There is an old saying on Wall Street that “financial markets are driven by just two powerful emotions: Greed and Fear.” Investors often let their emotions dictate their decisions on when to buy, hold and sell investments, with fundamental value a distinct second consideration. This is rarely a recipe for success, and largely explains why investors vastly underperform even the indices they track. For example, over the two decades ending in 2020 the S&P 500 advanced 7.5% per year, yet the average investor gained only 2.9% per year as they zigged and zagged at precisely the wrong times. Being aware of behavioural biases and creating strategies to deal with these can dramatically improve an investor’s performance.
During the late stages of a bull market, investors become increasingly optimistic about the prospects of a company, industry, or the wider economy. Purchases provide instant gratification, immediately rising after the trade goes through, and the constant upward trend provides ongoing validation–regardless of the investment’s underlying fundamentals. There seems to be no reason to hold any cash, and due diligence and risk sound like wasted time as markets inexorably move upward. The more the market goes up, the more investors follow the trend and momentum traders join in full swing.
The problem with this is that the more investors are rewarded with higher share prices, the more risk they take on. They consider increasingly speculative companies with unproven business models and poor balance sheets, and often take on leverage to do so. They believe their past success is a reflection of things to come. But trend reversals can happen at any point, often without warning or an underlying “cause.” When trading is based purely on momentum with little regard to fundamental asset values, the downdraft can be significant, with a tidal wave of selling as investors desperately try to unload positions they held only because prices were rising.
Rewind to the dot-com bubble and this is exactly how things played out, with a dramatic rise in share prices between 1995 and 2000–especially for any business remotely related to the Internet. Investors surged into the technology sector and the Nasdaq roared 400% higher in just five years, with very little attention paid to whether these companies generated any cash flow or had remotely viable business models. Once the furore was over and there were no more momentum buyers to be found, the trend suddenly reversed and share prices collapsed. It took the tech-heavy Nasdaq index 15 years to recover from the 2000 bear market, only returning to its former peak in 2015.
Fast forward to the Covid-19 pandemic era and it appears that history has rhymed. Lockdowns around the world caused investors to once again embrace the technology sector, replacing the dotcom darlings of AOL with Zoom Communications, whose share price roared five times higher as investors banked on the trend of remote work continuing. As a flashback, Amazon’s share price also doubled as the market bet that the heightened e-commerce demand would remain long after the pandemic. Once again these times were short-lived, with the share price of both companies falling more than 50% each as face-to-face interactions returned. Momentum investors who timed their exit poorly were left “holding the bag” and if history is any guide, it might be quite some time (if ever) before the share prices of these companies return to their pandemic highs.
Investing mistakes are not limited to market upturns. Investors can make similarly damaging errors when the market is falling–although these are usually “errors of omissions.” It’s generally well understood that markets can be volatile and investors are often told (and seem to be convinced) that they can handle drawdowns. They’ve been told what to expect and have the facts in front of them that the U.S. and Australian share markets have never failed to recover from a crash and surpass their previous highs. But this rarely seems to help. Fear overcomes rationality and investors succumb to pessimism. They become despondent with their losses, which studies have shown they feel substantially more than their gains. They expect the bear market to last forever, and get caught up in the media hype that fuels the pessimism that this time will be different.
This can lead to the very costly decision of choosing not to invest. And while it may feel less painful at the time, the lost gains can actually hurt far more over time. An extreme example is the performance of Magellan’s Hamish Douglass during the pandemic years. Prior to 2020, Douglass had made a name for himself, cementing his reputation as one of Australia’s most well known investors and amassing more than $100 billion of funds under management. But when the pandemic hit, Douglass made a decision that would cause significant underperformance and lose his status with investors. He sold a number of positions and increased his cash position dramatically, fearing the fallout from the pandemic would last for years. Instead, governments and central banks poured money into the economy, and the market rebound caught the Magellan fund off guard. While there’s no doubt this was a difficult set of outcomes to predict, the future is often cloudy and investors have typically been rewarded for buying great companies at steeply discounted prices in times of distress.
One extremely common mistake that investors seem to make regardless of the market cycle is refusing to sell an investment at a loss. While nobody likes losing money, there are very real and valid reasons to sell an investment in the red. The first of these is simple: the investment is not performing to your expectations and your investment thesis is no longer valid. This can happen slowly (such as a “melting ice cube”) or quickly, to one of your best investments or the worst. The important thing is to recognise that it’s happening and to take action. Just as the best investments can perform better than your wildest dreams, when things go awry, they can fall a long way.
The other big reason is that you simply have a better investment idea from this point forward. You may have gained more confidence in another investment, it may have become cheaper, something in the industry may have changed the game. Whatever the cause, don’t resist switching one investment to another if it’s a much better idea. Warren Buffett is no stranger to this concept, highlighting in his 2023 Berkshire Hathaway letter to shareholders that most of his capital allocation decisions had been ‘no better than so-so’ , and that the results he’s renowned for were the product of a handful of a few ‘truly good decisions’. Investors often make the mistake of expecting a near perfect record, and are sorely disappointed when their results fall well short of these expectations. In reality, a six out of 10 strike rate will often more than get the job done.
What To Do About It?
As the father of value investing Benjamin Graham once said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process”. Developing awareness of common emotion-driven investing mistakes prevents them from falling into the same trap, and is likely to have a positive impact on portfolio returns. One way of doing this is to implement a structured investment plan: adding a portion of each pay cheque to your best investment regardless of the market levels, state of the economy or trend of the day. This can be challenging, because often people’s personal finances will be under the most pressure when the market is down (market downturns often correlate with high unemployment, mortgage stress and lower savings balances). But if you can keep your personal finances healthy, minimise your debt and keep the contributions flowing during times of stress, your future self will certainly thank you for it. The market is unpredictable and turns when you least expect it.
Markets & Commentary
At TAMIM we are committed to educating investors on how best to manage their retirement futures.
Sign up to receive our weekly newsletter:
TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.