Investing Wisely: Logic Over Emotion

When it comes to investing, it’s essential to remove emotion from the equation. As human beings, our emotions often dictate our actions, and nowhere is this more evident than in the realm of investing. Historical data provides a clear picture of how emotions can undermine our investment strategies.

Consider the MSCI World Index, which tracks large and mid-size companies across 23 developed countries. Over the 20 years leading up to July 2024, this index averaged an impressive annual return of 11%. Simply allowing your investments to ride the waves of these global companies would have doubled your money approximately every six years.

This consistency is evident across various timeframes: the past five years have seen an average return of 11% per year, the past decade 12% per year, and since 1970, the average has been 11% per year. However, despite these strong returns, the average equity fund investor earned only about 5% annually over the same 20-year period.

Why the discrepancy? The answer lies in behaviour. Our investment decisions are often driven by emotion rather than logic, leading to suboptimal outcomes. Let’s explore some common mistakes that can erode returns.

Studies show that when the stock market rises, investors tend to pour more money into it, and when it falls, they pull money out. This behaviour is akin to shopping more when prices are high and returning items when they’re on sale, but only receiving the sale price in return. It’s a counterproductive approach.

As humans, we are prone to overreact to both good and bad news. When markets are booming, we become greedy, and when they decline, we become fearful. This emotional rollercoaster is even more pronounced during times of personal uncertainty, such as approaching retirement or during economic downturns. The field of behavioural finance studies these tendencies, labelling our irrational financial decisions with terms like recency bias and overconfidence.

One notable study analysed the trading activity of 10,000 clients at a brokerage firm to determine if frequent trading led to higher returns. The findings were clear: the stocks purchased underperformed those sold by 5% over one year and 8.6% over two years. In essence, the more active the investor, the less money they made. This pattern has been consistently observed across multiple markets and studies, leading researchers to conclude that frequent traders are “basically paying fees to lose money.”

Overconfidence is another common pitfall, leading investors to overestimate their ability to predict future market movements. Many believe they have an edge based on past data, but this confidence often leads to incorrect predictions and disappointing results.

One of the most effective ways to safeguard against these emotional missteps is to work with a Chartered Financial Planner. A professional can act as a buffer between you and your emotions, providing objective guidance that can significantly improve your investment outcomes.

In the world of investing, sometimes less is more. By taking a step back, embracing a more passive approach, and leaning on the expertise of a financial planner, you can help ensure that your investments grow steadily over time—without falling victim to the costly mistakes driven by emotion.