Keep a cool head – put a lock on greed

Philip Salter
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AS ANY elite athlete will tell you, timing is everything. It is just as true for investing. When you get in and out of a market is often vital for returns. As Warren Buffett – before his foray into advising the US government on taxation policy – said in a sage piece of advice: “Be greedy when others are fearful and fearful when others are greedy.” However, most lack the contrarian spirit of the Oracle of Omaha, jumping in and out of markets at the very worst time. Many would be better off divesting responsibility to someone else, ignoring the ebb and flow of the markets and holding on for the long run.

EMOTIONAL COSTS
There is plenty of evidence that paying someone else to manage your money doesn’t often and consistently beat the relevant assets’ indices. However, this doesn’t mean you will do any better. In fact, there is evidence to suggest you will probably do worse. As Mel Kenny of Radcliffe & Newlands notes: “Research by Dalbar (July 2008) found the average annual stock market return between 1988 and 2007 was 11.6 per cent, while the average stock market investor return was just 4.5 per cent, because on average, money tends to rush into the market when it does well and leaves when doing badly.” Emotions drive people to get in and out of assets at the wrong time – buying high and selling low.

“Investors often base decisions on past performance, buying something that has done very well, and not necessarily something that will do very well,” says Danny Cox of Hargreaves Lansdowne. “If you look at the inflows of money into property funds, this was at its most recent high during 2006, and the market crashed in early 2007.” Cox adds: “Investors can get swept along by momentum: it is when people start talking about an investment at dinner parties you probably know it is a bubble about to burst.”

In Preventing Emotional Investing, a recent paper for The Journal of Wealth Management, Philip Z. Mayman and Gregg S. Fisher test five predictions based on solid data from Gerstein Fisher, a boutique investment management firm with $1bn under management, which was founded by one of the co-authors. The hypotheses were:

1. Client touches [moving money] should be higher in the first months of the relationship with the investment adviser.

2. The touches should then decline to a relatively steady but significantly non-zero level.

3. Higher market volatility should lead to a higher volume of touches.

4. The incidence of substantial changes in investor allocation should be quite low, i.e., aggressive trading should be rare.

5. When aggressive individual trading does happen, it will coincide with a higher volume of touches.

Sadly, clients failed on all five points – demonstrating that many investment decisions are driven by emotional reactions to volatile conditions. Mayman and Fisher conclude that “an important way that an adviser adds value is by restraining clients from their own tendencies to aggressively trade.” They describe the investment manager as a lock on a refrigerator to prevent the individual investor from overindulging in unhealthy choices as it relates to their portfolios.

TAKING THE LONG VIEW
Given that micromanaging is often counterproductive, investors, by and large, would be better off taking a long view. The graph (right), supplied by Andrew Humphries, executive director of asset management at St James’s Place, shows that the FTSE 100’s fluctuations become increasingly unimportant over time. But holding on for the long run is easier said than done. Yannick Naud who is portfolio manager at Glendevon King Asset Management says buying Apple shares at $12 in May 2002 was probably a great decision that could have made investors many times richer, but by July the position was showing a 40 per cent loss. Now Apple shares are over $400.

Most investors shouldn’t be focused on timing the market perfectly, but asset allocation over the long term. Stephen Barber, who advises Selftrade on economics and markets, says “calling the bottom of a market is near impossible and over the longer term will make less of an impact on performance than getting the broad trend right.”

When injecting funds into a new investment, a drip-feed can be useful. Barber says “for those averse to timing and volatility altogether, regular investment can be the answer,” allowing investors to also take advantage of pound cost averaging. Naud is adamant: “Never invest the full amount at once, as it will give you enough flexibility to manage a position if your original entry point was wrong.”

Of course, you need to ensure that the person you are paying to manage your money doesn’t suffer from the same frailties that afflict many investors. And once empowered with the statistics confirming your bad habits, many investors should be able to overcome their cravings to meddle, mending their bad habits. The first step is admitting you have a problem.