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How psychology affects your investment program Investor Guide
How psychology affects your investment program
Investor Guide
Most individual investors, no matter how knowledgeable or experienced, eventually fall prey to psychologically induced biases that cloud their judgment and lead to poor investment decisions.
None of us wants to admit to being irrational. But human beings have emotions, and it is extremely difficult to keep these emotions from playing havoc with your investment program. In addition, investors generally lack the ability to measure risks and rewards accurately; most people are simply not hardwired to understand probabilities.
The good news is that there are simple strategies, described later in this brochure, that prevent emotions and cognitive errors from derailing your investment program and keep you on track to meet your goals.
How Psychology Affects Your Investment Program
Loss aversionIf you are like most people, you are not risk averse. You are perfectly willing to take on risk appropriate to your circumstances in exchange for the potential for extra return. But what happens when instead of providing this extra return, your stocks go down? The natural tendency is to hang on to losing stocks in the hope that they will rise again. This is because people are loss averse, not risk averse.
Regret theoryWhen a stock falls, many investors feel they have made a bad decision and a feeling of regret sinks in. To avoid admitting that they may have been wrong, they hold on to losing positions in the hope that the market (i.e., other investors) will vindicate their judgment and prove them correct in the end. This generally has a negative effect on portfolio performance.
AnchoringThis refers to our tendency to latch on to a figure that should have no bearing on our decisions. Investors often anchor to their purchase price and judge subsequent price changes in relation to this value. Anchoring can adversely affect performance, as investors are reluctant to sell investments for less than they paid and/or sell winners too quickly.
Mental accountingInvestors generally look at investments separately rather than in aggregate. This can result in a cafeteria style of investing whereby their portfolio consists of a hodgepodge of poorly diversified investments with no overall plan.
7 Common Investing Mistakes
1House money effectDerived from the gambling term whereby gamblers take greater risks with winnings than their initial bets, in the investment world this refers to a version of mental accounting where investors have one mental account for their initial invested capital and another for profits or earnings. This often results in investors taking on undue risk after making a gain.
Herding instinctAlso known as crowd psychology or peer pressure, we buy what everyone else is buying. That way, if the investment doesn’t work out, our ego is protected, since everyone else was buying it too. The technology run up of the late 1990s is a prime example of herd mentality in action. We all know the outcome of that story.
OverreactionInvestor overreaction to new information and market events has a powerful effect on stock prices. Earnings announcements are a prime example. If a company’s earnings fall below expectations, investors can be quick to express their dissatisfaction with management and oversell the stock. Taken to the extreme, investor overreaction can lead to stock market bubbles and crashes.
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A History Of Human NatureWhether today or 300 years ago, experts have clearly shown
that when it comes to investing, our biggest single liability is our emotions.
Confusión de Confusiones, Joseph de la Vega“The bulls are like the giraffe which is scared by nothing…they love everything, they praise everything, they exaggerate everything…The bears, on the contrary, are completely ruled by fear, trepidation and nervousness.”
A poet and businessman living in 17th century Amsterdam, de la Vega provides one of the first commentaries on market behaviour and investment psychology. In a series of four dialogues between a shareholder and a merchant, de la Vega describes the stock market as “the greatest comedy”, full of gamblers, biased participants, swindles and cunning deceptions.
Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay“Persons of distinction, of both sexes, were deeply engaged in all these bubbles; those of the male sex going to taverns and coffee-houses to meet their brokers, and the ladies resorting for the same purpose to the shops of milliners and haberdashers.”
Market behaviour today differs little from market behaviour 300 years ago. Mackay tells the stories of three major speculative bubbles: the Mississippi Scheme of 1720 in France, the South Sea Bubble of the same year in England, and the Tulip mania of 1637 in Holland.
Manias, Panics, and Crashes: A History of Financial Crises, Charles P. Kindleberger “Manias and panics, I contend, are associated on occasion with general irrationality or mob psychology.”
Updated since first published in 1978, Kindleberger reviews famous bubbles, crashes and panics and asks why, despite the best efforts of economists to predict them and regulators to curtail them, these events remain an inescapable reality.
Irrational Exuberance (second edition), Robert J. Shiller“Absurd prices sometimes last a long time.”
When Robert Shiller was writing the first edition of Irrational Exuberance in 1999, his warnings about what he felt was an overheated stock market fell mainly on deaf ears. Shiller recounts how “some kind of collective conclusion had been reached about the stock market – and it had a powerful hold on people’s minds.” In the second edition, Shiller broadens his territory and discusses the housing market as well as the stock market. Not much had changed, says Shiller: “Irrational exuberance is still with us.”
