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Emotional investing: What it costs, and what to do about it – Morningstar.ca

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In a recent Journal of Financial Planning article, I analyzed the costs and implications of selling investments during downturns. By my estimates, and others in the field, the cost to everyday investors is on the order of 100 to 150 basis points, annualized. Even if you aren’t likely to panic during a downturn yourself, though, the potential for panic by others affects your investment environment because of how the risk of emotional selling is built into common practice in asset allocation. Let’s take a look at that research, and what it means for investors and investing. 

By focusing one’s asset allocation squarely on ones goals and what is needed to achieve them, and using behavioral tools to mitigate emotional challenges, we can find a more effective answer than current risk-preference based allocations.

How bad is it?
We’ve all heard horror stories of people who panicked during a downturn, went to cash, and then lost out when the market recovered. Or of people who simply became uncomfortable with a sector- or investment-specific dip and dumped an existing investment only to see it promptly recover (and outperform the “new” investment they chased after).  

In this research, I start by analyzing the baseline: What would emotional selling do to a sample set of investors? I developed a simulation model of investing over time, similar to one in my recent paper on easing the retirement crisis, and explicitly modeled the probability of selling during downturns due to emotional triggers. Depending on each person’s risk preferences, they had a threshold at which they would sell; those with lower risk preferences panicked more quickly than those higher preferences. I then put them though a range of historical scenarios to see how they would behave over a 10-year period. 

These baseline results came back as a loss of between 100 and 150 basis points, which aligns the range of estimates other researchers have found. The most well-established estimates look at the costs of unwisely trying to time the market, of which emotional selling during a downturn is believed to be the most pernicious part. Researchers Friesen and Sapp (2007), for example, estimate that it decreases investor returns by about 150 basis points per year. Vanguard also places it at about 150 basis points (Bennyhoff and Kinniry 2013). Morningstar’s own Russ Kinnel, in his annual Mind the Gap study has shown how it has varied considerably from sector to sector and year to year, from over 150 to a current average of 26 basis points

That’s what happens to people who panic. But what about everyone else?

Emotional investing shapes asset allocation
One of the key lessons from the analysis is that the manner in which investments are often matched to individuals (often using a risk-tolerance questionnaire) is shaped by the potential for emotional selling. When one develops a long-term financial plan, at least two competing demands are placed on the asset allocation: taking on risk to help you reach your financial goals and avoiding excessive risk, in part to avoid discomfort and negative emotional reactions that might lead you to abandon the plan. 

To manage these competing demands, the field of financial planning generally applies two approaches: a risk capacity approach which focuses on goals and generating the required returns, and/or a risk preference approach that seeks to avoid panic.  Unfortunately, in isolation or in combination these two approaches can fail to meet either of the two demands–failing to help investors effectively reach their goals because the portfolio was positioned too meekly, and failing to forestall panic because the portfolio was intolerably volatile.  

In this paper for example, I found that using a risk-preference approach to place more sensitive investors into lower volatility investments reduced the damage from emotion-based selling only modestly, decreasing the losses for investors from 100 to 150 basis points to roughly 80 to 130 basis points. The problem is that when a downturn hits, even lower volatility investments can drop enough to trigger emotional selling among risk-intolerant investors (and similarly for risk-tolerant investors in higher volatility investments). To mitigate this problem, one needs to address the behavioral challenge head-on. 

A different approach
Yet it’s also possible to address the risk of emotional selling without changing the asset allocation. Investors and, as appropriate, their advisors can use behavioral tools to help prepare for and respond to volatility when it comes. For example, potential techniques from the literature include:

  • To alleviate loss aversion, investors (and advisors) can avoid frequent price updates (Larson et al. 2016). 
  • To decrease the likelihood of selling low, one can look for long-term investments that are explicitly “set it and forget it”; this approach learns from the positive behavioral outcomes that target date funds have achieved (Holt and Yang 2016).
  • Investors and advisors can become more educated about how all people suffer from common behavioral biases, like confirmation bias and availability heuristic, that lead to predictable and avoidable mistakes (Perttula 2010). Ideally, these lessons should be reviewed right before a trade, not as a general investor education or financial literacy program (Fernandes, Lynch and Netermeyer 2014).

Measuring the impact of investor panic and a combined approach
In the final part of the analysis, I looked at the impact of a combined approach: behavioral tools to mitigate emotional selling, and an asset allocation based solely on one’s needs (risk capacity, not risk preferences). The analysis couldn’t analyze the specifics of each of the behavioral tools above–much more work is needed there–but it could determine what would happen, in aggregate, if we can forestall emotional selling overall. In aggregate, investors focus on needs and avoid panic receive a net increase of 17-23% in assets over 10 years, or roughly 170 to 225 basis points per year in returns. Some of that return comes from avoiding panic, which supports the analyses by Vanguard and others. The rest comes from freeing up asset allocation to better serve the financial needs of investors. That removes the tension between the competing demands above: achieving an investor’s financial goals and avoiding uncomfortable volatility at the same time. 

