Saturday, August 07, 2010

Emotions Can Lead To Poor Investment Returns

Benjamin Graham, often referred to as the father of value investing, once said,
"Individuals who cannot master their emotions are ill-suited to profit from the investment process."
Graham's quote was alluding to the fact that individual investors tend to make incorrect investment decisions when they let their emotions overtake investment discipline. Behavioral finance has shown that investors have a much stronger preference for avoiding investment losses than they do investment gains. As a result, this bias against losses causes investors to sell an investment after the investment has already incurred substantial loss. A recent article in the Financial Analyst Journal, titled Relative Sentiment and Stock Returns ($), provides research supporting this conclusion.

The below chart details mutual fund equity flows relative to the performance of the S&P 500 Index. As the chart shows, equity outflows are at their greatest near the bottom of market cycles.

From The Blog of HORAN Capital Advisors

The impact on investors' investment returns due to this behavioral bias is lower overall investment returns. During the height of the financial crisis in late 2008 and through 2010, investors who maintained their exposure to stocks through the crisis have generated a higher level of return than those who sold all their stocks and stayed out of the market or those that sold all of their stocks and jumped back into the market.

From The Blog of HORAN Capital Advisors

Because of the tendency for individual investors to let emotions influence investment decisions, at HORAN we review various sources of sentiment data on an ongoing basis. In last week's individual investor sentiment report released by the American Association of Individual Investors, it shows bullish sentiment fell over nine percentage points to 30.4%. Bearish sentiment increased to 38.2% versus the prior week's bearishness level of 33.3%. A result is the bull/bear spread was reported at -7.9% versus the prior week's spread of 6.7%.

From The Blog of HORAN Capital Advisors
In concluding, investors should use this behavioral knowledge to review ones appropriate asset allocation and risk tolerance. Additionally, investment decisions should be grounded in a disciplined process to reduce the likelihood of making decisions that can harm overall investment returns. Also, choosing an investment approach that has its foundation built on lower volatility, especially in down markets, can reduce the feelings that influence ones emotions during volatile market periods.


Defending Your Investment Brain
Market Analysis, Research & Education
Fidelity Management & Research Company
July 29, 2010

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