Behavioral finance, Advisor insights Fear is the path to... underperformance?

Patience, you must have

The chance of seeing a trading loss on any given day is about 46%, but this probability falls precipitously as you extend your time horizon. This has two main consequences:

• Short-term time horizons make investing feel riskier

Unless you're a droid, it's likely that you suffer from a behavioral bias known as “loss aversion,” which means that you will tend to feel the pain of losses about twice about as powerfully as you feel the pleasure from gains.

The effect of loss aversion can be supercharged when it's combined with the fact that losses are much more common over short holding periods. This combined effect (which behavioral economists call “myopic loss aversion”) means that you will experience more stress and fear when you look at returns more frequently and over shorter time frames.

• Short-term investing requires a different approach.

Each dollar (or Imperial Credit) in your portfolio is earmarked for spending at some point in the future. It's likely that the bulk of your portfolio is earmarked for spending that's more than a decade away, in which case there is a very good chance that you will be able to grow your investment considerably, and only a small chance that you will experience a loss—especially if you are invested in a balanced, well-diversified portfolio. If you do have cash flow needs from your portfolio in the next few years, focus your attention on protecting that part of your portfolio first and foremost.

Recommendations

Myopia (shortsightedness—e.g., focusing on short-term returns) can skew our perception of risk and reward and make us more susceptible to emotional decision-making. To paraphrase Master Yoda:

“Fear is the path to underperformance. Fear leads to myopia…myopia leads to loss aversion…loss aversion…leads to underperformance.”

The good news is that we have some powerful tools to help us combat myopic loss aversion:

1. Switch off your targeting computer. To enjoy the benefit of long-term returns, you will need to be able to stay invested through short-term volatility. Unfortunately, short-term returns are very difficult to predict. Rather than relying on forecasts to determine when you need to protect yourself against a potential bear market, we recommend building a portfolio that structurally protects you from the risk of poor short-term returns.

The 3-5 year time horizon is the “Sarlacc pit” of investing. This is the range of holding periods where large losses are the most common. Therefore, if you need to take cash from your portfolio in the next 3-5 years, we recommend building a Liquidity strategy to safeguard those funds. No, that doesn't mean investing in moisture farms on Tatooine— it means building a portfolio of cash and high-quality bonds (paired with borrowing capacity) that you can deplete during a bear market.

2. Keep an eye on long-term returns. Ask your financial advisor about changing your performance reports to cover longer time horizons. There is obviously an entertainment factor to tracking short-term market returns and discussing them with your friend and your advisor—and that is okay, as long as you're enjoying yourself—but these discussions should usually not drive your investment strategy.

3. Expand the conversation. Consider cutting back on the frequency of performance discussions with your advisor. Looking at returns annually, instead of a monthly or quarterly basis, can help you to free up time with your advisor to focus on actionable discussions, like updating your financial plan, reviewing your insurance and estate strategies, and talking through risks and opportunities that go beyond financial markets.

4. Use others' fear to your advantage. When we look at investor sentiment, we find that when investors are fearful or pessimistic it tends to precede higher-than-average market returns. Today, according to the American Association of Individual Investors (AAII), only 24.1% of investors expect the S&P 500 to be higher in the next 6 months. In the past, this high level of pessimism has led to a roughly 60% higher average return over the next 6 months (9.3% vs. 5.7%).

5. Give yourself credit for your progress. Loss aversion is one reason why we don't generally become happier with our portfolios over time. Instead of appreciating the growth we've accumulated so far, we tend to grow accustomed to our gains, re-anchoring our mental image of our wealth to this new “high water mark.” This framework amplifies our frustration, because it's impossible to go above a high water mark that you keep increasing. While it's important to keep making progress on your investment goals, you should also give yourself credit for the growth you've earned so far.

6. Embrace illiquidity. Myopic loss aversion is one argument in favor of asset classes that don't provide daily (or worse, moment-by-moment) pricing. For these investments, the lack of liquidity and transparency—often viewed as drawbacks—help to improve their apparent risk-adjusted returns. For example, you rarely think about what your real estate investments are worth on a given day, and this helps to transform how you think about that investment's risk. The same can apply to private equity, hedge funds, and structured investments.

Happy Star Wars Day, may the force be with you...

Main contributor: Justin Waring, Investment Strategist, CIO Americas

This content is a product of the UBS Chief Investment Office.

Original report - Fear is the path to... underperformance? , 4 May, 2023.