It might not be possible to change the way our brains are wired, but recognising the biases that we are prone to as investors, can help us avoid them in future. In this monthly series, we examine investor biases and practical ways of overcoming them.
Please remember that the ideas and conclusions in the Better investing section do not necessarily reflect the views of Fidelity’s portfolio managers or analysts. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
BY NICK ARMET, 2 JUNE 2014
Inertia is a behavioural bias like no other when it comes to investing. In certain circumstances, it’s an unequivocal disaster – putting off the decision to invest for your retirement is a very bad idea. In other circumstances, inertia is one of the most powerful allies an investor can have once they have set out their investing stall and got skin in the game. Understanding whether the power of inertia is on your side or acting against you is essential to successful investing.
It is often said the best decision an investor can make is to simply start saving. The problem is that many people fail to make this one key decision to start investing early and regularly, despite the prospect of challenging retirements. The reason is inertia and the status quo bias.
The status quo bias is simply a preference for the current state of affairs. The problem is that people have a habit of perceiving any change from the status quo as a loss. And, we know from Kahneman and Tversky’s Nobel Prize-winning work on Prospect Theory that losses are felt about twice as deeply as gains are enjoyed. So, our fear of losses is a powerful force that supports the status quo.
When people save they are ‘losing’ some spending power – the evidence suggests that many people perceive this as a loss to their current spending account rather than a gain to be enjoyed in a future retirement account. The value of savings to a man aged 65 are obvious, but demonstrating this to the same man in his twenties is a problem if he assigns little value to that distant reward. Valuable years of compound investment growth are lost to inertia.
Too much choice is another driver of inertia – the bewildering range of investment options available today has a paralysing effect on decision-making. This has been called the paradox of choice and experiments show that when options increase beyond a handful, it actually impedes decisions to buy. In one supermarket experiment, a display of 24 jams was set up for customers to taste. Every few hours this was reduced to only six jams. When the selection was small, 60% of customers stopped and 30% bought a jam. When the choice was large only 40% stopped and only 3% bought a jam. If 24 jam jars represent a choice overload, then investors are certainly prone to choice paralysis.
This is the reason why default options are incredibly popular because they allow us to abdicate making a choice. When presented with a range of wines on a menu, how often do people simply opt for the house red? The default effect describes the dominant effect default options have on our decision-making. Interestingly, the default effect is at work even when we have no default option; we simply make our past experience the default, prolonging the status quo.
Auto enrolment into company pension schemes is a policy nudge that recognises the pitfalls of inertia by embracing the power of the default effect. It gets people automatically doing the right thing in saving for their retirements. According to one study, auto-enrolment programmes in the US increased individual pension account (401k) participation from 63% to 95%.1 In the UK, auto enrolment was introduced in October 2012 and figures from the Department for Work and Pensions indicate opt-out rates have averaged only 9%. All around the world, policymakers are turning inertia and the default effect into a positive force to bring about a greater public good in the form of increased retirement saving.
Interestingly, it seems that advertisements showing pensioners in yachts don’t really cut it when it comes to shaking people out of their retirement planning inertia. Adverts focused on the gains you might enjoy as a pensioner use a weaker incentive that lacks the emotional impact of loss aversion (by about two to one if you remember). Fortunately, the retirement industry is now learning to use loss aversion to encourage people to save. In their communications, pension schemes are increasingly framing the issue of saving in more powerful ‘loss’ terms. For example, emphasising the money that employees ‘lose out’ on in employer scheme matching contributions has been shown to boost company pension scheme take-up rates.
The pension fund is a great example of a binding commitment that effectively bars people from using their savings before retirement. The power of inertia is in built into the product structure since we cannot get our hands on the money till we retire. There is no such binding commitment for a mutual fund however. We have the flexibility to sell these investments early, and the evidence suggests that some investors do and they also overtrade by switching investments too much. This is in stark contrast to legendary investor Warren Buffet’s advice when asked about his favourite holding period for shares - his response was: “forever”.
Despite Buffet’s advice, there is a growing fascination among investors for tracking the daily ups and downs of the markets. No doubt this is thanks to a barrage of daily news flow from financial TV channels, newspapers, websites and blogs. The net impact of short-term monitoring is not helpful, however, since it encourages investors to sell too quickly or trade too much on what should be long-term investments. Professional investors too can be guilty of overtrading in an effort to find the best returns. This is where inertia can be a positive force once the decision to invest has been made.
You could find the reason to change investments on a daily basis if you really wanted. A sensible option is to invest early – in a global dividend mutual fund, for example, where dividends can be reinvested – then embrace inertia and wait. Time is an investor’s best friend , allowing stock market and compound dividend growth to work its magic. The acid test for an equity income investment is not a few months but in 10, or 20 years’ time. There is a good chance that you will have outperformed the overtrader who spent those 20 years trading in and out of markets, and for a lot less effort. It is a well-worn investing proverb that ‘time in the market beats timing the market’.
Source: FIL Ltd, Thomson DataStream, price return for S&P500 from 27.05.94 to 29.05.14.
The problem with timing the market – which even the best investors admit – is that it’s almost impossible to get right with any consistency. No-one knows when the market is going to have a great day and it can happen when sentiment is beaten down and investors least expect. The chart above shows the significant impact that missing the best days in the market can have on your investment return. The example shows a 20-year investment in the US market. If you just sat tight and did nothing, you would have been rewarded with a 320% return. However, missing only the best 10 days reduces your return to 109%, while missing the best 30 days would have seen you losing money.
So, inertia prior to saving for retirement is a big problem; once you have made your investment decisions however, doing nothing and keeping the status quo can be a very powerful ally.
Please note that nothing in this article is intended to be, or should be construed as, a recommendation or advice to buy or sell any particular fund, security or other investment. The views and opinions expressed in this article are those of the author and may not necessarily represent the views of Fidelity.
The objective of this page is to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications. Content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or investment by any Fidelity entity or any third-party.