Controlling your behaviour will save you from sabotaging your returns

Reaching your financial goals is far more important than outperforming an index, Carl Richards, United States-based financial planner, international speaker and regular contributor to the New York Times, says.

Many people worry about the performance of the markets or how one major currency is performing against another, but these are aspects of investing over which we have no control, Richards says.

You should let go of the things you cannot control and focus on what you can control, namely, your own behaviour. Adopting this approach is likely to make you much happier and prevent you from undermining the returns your investments can earn.

Richards, who is known for his back-of-a-serviette financial illustrations, addressed Allan Gray clients around the country recently.

If you invest in an investment portfolio with mediocre returns but control your behaviour, you will probably earn better returns than 97 percent of your neighbours, Richards says.

It is the behaviour you can control, but do not, that destroys the value of your investments and results in a gap between the returns that an investment produces and those you actually earn, he says.

Research in the US by a company called Dalbar has for many years highlighted the big difference between what funds return on average and what investors earn on average because of the timing of their investments and their withdrawals from funds.

In South Africa, Allan Gray published, in 2010, the average returns earned by investors in its three most popular unit trust funds. This showed that investors’ annual returns were 1.5 to 4.4 percentage points lower than the funds’ returns between 2000 and 2010.

The difference between what you could earn and what you do earn as a result of how you behave when investing is known as the behaviour gap, and Richards attributes it to mistakes that we make over and over again.

The first mistake is called anchoring, and it occurs when you focus on a particular number and allow that number to determine your financial decisions.

For example, Richards says, people often anchor on the price they paid for a property, and they find it hard to sell at less than that price even if the bottom has fallen out of the property market.

Similarly, you may buy a share for a particular price, and then its price falls. You decide you need to sell the share, but you are reluctant to do so until the price returns to what you paid for it.

You need to avoid making a single number – often the first number you encounter – your primary guide for a decision, because it will rarely be the number that should matter the most to you, Richards says.

Another common mistake is being biased by recent events and projecting the recent past into the future, Richards says.

Expecting the same things to happen day after day is good when it comes to many ordinary situations, such as commuting to work, but it isn’t a good thing in investing, Richards says.

In investing, your recency bias will, during a bull market, lead you to believe that the market will continue to rise indefinitely, and you will forget about the previous down cycles. You may continue investing only to find yourself surprised when the bubble bursts, wondering why you did not foresee it.

Conversely, when the market is down, you may become convinced it will never rise again.

Richards says you can put some plans in place to overcome recency bias and see yourself through the ups and downs of the market.

Confirmation bias occurs when you make a decision and then find evidence to support it. In the process, you dismiss everything that contradicts your theory.

Richards says you create your own feedback loop by seeking information that supports your theory, in the same way as you surround yourself with friends who agree with the things you do.

Richards says he found himself guilty of confirmation bias when targeting a goal weight. He would only weigh himself after exercise and before breakfast rather than after a night of staying up and eating pizza.

Seeking patterns is another mistake that investors make, Richards says. When you look for patterns, you invariably find them, and they work until they don’t, he says.

For example, he says, you may see a pattern in the performance of the market on days you have woken up without an alarm clock. But this correlation does not mean that your waking up without the alarm clock caused the markets to behave in a particular way.

Richards says the only pattern that matters is the pattern of your behaviour. If you are continually buying when prices are high and selling when they are low, you are destroying investment value.

Similarly, if you continually seek the top-performing fund, you are also likely to destroy value.

Investors repeat this kind of behaviour, because buying into markets when they are rising arouses feelings of security and pleasure in our brains, he says.

But when we buy into falling markets, our brains process this action as a severe threat.

Richards says if you want to reach your financial goals, you need to start talking about money, but talk about “the right” things.

It is no good just talking about a purchase or an investment; you have to discuss your financial situation and your goals and how you will reach them.

It may be a good idea, he says, to have this talk with a qualified financial adviser.