Emotional investing will lead to losses

by | Mar 9, 2021

Behavioural finance experts Oxford Risk have issued a warning that the current economic, fiscal and stock market environment, plus the recent rise in crypto-assets valuations and retail trading, has created a situation where the risk of emotional investing has hit a new peak. It estimates that on average emotional investing costs investors around 3% in lost returns a year over the long-term, but in the current crisis it believes this will be higher.

Emotional investing involves people acting on their behavioural impulses and emotionally buying and selling stocks and investments on the back of markets rising and falling. This often leads to people piling into investments when markets, stocks or asset classes are high, and selling when they are low, often instigated by a huge amount of ‘noise’ around these investment opportunities. Oxford Risk says investors frequently pursue investments that are familiar, for example companies that are highly publicised in the media, and those that have recently announced large gains. This is because in times of stress investors find emotional comfort in investments which they hear about regularly, and which offer the promise of short-term returns.

Greg B Davies, PhD, Head of Behavioural Finance Oxford Risk said: “We currently have the perfect ‘storm’ for emotional investing. Following the Coronavirus crash in the first quarter of last year when stock markets saw big falls, we are now in a bull market, with markets around the world rising. Optimism is higher because of hopes around the Coronavirus vaccine roll-out and economic and fiscal stimulus programmes. However, there are huge economic problems ahead around unemployment and huge public spending deficits for example, so we should expect the unexpected in the markets over the coming months.

“The rise in the value of Bitcoin has also led to a crypto-assets ‘gold rush’, with retail investors piling into an incredibly volatile asset class that most don’t understand. The pandemic means many investors are currently highly emotionally sensitive and have a shortened emotional time horizon which increases the appeal of get-rich-quick gambles.”

For those investors who have increased their allocation to cash during these volatile times for markets, Oxford Risk estimates that the cost of this ‘reluctance’ to invest is around 4% to 5% a year over the long-term. In addition, it estimates that the cost of the ‘Behaviour Gap’ – losses due to timing decisions caused by investing more money when times are good for stock markets and less when they are not – i.e., buy high and sell low – is on average around 1.5% to 2% a year over time.

Oxford Risk builds software to help wealth managers and other financial services companies assist their clients in making the best financial decisions in the face of complexity, uncertainty, and behavioural biases. However, it says that many wealth managers and financial advisers are poorly equipped to help clients deal with the emotional and psychological roller-coaster ride their clients have endured during the COVID-19 crisis, and the impact it has had on markets and their investments.

In helping clients to manage their emotions when investing, Oxford Risk says many wealth managers need to do more.

Greg B Davies added: “The suitability processes of many wealth management businesses are typically too human heavy, inefficient, and front loaded to the beginning of the client relationship to keep up with rapidly changing client circumstances at scale during a crisis. Understanding of client financial personality is typically limited to risk profiling – often badly – and subjective human assessment. Very few wealth management propositions are using the sort of objective, science-based measures that are needed to provide a comprehensive picture of their clients. There is too much guesswork and not enough technology.

“However, we are not advocating removing humans from the process as conversations with advisers are vital, particularly in a crisis, but they need to be assisted by better diagnostic tools enabling accurate assessment of the client’s personality and likely behavioural tendencies.”

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