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Why Investors Buy High And Sell LowEvery investor plans to make a profit – to buy low and sell high. But more often they do exactly the opposite. Why is this? The chart below shows the emotional factors that typically come into play as a stock’s price fluctuates.
Optimism
Confidence
Optimism
This is great! The price is going up!
I am buying MORE! Not to worry,
I am a long-term investor!
Euphoria
Denial
PanicCapitulation
Relief
Sell NOW!
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3,000
6,000
9,000
12,000
15,000
18,000
1981 1983 1985 1987 1989 1991 1993 1995 1997 2000 2002 2004 2006
Source: Standard & Poors as at September 30, 2006 (price index)
TSX Results* +525%*25-years as at September 30, 2006
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
1 Invest Like An Institution
2 Dollar Cost Averaging
3 Asset Allocation & Rebalancing
How to keep emotion out of your investment programIf you’ve recognized yourself in any of the behaviours described in this brochure, join the club – you are human. The good news is that there are three simple ways that can keep emotion from derailing your investment program:
How Can You Avoid This Psychological Trap?
TSX
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Since they act on behalf of the beneficiaries of the plan, they generally find it easier to be objective and avoid the psychological dilemmas that individual investors struggle with when dealing with their own money.
A successful institution has a clear definition of what they are trying to achieve and a means to assess if those objectives are being met. They incorporate “best practices” – techniques and controls that enable them to make the best investment decisions.
We do too.Assets in Mackenzie’s managed asset programs – Symmetry and Keystone Strategic Asset Allocation Service (Keystone) – are managed using the same rigorous techniques employed by institutional investors. The table to the right outlines the techniques of successful institutions and describes how Symmetry and Keystone apply these practices on behalf of individual investors.
Our program for newer investors, Keystone requires a minimum investment of $2,500. Specifically designed for emerging affluent investors, Symmetry requires a minimum investment of $25,000.
Invest Like An Institution
Institutional investors such as pension funds manage their money differently than individual investors.
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How Can You Avoid This Psychological Trap?
InSTITuTIonAl InvESTorS MACkEnzIE MAnAgED ASSET ProgrAMS
Determine investment objectives
Have clearly defined goals; they set forth exactly what they are trying to achieve and how they plan to go about achieving it
Symmetry and keystone determine a strategic asset allocation to match each investor’s stated investment objectives
Clearly documented strategy
Document the investment strategy in a formal Investment Policy Statement (IPS) that defines the asset mix and identifies the responsibilities of various parties that make investment decisions
Symmetry and keystone provide an Investment Policy Statement that provides discipline and ensures the investment strategy remains effective over time
Asset allocation
Combine managers in optimal ways to produce the asset allocation that has the most likely chance of meeting their investment goals
Multi-managed by professional money managers, a Symmetry or keystone portfolio can be constructed to meet nearly any investor’s needs
rebalancing
Many institutional investors establish investment committees that decide when to rebalance
Symmetry offers a choice of manual or automatic rebalancing; keystone portfolios are automatically rebalanced as required
Monitoring and reporting
Implement standards and practices for monitoring, measuring and reporting investment performance
Symmetry and keystone provide detailed, user-friendly quarterly performance reports that monitor and measure progress
A disciplined approach that takes emotion out of trade timing, dollar cost averaging results in buying more securities when prices are low and fewer when prices are high, which generally reduces the average cost of the investment.
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5,000
10,000
15,000
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25,000
$30,000
Mackenzie Ivy Canadian Fund* (since inception, October 31, 1992)
$29,965
$17,300
Market ValueInvested
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5000
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20000
25000
30000
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5,000
10,000
15,000
20,000
25,000
$30,000
Mackenzie Ivy Foreign Fund* (since inception, October 31, 1992)
$ 31,088
$17,300
Market ValueInvested
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2 Dollar Cost Averaging
“ Don’t try to buy at the bottom and sell at the top. It can’t be done except by liars.”
Bernard Baruch (1870-1965) Financier & Economist
You don’t have to invest a lot to build a tidy nest egg.
Dollar cost averaging means investing a set amount of money at regular intervals.
Mackenzie Pre-authorized Chequing Plan offers easy dollar cost averaging
An easy way to take advantage of dollar cost averaging is to set up a Mackenzie Pre-authorized Chequing plan, or PAC plan. A Mackenzie PAC plan lets you invest directly from your bank or trust company account into the Mackenzie funds of your choice. Contributions can be made at a regular interval of your choice, including weekly, monthly, quarterly or semi-annually. You don’t have to invest a lot to build a tidy nest egg. As the charts below show, even $100 a month invested in a PAC plan can realize substantial growth.
