Don’t let fear influence your investment decisions

By Alan Atkinson a Retail Business Analyst at Prudential

As human beings we often allow our emotions to influence our decisions; why purchase the second-hand family car when you could be driving the latest piece of German engineering? While emotional decision-making isn’t necessarily always a bad thing, it can be highly detrimental when it comes to investing your hard-earned money. In this article we take a look at how the “fear of missing out” (a.k.a. FOMO) can negatively impact your long-term investment returns.

We’ve all experienced “FOMO”; when you feel apprehension about missing a particular event or experience that could be rewarding.

When it comes to investing, FOMO could play out as a fear of missing out on the best investment returns, and influence your investment decisions through “performance chasing” behaviour. This is when an investor constantly switches their money into the unit trust(s) boasting the best (usually short-term) performance track record. This behaviour is borne out of 1) a misguided perception that past performance is certain to persist into the future, and 2) a fear of underperforming the market, i.e. not making as much money as other investors.

It may be surprising to learn that when you chase the past top performer, you don’t end up with the best returns over time.

Let’s have a look at the growth that would have been achieved by a performance-chasing portfolio in the South African market over the past 10 years. In the graph below, the gold line shows a portfolio where, at the beginning of each year, the investor switched into the ASISA South African Multi-Asset High Equity category fund (typical “balanced funds”) that had the best absolute return over the preceding three-year period. For comparison, the red line shows the growth of an investment in the Prudential Balanced Fund over the full 10-year period, while the black line shows a portfolio where, at the beginning of each year, the investor switched into the South African Multi- Asset High Equity category fund that had the worst absolute return over the preceding three-year period.

We see that the investor would have been significantly better off had they adopted a “buy-and-hold” strategy and remained consistently invested in the Prudential Balanced Fund for the full 10-year term. Interestingly, the strategy of switching into the worst performing fund at the beginning of each year delivered a better return than switching into the best performing fund for the 10 years to December 2016. It’s also worth noting that the growth of the performance-chasing portfolio ignores any potential fees and taxes incurred when switching between funds, which would have further decreased the overall return.

Another way that a fear of missing out can diminish future investment returns is through over-diversification. This occurs when an investor includes many highly correlated funds in their portfolio (where the underlying assets are very similar), for fear of not holding the ones that end up outperforming over the investment time horizon. As an extreme example, if you held every fund in the South African Multi-Asset High Equity category, you would ultimately achieve the average return for the category (shown in the graph by the dashed grey line), at a similar level of risk of a portfolio containing only a few carefully selected funds, i.e. a portfolio that has the potential to outperform the average return.

Removing emotions from your investment decisions is never easy, and accepting that your portfolio will underperform from time to time can be a bitter pill to swallow. Having a well-defined financial plan with clear investment objectives is key to ensuring that you stay the course during periods of short-term underperformance – which could mean a year or more.

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