NZZ series on investment Gut feeling is the enemy of successful investment

The financial markets have found themselves in an unusual situation for several years now, as the ultra-expansive monetary policy of the leading central banks has turned many previously valid investment rules on their heads. Nonetheless, one of the greatest obstacles faced by investors seeking success on the investment market is not monetary policy, but their own human instincts. 

Doubts about Homo economicus

Behavioral finance is the study of the psychology of investors, and is primarily concerned with the role of shareholders as traders and their typical behavior. The field looks at how investment decisions are actually taken, and which errors are made time and time again. Its findings contradict the frequent assumption that investors always know everything and trade efficiently and rationally. The well-known financial psychologist Joachim Goldberg has said that belief in Homo economicus, the rational decision-making investor, needs to be buried. In general, investors trust their intuition, walk into numerous traps, and thus frequently ruin their chances of success on the investment market. Adherents of behavioral finance also cast doubt on the assumption that all the available information is factored into share prices at all times, i.e. that markets are absolutely efficient.

Financial repression also causes investors to make other errors. Goldberg identifies two main ones: Many savers have chosen to ignore reality, as they have not had to pay negative interest rates. They keep putting off the decision to withdraw money from their accounts. After all, their friends aren't doing any better. The fact that they have already lost money in terms of real interest rates is lost on them. On the other hand, the quest for returns entices investors into putting money into instruments with which they are unfamiliar. They don't look at the amount of risk they’re taking on, or their ability to bear such risk. All that counts is the returns. When these returns dry up, the investor has to assume a very high level of risk to generate the same earnings as before. Jérôme Zaugg, Lecturer in Behavioral Finance at Zurich University of Applied Sciences (ZHAW) in Winterthur, has also noticed that investors are very unwilling to change. He says that clients allow their money to gather dust in interest-free accounts, which is particularly problematic for unrestricted retirement funds. Furthermore, many investors have a poor understanding of the financial markets, so they are rarely aware that the interest rate risk has recently risen rapidly as a result of low interest rates. What's more, very few investors know how far compound interest has fallen, or that it has almost dropped to zero.

Because most private investors hold their bonds until maturity when they are redeemed in full, they do not have to worry about changes in prices or spreads. Creditors, on the other hand, have to deal with changes in value within custody accounts on a quarterly basis, and wealth management advisors must account for these. This often leads to unnecessary work. The latest crisis on the Chinese equity market has shown hȯw many investors operate. Once prices started moving upwards, and as the trend continued, more and more Chinese wanted to jump on the bandwagon. Analyses have shown, however, that Chinese investors have little knowledge of the financial markets. While 85% of the trading volume on mainland markets is generated by private individuals, equity investing is not a tradition in the Middle Kingdom. Very little attention is paid to fundamentals. Instead, thinking tends to be along the lines of: "My neighbor has earned some money and prices are higher today than yesterday, so now I'm also going to jump on board." And once they have a few days or weeks of making a profit under their belts, they feel like shrewd investors. What they neglect to consider is how far the risks have grown and how great the danger is of a downturn.

According to Jérôme Zaugg, the greatest problem in general among investors is their overestimation of their own abilities – similar to what is seen with car drivers. Ask a group of drivers about their driving abilities, and the majority will claim to have above-average driving skills. This attitude among investors manifests itself in over-frequent trading activity and insufficient diversification. It is often forgotten that short-term fluctuations on the equity market are not caused by economic facts, but by market sentiment. People find safety in numbers and therefore follow the crowd, with many looking to "major" investors and copying their behavior. Investors often trust the advice of friends, work colleagues, client advisors and experts in the media, while forgetting that these people are also part of the crowd and chasing in the same direction.

Doubt – the constant companion

According to Goldberg, when a person makes a decision, for example to buy a share, they almost immediately feel a sense of regret – and think they have done something wrong. At the same time, the investor also starts to manipulate reality. In order to protect themselves, they now only take in information that appears to support their decision.

If a share rises in value by 10%, most investors would realize the gain, even if they had originally set a target price of a 50% increase. According to Goldberg, the average investor does not want to make too large a profit on one deal. Instead, they prefer to make five smaller profits. The situation is reversed when it comes to losses. Investors refuse to realize book losses, and convince themselves that if the loss is not real they can still make up for it. In contrast, many studies show that the surest method for being successful on the stock market is to limit losses – and the best way to do this is with stop-loss orders. If your chosen strategy is not going well, you should change it quickly.

Investors can also be deceived by the way an equity performs over time. If an investor buys a security that first grows in value by CHF 30 and then falls by CHF 25, they don’t see it the same way as if the security lost CHF 25 to begin with and then increased by CHF 30. In the latter case, the investor feels as if they’ve made a profit and so is more satisfied. Over the past few years, passive investing via exchange-traded funds (ETF) has become very popular. According to Zaugg, this reduces the tendency to fall into psychological traps. However, even with this strategy one can make one-sided investments, and many investors underestimate the volatility that ETFs exhibit.

Writing an investment script or diary

Wherever the human factor comes into play, there is a risk of psychological pitfalls. Zaugg notes that even professional investors can fall into such traps. When analyzing and assessing economic data and selecting countries, industries and securities, there are numerous sources of error. Several strategies can help investors avoid making wrong decisions. It could be helpful, for example, to write an "investment script" containing instructions on what to do in the event of positive or negative trends, and stick to this. This applies particularly to target prices and stop-out prices. It’s also good to write down the arguments that triggered the original purchase.

Goldberg tells how, during his many years working as a securities trader, he kept a "trader's diary," so that he couldn’t change his reasons and targets later on. It's only human, in his view, for someone to say something untrue in the morning and then to manipulate and sugarcoat it to mean something else by the evening, all in the interests of a clean conscience. Jérôme Zaugg goes one step further: he advises investors, wherever possible, to favor automatic systems that make rational assessments and are free of human emotion.