Investing is full of uncertainty, and investors are broad and diverse. This research provides an initial look at how one can combine a new set of tools from the behavioral science community, with thoughtful asset allocation, to help some investors avoid emotional selling during downturns. To see the full research paper, please check out “Using a Behavioral Approach to Mitigate Panic and Improve Investor Outcomes” Journal of Financial Planning 31 (2): 48–56.

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Tesla shares soar more than 14% as Trump win is seen boosting Elon Musk’s electric vehicle company

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NEW YORK (AP) — Shares of Tesla soared Wednesday as investors bet that the electric vehicle maker and its CEO Elon Musk will benefit from Donald Trump’s return to the White House.

Tesla stands to make significant gains under a Trump administration with the threat of diminished subsidies for alternative energy and electric vehicles doing the most harm to smaller competitors. Trump’s plans for extensive tariffs on Chinese imports make it less likely that Chinese EVs will be sold in bulk in the U.S. anytime soon.

“Tesla has the scale and scope that is unmatched,” said Wedbush analyst Dan Ives, in a note to investors. “This dynamic could give Musk and Tesla a clear competitive advantage in a non-EV subsidy environment, coupled by likely higher China tariffs that would continue to push away cheaper Chinese EV players.”

Tesla shares jumped 14.8% Wednesday while shares of rival electric vehicle makers tumbled. Nio, based in Shanghai, fell 5.3%. Shares of electric truck maker Rivian dropped 8.3% and Lucid Group fell 5.3%.

Tesla dominates sales of electric vehicles in the U.S, with 48.9% in market share through the middle of 2024, according to the U.S. Energy Information Administration.

Subsidies for clean energy are part of the Inflation Reduction Act, signed into law by President Joe Biden in 2022. It included tax credits for manufacturing, along with tax credits for consumers of electric vehicles.

Musk was one of Trump’s biggest donors, spending at least $119 million mobilizing Trump’s supporters to back the Republican nominee. He also pledged to give away $1 million a day to voters signing a petition for his political action committee.

In some ways, it has been a rocky year for Tesla, with sales and profit declining through the first half of the year. Profit did rise 17.3% in the third quarter.

The U.S. opened an investigation into the company’s “Full Self-Driving” system after reports of crashes in low-visibility conditions, including one that killed a pedestrian. The investigation covers roughly 2.4 million Teslas from the 2016 through 2024 model years.

And investors sent company shares tumbling last month after Tesla unveiled its long-awaited robotaxi at a Hollywood studio Thursday night, seeing not much progress at Tesla on autonomous vehicles while other companies have been making notable progress.

Tesla began selling the software, which is called “Full Self-Driving,” nine years ago. But there are doubts about its reliability.

The stock is now showing a 16.1% gain for the year after rising the past two days.

The Canadian Press. All rights reserved.

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S&P/TSX composite up more than 100 points, U.S. stock markets mixed

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TORONTO – Canada’s main stock index was up more than 100 points in late-morning trading, helped by strength in base metal and utility stocks, while U.S. stock markets were mixed.

The S&P/TSX composite index was up 103.40 points at 24,542.48.

In New York, the Dow Jones industrial average was up 192.31 points at 42,932.73. The S&P 500 index was up 7.14 points at 5,822.40, while the Nasdaq composite was down 9.03 points at 18,306.56.

The Canadian dollar traded for 72.61 cents US compared with 72.44 cents US on Tuesday.

The November crude oil contract was down 71 cents at US$69.87 per barrel and the November natural gas contract was down eight cents at US$2.42 per mmBTU.

The December gold contract was up US$7.20 at US$2,686.10 an ounce and the December copper contract was up a penny at US$4.35 a pound.

This report by The Canadian Press was first published Oct. 16, 2024.

Companies in this story: (TSX:GSPTSE, TSX:CADUSD)

The Canadian Press. All rights reserved.

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S&P/TSX up more than 200 points, U.S. markets also higher

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TORONTO – Canada’s main stock index was up more than 200 points in late-morning trading, while U.S. stock markets were also headed higher.

The S&P/TSX composite index was up 205.86 points at 24,508.12.

In New York, the Dow Jones industrial average was up 336.62 points at 42,790.74. The S&P 500 index was up 34.19 points at 5,814.24, while the Nasdaq composite was up 60.27 points at 18.342.32.

The Canadian dollar traded for 72.61 cents US compared with 72.71 cents US on Thursday.

The November crude oil contract was down 15 cents at US$75.70 per barrel and the November natural gas contract was down two cents at US$2.65 per mmBTU.

The December gold contract was down US$29.60 at US$2,668.90 an ounce and the December copper contract was up four cents at US$4.47 a pound.

This report by The Canadian Press was first published Oct. 11, 2024.

Companies in this story: (TSX:GSPTSE, TSX:CADUSD)

The Canadian Press. All rights reserved.

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