When Emotional Investment Is a Bad Thing

Who knows where this IT student got the inspiration from when ten years ago he borrowed a couple thousand francs to invest in Bitcoin – for less than a dollar apiece. Today he’s a multimillionaire, with a diversified portfolio, and is working toward his PhD under Dr. Thorsten Hens, professor of financial economics at the Department of Banking and Finance at the University of Zurich. “That was brave of the young student,” says Hens, “because from a purely scientific perspective it wasn’t really a smart investment, and definitely not a balanced one.”

It’s well known that it’s the exceptions that confirm the rule. The imprudent behavior paid off, and in any case the IT student had avoided the biggest mistake that you can make when investing – not investing at all. The second-biggest mistake, according to Hens, is getting out too early. Many an investor has gotten in when times were rosy, and then got cold feet when dark clouds rolled in. Hens reveals one rule of thumb up front: “Sell only when you need the money. Never ever sell when the market’s down, even if your emotions tell you to.”

And that takes us to the thick of it regarding the psychology of investing. Our investment decisions are heavily determined by psychological factors such as greed and fear. Greed can arise when I make a moderate return, and everyone around me is becoming filthy rich with Bitcoin. I wind up tempted to make up for it, and increase the risk. Fear arises when equity prices take a hit and the media accentuates that fact with horror stories. I lose sight of the long-term objective and want to sell. “Profits are seen as normal, while losses are viewed as a warning sign,” says Hens. “Losses motivate investors to act. That’s why in declining markets there’s much more trading activity than in rising markets.”

Psychological paradigms are behind the relative risk tolerances of investors. People who are open to new things or are extroverted show a greater risk appetite. Those who are cautious or neurotic show a lower risk appetite. One’s own life experience also influences risk appetite. Reflected in terms of an “investor life,” that means that the recurring up and down of the markets makes you more inured, or risk-tolerant, while a traumatic experience such as a complete loss has the opposite effect.

One’s own culture also has an influence, says Hens. “In Australia there’s a tendency toward impatience, and the Swiss often have a home bias, i.e., they have the tendency to have a disproportionately large portion of their financial investments in their home market.” And there are gender-specific differences as well: “Women are traditionally more risk averse than men, and prefer to invest in tangible assets such as real estate or gold, rather than financial investments like equities or bonds. There’s also a tendency for both men and women to be backward-facing instead of forward-looking – to do precisely what would have been best to have done in recent weeks, and not what would be good for the future.

Believing that you’re always able to do the right thing at the right time is thus a fallacy. “You need a plan, a strategy, to avoid becoming a plaything for these psychological factors, and a victim of your emotions,” says Hens. An investment strategy is successful over the long term when it suits your personality: “A lot of strategies work, but you have to ask yourself, ‘What suits me – and how do I measure success?’” Typically, after ten years, women earn a lower return than men. But is a high rate of return always the objective? Some investors are after higher returns, and are willing to accept significant market fluctuations, while others are satisfied with lower returns in exchange for being able to sleep at night knowing the fluctuations won’t be as great.

Investing isn’t purely a mathematical task. “Investing is a test of character,” says Hens. Investors discover a lot about themselves. They learn to emerge from crises stronger, and learn how to keep their nerve. But you also get to experience the sweet poison of success, which entices you to become too optimistic, overconfident. “From a psychological standpoint, that’s the crux,” says Hens. “When everyone’s celebrating, you have to be careful, and when everyone’s wailing, you have to be bold.” Over the long term, you’re better off to swim against the flow. But you’ve got to have the personality to do so.

An investor needs a strategy that they feel comfortable with, one that fits with their risk tolerance and objectives, and takes the capital and investment horizon into account. Proven investment strategies abound: Value, Growth, Index, Trend, as well as Buy and Hold investing. Each strategy has both advantages and disadvantages. There is no perfect strategy. That doesn’t matter, says Hens. These and many other investment strategies have been successful in the past. “Looking at the investment strategies to have hit the markets in the past 25 years, we see that the difference between the worst return of 8.58% and the best return of 11.51% over the entire period was “just” 3% annually. Moreover, in the next 25 years this difference could just as easily be gained back by the strategy that had performed the worst in the first 25 years. You can never predict these things.”

In other words, the question as to which strategy to choose is relatively unimportant in comparison with the psychological risk associated with the two biggest investing mistakes mentioned earlier – not investing at all, and cashing in too early. That’s because if I get out during a crash, my loss will probably be too great to make up for in the years that follow. That is why it’s so important, says Hens, to select a strategy that you can stick to: “It’s like being married – marry the person who you want with you through thick and thin. Changing constantly is too expensive.” In any case, all proven strategies are better than leaving the money sitting in a savings account. In the last 500 years, there was only one decade in which equities were a losing proposition – between 1929 and 1939.

Having an investment strategy has become even more important in the era of digitalization. Without one, there’s the danger of thrashing around in a constant flood of information. The turbulence surrounding GameStop shares is an impressive example of how social media, in this case Reddit, can steer the behavior of investors. Hens is convinced that the frequency and overabundance of information has a rather negative influence on investing: “At any one time there’s X amount of information indicating that you should buy, and just as much info that supports selling. In the end, you make the decision based on your mood.” You don’t have to know everything if you have a long-term strategy.

While new communications technologies can be a curse at times, robot technology or artificial intelligence could count as a blessing. At financial institutions, robots can take care of routine work like customer surveys more quickly. During the actual consultation session, the chemistry or psychology between the advisor and the client has to be right. That’s hard to do with a machine, says Hens. People would rather place their trust in other people than in machines.

In his latest project, he therefore stood the process on its head and built a robot with which the personality of investors could be investigated. “We begin with the psychological personality and not just with the risk-return preferences of the client, and certainly not with the product features.” The psychology of investing is being robotized so to speak.

BME Inntech also uses robot technology, and recently launched a robo-advisor. BME Inntech offers technological solutions along the entire value chain of the financial markets, and, following the takeover of BME Spanish Exchanges, now belongs to SIX. The robo-advisor allows financial institutions to optimize investments of their customers. It uses an entertaining game in order to identify their preferences and prior knowledge. It’s the same principle that, for example, Netflix uses: The robo-advisor displays a variety of investment options from which the customer can choose, based on how attractive they might be. Building on that, it suggests suitable investment options.

Berta Ares, Head BME Inntech, is confident that intelligent robo-advisors will become an integral part of tomorrow’s investment world: “If everyone’s using them but me, I’ll be losing money – and just gambling,” she says.

Gambling is also a no-go for the 15 students that Hens recruits from a pool of 300 each year. In groups of five, they have a year to manage a portfolio provided by a sponsor. Eight years ago, the first groups started with three million francs. That sum has since grown to six million. A 100% return over eight years isn’t too bad. In the process, the students aren’t allowed to rely on any already-established strategies. Anyone could do that. They have to devise something new, something from which in a few years’ time new strategies might be developed, and become tried and true. Thereafter, we normal investors will be happy to rely on the strategy that best suits our personality.