What rules your investments: head or heart?

Published by Sarah Coles on 13 October 2008.
Last updated on 25 August 2011

Love heart

Most people like to think that they are rational and intelligent creatures. But, when it comes to investing, far too many of us are guilty of letting our hearts, not our heads, rule our decisions. If you let your emotions get in the way of investing – whether it’s clinging on to an investment in Marks & Spencers just because you like shopping there or not ditching a plummeting fund in the hope that it will one day return to its former glories – you stand to pay the price.

It’s the kind of pattern any veteran of poor relationships would recognise. We need to understand the reasons behind our dysfunctional relationship with our investments, so we can be aware of the pitfalls and learn how to
sidestep them.

Love is Blind

When we first fall in love with an investment, we are blind to its faults. While we’re happy to research a stock or a fund, we are only looking for good news and, when we come across bad news, we find a way to justify it and will the problem away. So, for example, we may find a company with growing cash flow, so we are happy to overlook a shrinking customer base.

Likewise, we may love the past performance of a special situations fund over the past five years and put the fact that it has struggled over the past year, as it grew too large to be nimble, to the back of our mind.

Colin McLean, managing director of SVM asset management, says this isn’t uncommon among the professionals either: “Professionals are well placed to gather more information, but this may not actually lead to better decisions. Instead, they are often guilty of selectively picking out information that supports an initial view or prejudice.

"Much of what has happened in the bank sector shows just how long it can take for a major change in prospects to be recognised.”

It’s vital, therefore, to consider all the data on either a fund or a stock.

Fen Sung, manager of the China Enterprise fund for Premier Fund Managers says: “I will always look for the bad news. China is a developing market, so the corporate governance is not always the same as the UK. I’ll research the directors and their past dealings as well as the company. You always look at the downside, because when something blows up in Asia it can be really bad.”

Golden days

How many people can say they never look back with fondness at the early days of a relationship when everything seemed easier? Well, it’s the same with shares and funds.

When we came across an investment in the heady days of a rising market, there’s every chance we saw its value soar. Since then, it’s likely to have gone off the boil.

However, when we’re investing directly in shares, we can’t get out of our heads that our stock was once ‘worth’ £5, so the fact that it now only fetches £2 should surely mean it’s a bargain and will eventually soar back to the values we knew in those golden days of 2007. This irrational expectation that things should go back to the way they were is known as anchoring, and there’s no real justification for it. This long-remembered £5 price is no more a true reflection of its value than the current £2.

Investors in funds are at just as much risk from anchoring. They too will hark back to the golden days when their investment was worth 30% more and fully expect their fund manager to get things back on track. As in a relationship, if the fundamentals of the stock or the fund are strong then things may improve as markets recover but, if those fundamentals are lacking, there’s only going to be turmoil ahead.

This means investors need to seek out the data that should indicate the fortunes of the investment. For shares, this will include profits, cash flow, debt or whatever measure is most important to the stock and the sector.
For funds, this will be the manager, the mandate, the portfolio holdings and the strategy.

We have a one-sided view of the past

This is known as hindsight bias. Experts found that we rationalise past investments to come up with a version of events that suits us. It’s not unlike the analysis of past relationships – with the same unfortunate results.

So, for example, we see past meltdowns as having been obvious. We look back at the technology bubble and think it was clear that prices were getting out of hand and that investors were taking terrible risks with technology funds. We assume that, if something similar happened again, we would know better than to get sucked in. Of course, at the time, it wasn’t obvious at all. The danger with this kind of thing is that it leads us to be overconfident in our ability to predict the future.

Likewise, we look back at things and see patterns. So, for example, we may see a certain share or fund has risen relentlessly for years so we assume that, barring a catastrophe, it should continue to do the same. If we think we can rely on patterns, we are becoming overconfident about our ability to predict. It’s as if we assumed that our new partner was going to show up with flowers and chocolates at every date, because they did the first time. And that’s not the only distortion of the past that can trip investors.

When we get an investment right, we assume it’s because we made a great decision; when an investment goes wrong, we say it’s bad luck. However, this rose-tinted view of the past can be dangerous for investors, because again it’s likely to lead to overconfidence.

Advisers suggest that the way to overcome this is to lay out your investment strategy and the approach you intend to take at the outset, and to return to these principles each time you make a decision. Professionals have to do this when outlining a fund’s objectives, and it’s a helpful tool to keep in mind.

Managers also seek out opposing views. Some investment houses hold fund manager meetings, where each professional argues the case for additions to their portfolio, while their colleagues question them.

