The most important factor in successful investment is your behaviour and it’s the hardest thing to manage, because it is usually driven by irrational thinking and the failure to learn from past mistakes.
No matter how much evidence is provided proving long-term outperformance from shares investors are still prone to repeating the same mistake of switching out of the share market into cash at the bottom of the cycle, thus disregarding the empirical evidence that shares out outperform cash over any meaningful period.
Investors need to stop and engage their rational brains before taking instinctive decisions to change a proven investment strategy. Warren Buffett, arguably the most successful investor of all times, is quoted as saying, “investors should know themselves before investing in the stock market as the stock market can be a very expensive place to get to know yourself”. His is of course referring to the irrational behaviour of buying high and selling low, which is responsible for most client’s losses.
I am going to try illustrating irrational thinking using performance charts. When you initially invest companies will show you their long-term track record, which we typically refer to as a time weighted return chart. The graph will usually look something like this, with significant out-performance vs. the benchmark. Now I have heard the most intelligent investors state that they don’t attach much value to these graphs because returns always look too good.
This implies that they do not trust the figures, which is irrational given that the figures are audited and 100% correct. The basis for their scepticism is that their actual return experience will differ from the time weighted return chart unless they invested at the start of the fund.
With reference to the table above if you invested in this fund 3 years ago, which we call a money weighted return, you are understandably upset as your investment has under-performed the benchmark by (0.8%) over the 3-year period vs. the return experience of the client who had invested at inception, which is excellent given the initial $100 000 is now worth $ 140 773 compared to the benchmark return of $107 527. Same fund, but you have a happy client and an unhappy client.
The typical response from the unhappy client is to change the investment, disregarding the fact that this investment has out-performed the benchmark by 33.2% since inception and probably will do so again given time. Unfortunately, most investors ignore the evidence of long-term outperformance opting to switch the investment out of frustration and lack of patience, resulting in the classic irrational behaviour error of selling at the bottom.
Mcomm, CFP®, HdipTax
T. 021-851 3746