KEY POINTS:
The human brain has evolved to help us make decisions under conditions of uncertainty, but nothing could have prepared us for the complexity of the sharemarket. We are ill-equipped, and exposed to emotions and mental biases that have the potential to destroy wealth faster than the meanest bear market. And yes, that includes the bear market that we are now enduring.
While the financial crisis that has triggered the recent sharp falls in markets is serious, in due course it will end and the sharemarkets will recover their upward trajectory, even though the timing of this is impossible to call. However, at times like this, panic causes a loss of perspective and money moves from weak to strong hands. So what does it require to have strong hands?
One insight that can make a big difference to long-term financial planning is that on average, shares have out-performed cash and fixed interest investment by around 5-7 per cent annually. Barring any extreme events, this basic relationship should continue to hold true. The return above the cash rate from shares is called the "equity risk premium", but we'll call it The Prize. It is one of a handful of resilient forces in the world of investing.
Say you invest $100,000 today and received a 4 per cent return for 30 years, compounded monthly. Ignoring inflation and taxes and assuming you reinvest all income, after 30 years you have $331,350.
Now, what if you could turn that $331,350 into more than a million dollars? If you invest the same amount of money over the same period, but this time your average return is 5 per cent higher - which equates to the lower end of the historical range of the equity risk premium in the US - at the end of the 30 years you come away with $1,473,057.
And suddenly your retirement is a brighter proposition and your ability to make the most of life's choices has improved dramatically.
It's no exaggeration to say that funding retirement aspirations is one of the biggest challenges in the developed world. With planning and foresight, most people can meet this challenge. Your future lifestyle will depend on how you want to live and how much money you have to finance your lifestyle.
A good financial adviser can give you a portfolio that is diversified across the asset classes, from shares to property, bonds and cash, and one that at least mirrors the long-term performance of these markets. The difference between success and failure is not how investment markets behave - we know they generally do well over the long term - but how you, as an investor, behave.
By investing in a quality diversified portfolio of shares, having a long-term outlook and avoiding knee-jerk reactions to short-term volatility, it's actually quite easy to capture The Prize.
Yet for many, The Prize eludes them because they react to short-term market movements rather than sticking to their long-term plan.
Why do so many investors fall into this trap? Research suggests that investors detest the way a loss makes them feel - even more than they fear the loss itself. It appears that the emotional impact of a loss may have an equal or greater effect than the financial loss itself.
Many people assume investors are risk-averse. In fact, investors will often take a risk to avoid an expected loss. So investors are not so much risk-averse, but loss-averse. It's the emotional sense of regret caused by financial loss - rather than the actual loss - that people desperately want to avoid.
When we take investment risks, we should acknowledge that they involve accepting the possibility both of making a loss and of experiencing regret. We need to work against the brain's response mechanism which says it's more important to get through today than to worry about the future. Risk-averse investors may avoid loss, but in doing so they also lose the possibility of significant gain.
Why is The Prize so generous? In their 1995 paper Myopic Loss Aversion and the Equity Premium Puzzle, Shlomo Benartzi and Richard Thaler put forward a convincing explanation which they call "myopic loss aversion".
Assume you have the choice of investing in either of the following two assets:
A risky asset expected to return 7 per cent annually on average, but subject to all the ups and downs of the market, or
An asset that pays a guaranteed 1 per cent annually.
Which would you pick? For an investment over a single year, an allocation to the risky asset would be considered a gamble. Over five (or more) years, however, the risky asset would start to look attractive as the length of time would generally allow for markets to recover from a fall.
Time is an important factor influencing investment decisions. Suppose that, even if you have invested for 30 years, you receive a report every six months from the manager of the risky asset showing you its price. Would these performance updates affect your decisions?
Research says it would: if you don't like what you see, you'll sell (at least part of) the risky asset, despite its long-term prospects. Investors who check their returns over short time periods are likely to be influenced more by their evaluation period than by their investment time horizon. If they don't like what they find they will sell some or all of the risky assets, despite their long-term prospects.
This myopic loss aversion means that investors treat the long term as a series of short terms. The more frequently investors evaluate their returns, the more likely they are to make inappropriate short-term decisions.
The table (left) illustrates this by imagining an investment with an average annual return of 10 per cent and annual volatility of 20.5 per cent. It shows a long-term focus is important, because negative short-term performance, which makes some investors nervous, is often absorbed by the investment's long-term performance.
This helps goes to explain one of the reasons why The Prize from sensible long-term share market investment is as high as it is - a fact that astute, emotionally strong investors can benefit from.
Seasoned investors with long-term investment horizons learn that daily news reports relating to market movements are largely irrelevant. Rather, it is the fundamental principles on which their investment portfolios are based, and patience, that really count.
Arun Abey is executive chairman of financial planning firm Ipac, head of strategy for AXA in the Asia Pacific and a director and advisory board member of Spicers Portfolio Management. He is also the author of How Much is Enough?
www.howmuchisenough.net