Fen Sung says: “We all sit together and, although we all have meetings, we will also talk to each other over the desk.” It could be helpful therefore to talk through your decisions with fellow investors.

We all fight for the popular ones

Perhaps the best-known pitfall is our human inclination to follow the crowd and to seek the partner, fund or stock that everyone else is after. Part of this is peer pressure. With investment, there’s a feeling that, if everyone else is flocking to something, they can’t all be wrong. However, this is clearly not true, as anyone who bought into the technology bubble will tell you.

The fact that people are flocking to something actually means it’s even more likely to go wrong, because there’s a bigger chance that prices are a feature of short-lived demand rather than underlying value. There’s no real way to avoid this pitfall other than to fight temptation.

There’s no reason not to consider investing in something that has become popular. You just need to do your homework and make your own decisions. Sung says of his stock picking: “To avoid jumping in at the end of a run and losing money, I look at the valuation and the P/E ratio to see whether it’s at a fair valuation, so I don’t buy in as it hits the top.”

We overreact to new information

In a relationship, if our other half forgets our birthday, we read a lot into it, regardless of the fact they remembered our anniversary or our mother’s birthday. Likewise, we will take new information about a company or fund out of context.

When a company’s sales figures go up, there’s a surge in the share price. People ascribe more importance to it because it’s new, so you think it’s more likely to happen again, but it’s no more important than all the preceding news and just needs to be factored in.

Colin McLean says: “It’s all too easy to be drawn into day-to-day stockmarket turmoil, as share price volatility seems to demand action. The human mind is hard-wired to react to movement and only later evaluates, so daily share price moves get disproportionate attention. The day-to-day noise may have little relevance to the real progress of an investment year by year.”

Professional contrarian investors view these overreactions as buying or selling opportunities; when the market briefly surges upwards on good news, it’s time to sell and, when it briefly dips on bad news, it’s time to buy.

While private investors may not always be comfortable with this approach, the success of contrarians like Anthony Bolton might make them think twice about joining the ranks of the overreactors (see the box above right for recommendations for funds managed by contrarian investors).

Funds tend to make fewer announcements, so it may be worth paying attention when new data is released about a manager or mandate change, for example. However, if you’re regularly checking the portfolio
valuation, it’s just as easy to get obsessed with daily movements. It’s important to take a step back and look at a broad overview.

We refuse to let go of something that’s not working

We’ve all seen people in relationships where they cling to an inappropriate partner in the hope that things will change. Likewise, it’s easy to hang onto stocks or funds that have fallen in the hope they will improve. In the meantime, of course, it’s possible that you could have missed investments that might have been better performers.

Professionals avoid this by having an exit strategy. If one of their holdings falls below an agreed floor, they sell and move on, crystallising losses but also containing them.

Tony Yousefian, CIO at multi-asset multi-manager OPM Fund Management says: “We have parameters which, when they are breached on the downside, can alert us to re-examine a particular position.”

Sung says: “I have stop losses. If I buy and a few weeks later it has fallen 20%, I’ll review it. If I decide I have made a mistake, I’ll sell. If it’s just that the sector has briefly fallen out of favour, I’ll top up and, if something fundamental has happened to the business, I’ll weigh up what it means.”

Bradley Mitchell, a fund manager with Royal London Asset Management, takes a slightly different approach: “If I had five good reasons for buying a stock and those five reasons are still valid when the stock has fallen, I may hold onto it.”

However, he points out that even professionals have to take care not to reinvent the past: “Whenever I buy, I send myself an email of the reasons why I did so I can revisit it and don’t let myself come up with other reasons to hang onto a stock.”

A combination of these approaches should keep investors from making decisions with their heart, so should save them from the worst investment pitfalls. Having a sounding board, and a clear investment strategy should go a long way towards giving their head the upper hand.

Unfortunately, there’s not such an easy cure for hopeless romantics.

Warning signs of your heart ruling your head:

* I’ve held it so long now, I’d hate to sell just before a recovery

* But it was 10% higher when I bought it...

* It’s such a great idea, I don’t think past performance does it justice

* I can’t believe anyone fell for the tech bubble

* Look at its performance this week; I should buy more

* I should sell now, before it starts falling

* My friend made a fortune from it; I should get some

* I don’t want to miss out

* This company/fund always does well

* I know what I’m doing; I made 20% last year

And five techniques to help your head get back in control:

1. Question every decision
2. Bounce ideas off a sounding board
3. Make a case for every stock or fund in your portfolio
4. Write down your investing principles and stick to them
5. Have an exit strategy

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