By Martyn Hole
Investor behaviour often appears to defy all logic and reason. Why? According to research into behavioural finance, most investors are not strictly rational.
Rather, they are subject to behavioural biases; past experiences, personal beliefs and preferences can influence judgment and skew decisions. These biases can steer them away from logical, long-term thinking, and deter them from reaching their long-term investment goals.
At Capital Group, we believe there is a strong case for long-term investing, particularly in relation to buying and holding sound investments. More importantly, we think it’s time to put new focus on long-term investing and how it can create meaningful value for the investor.
Behavioural finance contends that when it comes to investing, people often exhibit herding behaviour or a ‘group think’ mentality. They mimic the behaviour of others, especially in times of uncertainty. But basing one’s investment decisions on the actions of others makes little sense given different investment goals and financial circumstances.
Most investors are also loss-averse. According to research by Nobel laureate Daniel Kahneman and his late collaborator Amos Tversky, losses hurt about 2-2.5 times more than gains satisfy.1 So the pain of losing $10,000 is disproportionately greater than the pleasure of gaining $10,000; this asymmetry can lead to panic selling during severe market setbacks.
If behavioural biases can influence financial decisions, what subsequent impact would that have on investment returns? We have conducted research into the effects of loss aversion and herding on investment returns, analysing multiple scenarios using a loss aversion ratio of 2.5 times and covering a total of 301 rolling periods.
Our research suggests that buy-and-hold investors can earn much better returns compared with those who move in and out of markets. Over the average 20-year rolling period between 1970 and 2014, an initial investment of $100,000 would have had an ending value of $845,162. By contrast, highly loss-averse investors would have gained $593,974, or 30% less, while those with low loss aversion produced an ending value of $521,275, or 38% less.
Given the conclusion that buy and hold can yield greater value over the long term, it helps, therefore, that there are skilled active managers who are better oriented to downside resilience and low volatility, both of which can counter behavioural biases. Passive index investors, by contrast, bear the full brunt of market declines.
That is also why we stress a long-term perspective and the importance of preserving capital during downturns. We believe that by producing results that are less volatile than the broader market, investors are less likely to react to fluctuating market conditions by making short-term decisions with potentially destructive long-term consequences.
Moreover, certain actively managed portfolios can provide an added advantage as compounding excess returns over time can lead to significantly higher returns for the investor with a long time horizon.
That, in our opinion, points to the potential value of active management. By picking solid companies, backed by a well-thought-out, in-depth global research process that combines fundamental, on-the-ground research with comprehensive macro analysis, we believe active managers can serve the long-term interests of investors very well.
In our view, these outcomes make a strong case for buying and holding solid portfolios that generate more favourable long-term returns – with lower volatility. Their downside protection can mitigate falls, which helps to keep investors from being overly irrational, while their strong rebounds reward investors’ patience. The benefits of such a powerful combination cannot be overstated.
Martyn Hole is an investment director at Capital Group.
Kahneman, Daniel and Tversky, Amos (1979), ‘Prospect theory: An analysis of decision under risk’, Econometrica: Journal of the Econometric Society, 47.2: 263-291
