set it and forget it"; this approach learns from the positive behavioral outcomes that target date funds have achieved (Holt and Yang 2016).
  • Investors and advisors can become more educated about how all people suffer from common behavioral biases, like confirmation bias and availability heuristic, that lead to predictable and avoidable mistakes (Perttula 2010). Ideally, these lessons should be reviewed right before a trade, not as a general investor education or financial literacy program (Fernandes, Lynch and Netermeyer 2014).

Measuring the impact of investor panic and a combined approach

In the final part of the analysis, I looked at the impact of a combined approach: behavioural tools to mitigate emotional selling, and an asset allocation based solely on one's needs (risk capacity, not risk preferences). The analysis couldn't analyse the specifics of each of the behavioural tools above--much more work is needed there--but it could determine what would happen, in aggregate, if we can forestall emotional selling overall. In aggregate, investors focus on needs and avoid panic receive a net increase of 17-23% in assets over 10 years, or roughly 170 to 225 basis points per year in returns. Some of that return comes from avoiding panic, which supports the analyses by Vanguard and others. The rest comes from freeing up asset allocation to better serve the financial needs of investors. That removes the tension between the competing demands above: achieving an investor's financial goals and avoiding uncomfortable volatility at the same time.

Investing is full of uncertainty, and investors are broad and diverse.

This research provides an initial look at how one can combine a new set of tools from the behavioural science community, with thoughtful asset allocation, to help some investors avoid emotional selling during downturns. To see the full research paper, please check out Using a Behavioral Approach to Mitigate Panic and Improve Investor Outcomes Journal of Financial Planning 31 (2): 48–56.

This article initially appeared on Morningstar.com

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