Human beings are inherently psychological creatures. We get worked up watching our favourite sports teams and cry during sad movies. And we often fear flying more than driving, even though the latter is far more dangerous statistically.
Much of how our brains are wired isn’t necessarily harmful, but rather what makes us human. Yet when it comes to investing, our psychological tendencies often let us down.
Consider the following.
Studies have shown that, left to their own devices, average investors are prone to significantly underperform the market. Why? In a nutshell, because individuals are likely to let their emotions get the best of themselves when it comes to investment decisions.
Experts have identified a number of behavioural patterns that work against investors, such as:
- Loss aversion: research indicates that humans experience a loss much more strongly than a gain. This in part explains why investors sell at the worst possible time (i.e. during sharp market declines), as they can’t stand the possibility that they’ll lose even more.
- Recency bias: we often extrapolate what has happened in the recent past into the future. This can lead to someone buying a stock that’s been hot, while selling an asset that has been underperforming. So, despite everyone knowing the adage “buy low, sell high” many people consistently do the opposite.
- Confirmation bias: when we formulate a belief about something, we often then look for information to corroborate it. In the world of investing, this can lead individuals to ignore red flags about a stock they own, in favour of reading articles that confirm their existing bullish thesis.
Protecting ourselves from ourselves: The Value of an Advisor
One of the greatest values a financial advisor brings to the table is an ability to protect the individual investor from the types of psychological traps that lead to portfolio underperformance.
Here are some examples of how this can play out in the real world:
- An investor who constantly follows the markets is increasingly worried that heightened volatility will continue, and is considering selling all her stocks as a result. The advisor can help by: telling the investor that while big swings in the market can be unpleasant, they don’t change the long-term outlook.
- An investor who read that one country’s stock market has been the best performer over the past decade wants to shift most of their equity allocation to that nation. The advisor can help by: gently reminding him that chasing returns is probably not a good approach, because today’s leaders could be tomorrow’s laggards.
- With property prices soaring ever higher, an investor is tempted to withdraw money from their portfolio and invest in real estate instead. The advisor can help by: talking to the client about how a balanced portfolio is likely to outperform real estate over the long term.
A financial advisor isn’t just someone who can help manage your money. They’re also a professional who can set up processes and strategies so that you don’t become emotional with your investments. In doing so, you have the best opportunity for solid long-term returns.