Investor habits: The good, the bad and the ugly
17 January 2017 | Topical insights
Commentary by Robin Bowerman, head of marketing and communications for Vanguard in Australia.
The Good, the Bad and the Ugly is, of course, the classic 1966 Western starring Clint Eastwood. It's also an apt way to describe common habits of investors.
A recent article in The Journal of Portfolio Management, "Bad habits and good practices", addresses three bad aspects of investor behaviour, along with three contrasting good investment practices. I'll focus mainly on the bad habits in my commentary, touching on the good, and leaving the ugly for another time.
The article's authors – University of Lausanne professor Amit Goyal and investment fund managers Anitti Ilmanen and David Kabiller – open with a disarmingly simple message for investors seeking sustained long-term success: "Good investing results require both good investments and good investors.
"We have spent our careers also battling these same bad habits in ourselves", they write, "so our perspective is fully intended as commiseration and shared experience, not as lecturing.”
Bad habit 1: Chasing multi-year returns
Goyal, Ilmanen and Kabiller say the "premier bad habit" involves abandoning long-term strategic investment practices to chase multi-year winners – meaning those that have outperformed in the last few years – while dumping multi-year underperformers.
This habit, which has been termed as "pro-cyclic" investing, can affect an investor's investment style, portfolio asset allocation and selections of individual investment assets and managed funds.
"Many investors understandably lack patience when facing years of underperformance, even if they are aware of the limited predictive ability in past performance and potentially high transition costs associated with hiring and firing," the authors add. "At worst, some investors may enter the market near its peak, despite exorbitant valuation levels, or capitulate near the bottom and miss the subsequent reversal."
Many investors are willing to put up with a year of underperformance but "draw the line" at multi-year underperformance of, say, three to five years.
The counterbalancing good practice to this bad habit is to take a disciplined, long-term and appropriately diversified approach with the aim of achieving well-defined investment goals. And regular counter-cyclical rebalancing of one's asset allocation is fundamental to keeping on track.
Bad habit 2: Under-diversification
Goyal, Ilmanen and Kabiller say many investors don't appreciate the benefits of proper diversification of asset classes and securities to spread their risks and opportunities.
Examples of under-diversification given in their paper include holding just a few equities – in other words, having excessively concentrated portfolios – and having a home bias with insufficient exposure to global markets. They say a broad explanation is known as "narrow framing". This is the tendency for investors to focus much of their attention on a single investment aspect or asset class rather than how it relates to their overall portfolios.
Investors taking what could be described as a wider frame would tend to see a fall in the price of individual investments or an asset sector as just part of the expected movements within an appropriately diversified portfolio. Indeed, well-diversified portfolios are designed with the intention of having some assets rising in value to counter other assets falling in value – rather than moving in lockstep.
Bad habit 3: Seeking comfort while overlooking fundamentals
"Some investors seek comfort when selecting investments, whether individual securities or asset classes, instead of judging them purely on their risk/reward merits," Goyal, Ilmanen and Kabiller write.
An example of seeking comfort is to invest in the latest glamour stocks because of their image and their current popularity rather than on investment fundamentals. And many comfort-seeking investors pay too much for assets in their expectation for smoother, less-volatile returns.
A classic illustration of investors seeking comfort to their detriment involves following the investment herd by shifting to all-cash portfolios when the sharemarket experiences a sharp dip. And when share prices have already risen sharply, investors attempt to gain comfort in the crowd by following the herd back into the market.
A key takeaway message for investors is that for every bad habit, there is a good practice. Astute investors not only know what bad habits to avoid but develop strategies or practices to avoid them.
No matter whether investment markets are rising or falling or somewhere in between, an investor's habits – good and bad – really do matter.
This article is directed at professional investors and should not be distributed to or relied upon by retail investors. It is designed for use by, and is directed only at persons resident in the UK.
This article was produced by Vanguard Asset Management, Limited. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Ltd.
Issued by Vanguard Asset Management, Ltd which is authorised and regulated in the UK by the Financial Conduct Authority.