Why do smart investors still make bad financial decisions? In this episode, Mark and Shani break down the three most common behavioural traps—FOMO, loss aversion and analysis paralysis—and explain how these biases can seriously drag down your long-term returns.

With real-life examples, they explore how poor investor behaviour can cost you up to 15% of your returns—and what to do instead.

Topics Covered:

• How FOMO leads to performance chasing and poor timing

• Why loss aversion stops investors from cutting bad positions

• How too much choice (and overthinking) can paralyse action

• How to use an investment plan to reduce emotional decisions

• What the Morningstar “Mind the Gap” study reveals about behaviour and returns.

You can find the full article here.

Listen on:

[embedded content]

Get Morningstar insights in your inbox

You’re able to find the transcript of the episode below:

Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general nature. It does not take into consideration your personal situation, circumstances, or needs. So, Shani, I’ve been listening to this history podcast and they spend a lot of it making fun of their producer.

Shani Jayamanne: Okay.

LaMonica: So…

Jayamanne: I feel like we’re very nice to Will.

LaMonica: Well, yes. We want Will to be happy. And in order to make Will happy, you need to subscribe to our YouTube channel. So if you are watching this on YouTube, which has become increasingly popular, then subscribe to our channel because that makes Will happy. Anything to add, Shani?

Jayamanne: No. We like to make Will happy.

LaMonica: Yeah. Yeah. Shani wants this to end really quickly because right after this podcast ends, she goes on vacation again. Now, you probably think that Shani was just on vacation. But she’s going again.

Jayamanne: Yes.

LaMonica: And what are you going to do on vacation?

Jayamanne: Well, I’m going to Byron Bay and I really like the kebabs at Byron Bay Kebabs. So I’m just going to swim, eat kebabs, drink, hang out. That’s about it.

LaMonica: There you go.

Jayamanne: It’s winter, so it’s not…

LaMonica: No, listeners are aware. All right. So what are we talking about today?

Jayamanne: So today we’re going to talk about one of the biggest return drivers in investing and that’s you. Not you.

LaMonica: Not me.

Jayamanne: Yeah.

LaMonica: But, you know, look in the mirror. So we’ve done an episode before on Shani’s investment strategy, which works out so well that she gets to buy kebabs. And what you always say is you focus on what you can control.

Jayamanne: Kebabs, Mark. But that’s right. I can control the amount of risk I take in my portfolio. I can minimize my transaction costs and fees. I can control my behavior. And controlling my behavior leads to lower transaction costs and better tax outcomes. So it is a bit of a virtuous cycle.

LaMonica: One thing that Shani cannot control is her desire to make fun of me.

Jayamanne: No, I definitely can’t.

LaMonica: No. Okay. So you wrote an article on long term equity market returns. And so what you found in this article is that poor behavior was one of the largest detractors of total returns for investors. So today what we’re going to look at are some of the most common behaviors that put investors on the back foot and how you can reduce the likelihood of falling prey to these issues.

Jayamanne: That’s right, Mark. And your behavior is a huge influence on the returns that you get. And it’s one of the only factors that influence your returns that are entirely within your control. So let’s go through some of the common mistakes that we do see.

LaMonica: Okay. The first is FOMO. And for old people like me, that stands for fear of missing out. And the term is usually used to describe someone upset at missing out a party or a social event. But with investing, it is talking about the part of human nature that wants to avoid missing out on the returns that you at least perceive everyone else is getting.

Jayamanne: And we spoke about this a little bit in our recent episode where we discussed the top holdings of the best performing super funds.

LaMonica: And we acknowledge that looking at these top performing super funds is pretty common behavior for most investors. And often what we see is that these funds will see big inflows when they make it to the top of the list. People want the best for themselves and that’s not something to be ashamed of. But often this behavior can lead to poor outcomes.

Jayamanne: And I’ll speak a little bit about my own experiences with FOMO with investing.

LaMonica: Not the parties you’re missing out.

Jayamanne: No, I’m very glad to be on a party these days. It’s definitely easy to speak on the podcast and write articles and preach that you shouldn’t partake in poor behavior. But it is definitely harder in practice.

LaMonica: Yeah. And this FOMO effect generally happens when markets are rising. So you keep seeing the markets are green, they keep going up and you just want to take advantage of that. But FOMO is not just on the upside, Shani.

Jayamanne: Yeah, exactly Mark. For me, it’s when markets fall. So I tend to get anxious about missing out on an opportunity when shares are cheap. And if markets are temporarily depressed, I start to get itchy fingers and want to put more money into the market.

LaMonica: And speaking of temporarily depressed, you’re turning this back over to me.

Jayamanne: No, I can keep going. It is an ongoing battle. My last trade out of my regular cycle was in mid-April because I saw the US markets dropping and it was sometimes over 5% a day. And I struggled to watch the markets and not invest fearing I’d miss out on entering at an attractive price. So I did something that completely contradicted my investment strategy and financial plan. I took funds out of my emergency fund to put into the market. And it’s not my investment strategy. It’s not a sustainable way to invest. And I let the fear of missing out get to me. And I think, you know, I realize that the best way for me to achieve success with my investment strategy is to set clear guidelines and intervals for when to invest. And I try to mimic what happens with my superannuation account. My employer contributions are blind to how markets are moving. Lucy from our finance team at Morningstar who does our payroll. She isn’t sitting there watching real-time data and waiting for a dip before she sends my employer contributions into my super fund.

