Keep the Emotions Out of Investing

“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ….Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”  -Warren Buffet

As Greg  B. Davies, PhD, head of behavioral and quantitative finance with Barclays, wrote in a behavioral finance topical piece entitled “Overcoming the Cost of Being Human”: “Managing one’s wealth requires using all of one’s long-term capital effectively and committing to the journey.  What investor’s really want are the best returns they can achieve for the level of stress they’re going to have to experience.  Some of this stress does come from taking risk, but a great deal of anxiety arises from emotional responses to fluctuations along the investment journey, which can be quite independent of risk.”

Dr. Davies goes on to comment about how behavioral finance provides insight into two aspects of investor behavior.  “The first is reluctance: Individuals often fail to see the potential long-term benefit of investing in a diversified portfolio compared to holding cash.  The second issue that behavioral finance illuminates is the behavior gap, the difference between actual investor returns and the returns investors might have achieved had they doggedly adhered to classical principals”.

A study by Dalbar (the nation’s leading financial services market research and consulting firm) underscores the importance of controlling emotions and avoiding self-destructive investor behavior. From 1992–2011, the average stock fund returned 8.2% annually while the average stock fund investor earned only 3.5%. This “behavior gap” is purely attributable to market timing decisions , not costs or fees.

Contrary to the belief that “timing is everything,” research by Roger Ibbotson (Yale School of Management) and Paul Kaplan (Morningstar, Inc.) shows that asset allocation determines more than 90% of a portfolio’s performance – whereas market timing accounts for less than 2% of a portfolio’s performance.

Dr. Davies concludes  that “all of us can acquire the focus we need to invest successfully, but we need to put in the effort to construct a considered framework of rules and guidelines to govern our own investing behavior. One of the key reasons individual investors systematically under-perform compared to  institutional investors is not that they are inherently worse investors, but simply that professional institutions have more controls imposed on them through a strong set of rules.”

HFA advocates that asset allocation is the primary driver of investment returns and is to be determined by the long term objectives, time horizon, and risk tolerance of the individual client.   We also believe in a broadly diversified approach and that investors are not compensated for the additional risk that is added by not being adequately diversified.

Following this framework means we don’t make every decision when our emotions may be rattled.  Instead we follow guidelines that have been established during times of rational contemplation.