Overcoming emotional and personality-driven investing mistakes is widely recommended, but hard to achieve. One of the keys to success is recognizing that a problem exists, and then devising mechanisms to control or limit bad decisions.
According to a new global survey by Barclays Wealth, a large percentage of wealthy investors not only realize their tendency to make emotionally-driven decisions, but would welcome more help in wrestling with these issues.
The report, "Risk and Rules: The Role of Control in Financial Decision Making," also revealed an extensive set of control strategies that people use to limit bad decisions. The most successful at doing so also happen to be the wealthiest, although there could be other factors at work that determine high-wealth achievement.
Perhaps the most novel finding of the research involved what the report called "the trading paradox," according to Greg Davies, who directs Barclay Wealth's work in behavioral and quantitative finance. Many wealthy investors believe they need to trade frequently in order to maximize investment gains. At the same time, wealthy investors were most likely to believe their overall returns suffered because they traded too much. "Almost 50 percent of traders who believe you have to trade often to do well think they overdo it," the report said.
"Failures of rationality," as the report called them, were seen in four types of investment decisions:
1. Failing to see the big picture—considering decisions in isolation and not including their impact on an entire portfolio.
Consequence: Investing too much in a single asset class, industry, or geographic market because you know a lot about it and are comfortable with such decisions.
2. Using a short-term decision horizon—ignoring the appropriate goal of long-term wealth accumulation in favor of short-term returns.
Consequence: Statistically, losses are more likely in the short run than over longer time periods. Because people are twice as sensitive to losses as to gains—a behavioral phenomenon known as "myopic loss aversion"—their willingness to take short-term risks is too low and they often make the wrong investment decisions.
3. Buying high and selling low—doing what's comfortable amidst either bullish or bearish market conditions.
Consequence: Buying when markets are high or selling when markets are low is a risky strategy that fails to take advantage of market opportunities. A buy-and-hold strategy turns out to be superior.
[See the top-rated T. Rowe Price funds from U.S. News.]
4. Trading too frequently—a result of multiple emotional and personality-driven traits that produce an irrational bias toward action.
Consequence: Investment costs are higher and the frequency of making the three other types of poor decisions is increased.
"This lack of control over our emotions is not an abstract problem; in fact, it can have tangible, detrimental effects on both investor satisfaction and performance," according to the Barclays Wealth study. "A recent Dalbar study into investor behavior found that over 20 years ending December 31, 2010, the average equity investor earned 3.8 percent a year, while the S&P 500 index returned 9.1 percent annually—a considerable difference."
For older investors and retirees, the report found substantial improvement in investment decisions as people aged. Compared with younger investors, older investors were much less likely to trade too often, to try to time the market, or base investments on short-term considerations. They were also more satisfied with their financial situation.
Barclays Wealth also found that women are better long-term investors than men. Men tend to take more risks and are more likely to favor frequent trading and efforts to time the market. "Women tend to have lower composure and a greater desire for financial self-control, which is associated with a desire to use self-control strategies," the report said. "Women are also more likely to believe that these strategies are effective." As a consequence, women tended to trade less and earn higher returns over time.
Barclays Wealth sponsored surveys of more than 2,000 people from 20 countries who had at least $1.5 million in investment assets, including 200 with at least $15 million. These investors may not have known the details of their emotional flaws as documented by behavioral economists. But they were aware that they were prone to making bad decisions, and equally open to getting help.
The report identified seven self-control strategies that people used to help counter their tendencies to make bad decisions. The use of these strategies was not limited to investments and often included other behaviors—dieting and exercise, big-ticket purchases, and other important lifestyle decisions.
Here are the seven strategies and their application to financial decisions:
1. Limiting options. Purchasing illiquid investments to avoid the urge to sell investments when the market is falling.
2. Avoidance. Avoiding information about how the market or portfolio is performing to stick to a long-term investment strategy.
3. Rules. The use of rules to help make better financial decisions, such as only spending out of income and never out of capital.
4. Deadlines. Setting financial deadlines. For example, aiming to save a certain amount of money by the end of the year.
5. Cooling off. Waiting a few days after making a big financial decision before executing it.
6. Delegation. Delegating financial decisions to others, such as allowing an investment advisor to manage your portfolio.
7. Other people. Using other people to help reach financial goals. An example would be meeting with a financial advisor to make and execute a financial plan.