* The indicated rates of return are at october 31, 2006. Mackenzie Ivy Canadian Fund performance: 1 yr. 7.2%, 3 yr. 7.3%, 5 yr. 6.0%, 10 yr. 7.5%. Mackenzie Ivy Foreign Fund performance: 1 yr. 14.7%, 3 yr. 6.7%, 5 yr. 3.9%, 10 yr. 8.3%.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The index cited is a widely accepted benchmark for investment performance within its region, represents a non-managed investment portfolio, and is not necessarily indicative of future investment returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
Once you and your advisor have determined your asset allocation – the portion of your portfolio that should be invested in stocks, bonds and cash – think long term and give your investments time to grow. History has taught us that staying invested pays off.Over time the constant ups and downs of the stock market will cause your asset mix to stray from its original weightings. Rebalancing your portfolio not only keeps your asset allocation true to your original
Optimism
Confidence
Optimism
This is great! The price is going up!
I am buying MORE! Not to worry,
I am a long-term investor!
Euphoria
Denial
PanicCapitulation
Relief
Sell NOW!
0
3,000
6,000
9,000
12,000
15,000
18,000
1981 1983 1985 1987 1989 1991 1993 1995 1997 2000 2002 2004 2006
Source: Standard & Poors as at September 30, 2006 (price index)
TSX Results* +525%*25-years as at September 30, 2006
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Staying Invested Pays off
3 Asset Allocation & Rebalancing
A portfolio that is not rebalanced
Asset allocation after 20 years Initial investment 20 years later
$234,019
$40,000
20%
29%
27%
24%
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100000
150000
200000
250000
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50000
100000
150000
200000
250000
Initial investment 20 years later
$40,000
$248,958
Asset allocation after 20 years
25%
25%
25%
25%
A portfolio that is rebalanced
goals, it can deliver better returns over the long term. However, manual rebalancing can be a complex process, one that many investors find easy to put off. As well,
emotion – namely greed – can make it difficult to take profits and reinvest them in lesser performing assets. Automatic rebalancing is the solution to this problem.
Develop an investment strategy that takes emotion out of the equation – and stick with it.
Mackenzie Guided Portfolio Service (GPS)
Mackenzie’s GPS is a portfolio automatic rebalancing service offered free to investors in most Mackenzie funds. You can choose to have your portfolio rebalanced quarterly, semi-annually or annually when the asset mix deviates too far from its target.
Canadian equities
Canadian bonds
u.S. equities
global equities
25%
25%
25%
25%
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25%
Initial asset allocation
The example below shows how over a 20-year period, a rebalanced portfolio grows from the initial investment of $40,000 to $248,958, nearly $15,000 more than the non-rebalanced porfolio.
Source: Mackenzie Investments and globe HySales. From August 31, 1986 to September 29, 2006. The illustration shows two hypothetical portfolios with initial investments of $40,000 distributed equally across four indexes. Canadian equities are represented by the S&P/TSX Total return Index, Canadian bonds by the Scotia Capital universe Bond Total return Index, uS equities by the S&P 500 Composite Total return Index ($CDn), and global equities by the MSCI World Index ($CDn). The first portfolio is not rebalanced. The second portfolio employs a rebalancing range of 3% and a semi-annual rebalancing frequency (December 31 and June 30). The rebalanced portfolio also assumes that each index is rebalanced to the 25% target if any one of the components exceeds 28% or drops below 22% of the portfolio allocation. All rebalancing (selling and buying) is done on a tax-deferred basis. neither of the portfolio illustrations take into account any tax consequences that could be incurred by an investor over the 20-year period. neither illustration takes into account any fees that an investor may pay.
MF3882 3/08
M a c k e n z i e a l l - a c c e s s s e r v i c e
To help save you time, we’ve made fund and account information available for you to access whenever you need through three convenient options:
online get all of the information you require 24 hours a day, 7 days a week by logging into InvestorAccess at mackenziefinancial.com. InvestorAccess is a secure connection that only you can access.
For technical support, please call Client Services at 1 800 387 0614
touch-tone phone You also have convenient and direct access to all your fund and account information by calling the Mackenzie Accessline at 416 922 9143 or 1 800 440 0577
fax request a fax transmission through the Mackenzie Accessline at 416 922 9143 or 1 800 440 0577
G e n e r a l i n q u i r i e s
For all of your general inquiries and account information please call:
english 416 922 3217 1 800 387 0614
bilingual 1 800 387 0615
asian investor services 1 888 465 1668
fax 416 922 5660 1 866 766 6623
e-mail [email protected]
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