** Special to The Just Word Blog from Lisa Kramer, University of Toronto **
With so much recent media attention on the burgeoning field of behavioural finance, most people recognize that their human nature can adversely influence the choices they make in financial contexts. One of the most glaring examples of this fact is that emotions can affect investment decisions in ways that may be unexpected, and with implications that certainly can be detrimental to the achievement of investment goals.
It’s surely not news to Canadians that the reduced hours of daylight in the fall and winter seasons can put a real damper on our spirits. Many people become severely depressed in the fall and winter, and the rest of us also tend to become a bit more “blue” during these darker months. Being in even a mildly depressed state of mind, causes increased risk aversion. That is, investors become more reluctant to hold risky assets during the fall and winter. Then in spring and summer, they tend to become more tolerant of risk.
This annual cycle in mood and willingness to bear financial risk has important implications for financial markets overall, and for individual investors as well. At the individual investor level, investors’ marginal preference to hold safe versus risky assets varies with the seasons. In the fall and winter, people tend to prefer relatively safer assets, and in the spring and summer, they gravitate more toward riskier securities, on average. All of these individual preferences sum up to influence the way international capital markets work. Stock and bond returns exhibit striking seasonal patterns as a consequence of the way individual risk preferences vary by season, and the patterns depend on the location of the market based on seasonality in daylight around the globe. Seasonal patterns in markets are stronger in more northern countries, like Sweden, where there are very few hours of light in the deepest days of winter. And the effects are offset by six months in southern hemisphere countries like Australia and New Zealand, just like the seasons.
Unfortunately, making financial choices in direct response to these emotional urges can have serious and costly consequences for an investor’s portfolio. An investor who becomes risk averse in the fall may feel compelled to reallocate her portfolio towards safer assets at that time. With many investors experiencing the same emotions simultaneously, the prices at which the associated trades are executed may not be ideal. As an example, it’s likely not a coincidence that market crashes tend to occur with greater frequency during the months of September and October, when many investors are entering their annual cycle of reduced preference for financial risk. Similarly in the spring: many investors become more tolerant of risk around the same time, which can translate into less than ideal execution prices for an investor who makes portfolio allocation decisions based on her emotions.
The body of research connecting emotions and risk preferences with financial markets and decisions has several important and practical implications for investors:
- Investors need to recognize that as humans, our preferences for financial risk can vary markedly during the year. Be on the look-out for changes in emotions and resist the urge to make important financial decisions when emotions are flaring.
- A sound way to avoid making sub-optimal decisions driven by emotions is by adopting a portfolio that you commit to hold for the long term, regardless of what happens short-term in markets. That is, have a plan that is based on awareness that emotional temptation may arise but will be resisted.
- You will have a much better chance of sticking to this commitment if you avoid taking frequent glimpses of your portfolio (and overall markets, if necessary). For instance, people who peek at their holdings every day perceive their investments to be much more volatile than people who look only at their monthly or quarterly statements. Frequent glances can trigger a knee-jerk reaction to adjust your holdings rather than to stick to the long-term buy-and-hold commitment you made in the previous step.
- Recognize that markets will always go up and down, and sometimes the movements will be drastic. But the buy-and-hold investor who ignores those variations will tend to outperform those who try to outsmart the market through frequent trading.
Investors are human, and it’s perfectly natural to experience emotions. But smart investors don’t permit their emotions to dictate impulsive trading decisions. Instead they develop a long-term buy-and-hold investment strategy and then stick with it.
Lisa Kramer is Professor of Finance at the University of Toronto. She is an expert on behavioural finance, a topic she tweets on as @LisaKramer.