Thinking Money with Dr Peter Brooks: emotional investing
Dr Peter Brooks is Head of Behavioural Finance at Barclays Wealth and Investment Management. In the second in our series exploring the motivations behind the financial choices people make, he explains how overcoming emotional impulse is the key to long-term investing – and why investors need to hold their nerve for long-term gain, even during a downturn.
1. Fearing the worst
The only thing we know for certain about the economy going into recession is that, at some point, it will happen. We’re now 10 years on from the last recession, which seems like a long time, and the next one should be around the corner – right? It almost seems as if there’s regularity to it, but there isn’t. Recessions don’t happen after a set number of years, but they do inevitably happen, and what you get is people projecting their fears of a recession based on past experiences.
For many, the financial crisis in 2008 is the recession they remember. And that was a very sharp downturn – but it was an outlier in the history of recessions. The next recession, if things have normalised, shouldn’t be as bad as the last one, but people are wired to think it will be. The fear of it being terrible can dominate people’s thinking of how it will be.
2. Short-circuiting the “cut losses” impulse
When investing for the long-term, we know that any downturn will at some point reverse, but the temptation is a “cut losses” impulse, which can become overwhelmingly strong for individuals. It’s one of the ways our brains are naturally wired to be terrible investors. Markets tend to go up relatively slowly and fall relatively quickly. We talk about crashes not surges.
As markets grind their way upwards, people’s perception of risk in the market tends to fall. Decent return and low risk is a really comfortable place to be as an investor, but as markets fall, the sense of risk increases and the sense of return evaporates because investors are losing money month after month – and that’s a horrible place to be.
Our own brains are wired in the opposite direction to buying low and selling high – they’re more comfortable buying high with apparently low risk and solid return – then selling towards the bottom of the market. That’s repeat behaviour, which is difficult to override. But to be successful investors, people need to short-circuit that reaction.
3. Hold tight for late stage gains
When they think about investing, people assume that in downturns and recessions, markets are going to fall, and they naturally want to avoid that. So, do they sell everything and sit on cash and wait for the storm to come, and start investing again afterwards? The difficult thing there is the timing.
The late stages of market gains can be strong. If you sell too early, the market can rise from that point more than it drops in the actual recession. And nobody knows where the peak is going to be – it’s only apparent once you are past it.
The difficult thing for many investors will be acknowledging that riding the markets could be the best way to protect their investments. If somebody is investing now and needs the money in 20 years, then why do they care if there’s a downturn now? The market will recover in that time – upsetting as it looks to see a portfolio go down day-to-day.
4. Manage your emotional reaction to the news
Mainstream news tends to only cover the stock market and not other asset classes, so one of the other mistakes we see from investors is – if they are diversified – projecting those stories on stocks to their entire portfolio.
That gives an inaccurate picture. There’s an imbalance with a combination of the news stream causing stress, an over-representation of the stock market in portfolios, and apparent need to make both sell decisions before a drop and a buy decision at the end of a drop, when the markets are scariest. People can end up sitting out of the market after the drop, missing a period of gain.
It’s important for any investor to be aware of time horizon – markets go up and down and if the money isn’t needed soon then it’s possible to ride that.
The issue is managing our emotional reaction to the news that’s on every television screen and in every newspaper.
5. Think in years not days
There’s clearly a huge amount of uncertainty about what the UK economy will look like in a year’s time, but investing is a long-term activity – investors get rewarded for taking on a bit of risk over the long-term, and history suggests that happens. The problem is, people’s emotional experience of risk is day-to-day and week-to-week – investors are not going to see they were “right” for many years. So, the key is to manage that reaction.
One of the easiest ways to do that is for people to look at their portfolios less often. Tune out. Don’t look. Much as we want to look for an edge, in investing you get very little useful information day-to-day.