One of the lesser talked about risks in investing is one that no less needs addressing: behavioural risk. But get into good habits early on and your behaviour will pay off. And this is just one of the ways that ISAs can help—getting you into the habit of making regular savings, no matter the weather, and avoiding emotional decisions.
Behavioural risk is the risk that you'll undermine your own returns by doing stupid things with your investments. We spend a lot of time talking about how to find good investments and think about things like low expense ratios and long manager tenures and company quality and so forth. Well, it turns out the best investments might be investments that you won't do stupid things with or you won't be inclined to make bad timing decisions with. So this is a risk that investors really need to stay tuned to.
Here at Morningstar we like to look at a statistic called investor returns for funds, and what we see is that consistently investors undermine their own returns with bad timing, i.e. they buy high and sell low.
One of the methods that you can use to combat your bad instincts and avoid being your own worst enemy is known as the bucketing approach. The basic idea is that you set aside money that you may need for near-term expenses, i.e. money that you’re likely to want to access in the next two to five years, and you keep that in very liquid investments, such as cash and short-term bonds. Once you have this money set aside, you can afford to tolerate some fluctuations in your longer-term investments because you know you won't need to tap them for any near-term expenses. It’s a very simple idea but it’s also very powerful in terms of segregating a pool of assets, knowing that your near-term needs will be met and so you can let the market do what it's going to do with the longer-term portion of your portfolio.
Talking of the longer-term portion of your portfolio, time horizon is also very important and particularly so when it comes to driving your allocation of assets. It can be a good idea to actually write down what your long-term goal is and articulate your investment policy, i.e. what your parameters are for stocks, bonds and cash and match that to your time horizon. That way you should be able to, under the guidance of your personal investment policy, sell only when you see big deviations in your portfolio versus your self-imposed targets, or when specific sell criteria that you had previously specified occur. That way, if something happens that's not on your list of reasons to sell, then it’s probably not going to be an impetus to sell.
Another tactic to avoid making behavioural mistakes is to put as much of your investment portfolio as you can on autopilot. Pension plans work like this already—you contribute money whether you like it or not, and you have to go through some steps to override that policy. Try to do that with any other investments that you can, too. So if you have money flowing into an ISA, for example, average out your payments throughout the year to avoid making that single investment at what in hindsight could turn out to be an inopportune time. The flip side of this strategy is that when things are cheaper, i.e. the market is heading south, your regular investment amount will buy you more shares than it would when the market was stronger, therefore setting you up to benefit in the rebound.
You could also apply this tactic to selling: if you’re inclined to sell an investment, instead just sell some of it and you may find that you will be able to sell the rest at a more advantageous point down the line. In essence, what you want to avoid doing is panicking and thinking “I must decide now”, which could cause you to make a bad decision.
And a final note on good behaviour. It’s not uncommon to see investors get into investments that don’t suit them. Our data on investor returns shows a near perfect correlation between higher volatility funds and worse investor returns. So, the more volatile fund types, investors often get greedy and they look at staggeringly high returns and decide that they want to buy a fund there and then, and it turns out that it tanks immediately. This is one of the reasons why for those investors volatile products probably aren’t great choices because of that tendency to time them poorly.