LaMonica: No, what she’s actually doing, she has her job, but most of her job is you email her like every other day with some sort of comment or request about your pay. You’re like the problem employee.

Jayamanne: Yeah, I probably talk to her a lot more than other people talk to her in the office.

LaMonica: You’re not talking to her. You’re sending her emails being like, why is my pay stub wrong?

Jayamanne: Anyway, I’m not a tactical allocator because I’ve found that that’s not what will maximize my outcomes. I automate my additional investments and I try to maximize my contributions and I limit costs as much as possible. So engaging in tactical allocations mean I would have cash sitting there waiting to be invested all the time. And I think, you know, with my long time horizon, it’s in my best interest that I invest and give funds the most time in the market as possible. And in mid-April during the market volatility, I was a tactical allocator and this behavior was similar to how I acted when I first started investing. So for the most part, I’ve been able to avoid this behavior by setting up a proper strategy, but there are still slip ups and like in April and the slip ups have gotten less common, I can say.

LaMonica: I mean, if you think you had a bad mid-April, in mid-April, I turn 46. So we’re all struggling.

Jayamanne: I was in Europe.

LaMonica: There we go. So you were in Europe, trading away in Europe. All right. So this is Shani after having like eight drinks, which…

Jayamanne: That probably helped to be honest.

LaMonica: Contributed to her FOMO. Speaking of poor behavior, don’t go into your accounts when you’ve been drinking. So I think we can all agree on that. But I think sort of the data shows why it’s so important that someone like Shani controls her inebriated behavior because she’ll do better. So we reference this a lot. Morningstar’s Mind the Gap study shows that investors realize a return of 6.3% a year over the decade to December 31st, 2023. The investments they purchased and sold had a total return of 7.4%. That is a gap of 1.1% a year or about 15% of the total return that is lost by poor behavior. So this is purely because of decisions that investors have made to enter and exit funds at certain times, which turn out to be the wrong times. And there’s a few ways to fight back against this FOMO besides sobriety. Write out an investment strategy that aligns your goals and stipulates when you can and can’t invest. We have plenty of resources to help you write this out.

You can find them in the article linked in the episode notes. Automate your contribution so it invests based on a schedule. Not having spare cash lying around means that you are less likely to try to time the market and get in at a good price, which is really what FOMO is attempting to do. Compare your portfolio turnover on a year on year basis. If it’s higher, understand the underlying reason behind an increase and whether it’s tied to chasing performance.

William Ton: I’m Will, producer of Investing Compass and here are this week’s must reads on Morningstar.com.au. In this week’s edition of Unconventional Wisdom, Mark goes through the process of playing Devil’s Advocate for his ETF choice for Australian equity exposure. An important exercise for all investors as it assures that there are no biases at play and helps you make a strong decision about securities that you choose to include or exclude in your portfolio. He runs through detailed analysis for why it should be included in his portfolio.

This week in Future Focus, Shani explores trust. In a meeting with a tax specialist, she was pointed towards them as a way to minimize tax especially for those individuals on a higher tax bracket. She looks at who these vehicles suit and when they might be too much effort with not enough reward. Joseph tapped the insights of Morningstar’s energy analyst to compare integrated fuel and gas station company Ampol with its industry peer, Viva Energy, the owner of Ready Express. How might Australia’s biggest gas station firms fare in a world with more EVs? Are they likely to keep their Australian oil refineries open amid tough competition? And do the shares offer enough value and yield for income investors to look past these question marks?

Humans have a natural inclination to assume that expensive equals better. But is that the case with investing? Not really. Paying more often means getting less in return. Investors have largely taken this message aboard and clearly favor low-cost funds while rejecting more costly options. But are we missing out on better products by doing so? In this week’s Young and Invested, Sim explores if investors are too obsessed with fees and when paying extra may be worth it. These articles and more, they’re now in the show notes. And let’s get back to Mark and Shani.

Jayamanne: Alright, let’s move on to loss aversion. Loss aversion is simply the concept that a loss feels much worse than a corresponding gain. Morningstar’s behavioral research team has found that losses can feel about twice as painful as an equivalent gain.

LaMonica: Yeah, and this asymmetry of emotional responses can drive poor decision-making from investors. It means that investors can often sell positions that still have the potential to grow because people are worried about experiencing a potential loss in the future that has not been realized. And investors can also stay in positions that they shouldn’t stay in. So people will sit in these positions that they already own, not wanting to actually realize that loss. And in doing so, they’re holding positions that are freezing up capital that could be used for another better investment opportunity, could be over-complicating your portfolio and not efficiently realizing these losses.

Jayamanne: So how do you fight back against loss aversion? Coming up to tax time, it’s important to have an honest review of your portfolio. Question whether you’re holding onto positions that no longer have potential or align to your investment strategy. There may be gains that these losses could potentially be offset against.

LaMonica: And as horrifying as it is during these reviews, you want to be transparent and honest with yourself about what you’re doing and what you’re holding. Investing is an art where you’ll never be correct 100% of the time. It is inevitable as an investor that you’re going to have some bad outcomes. That is fine, and even the most successful investors have poorly performing investments.

Jayamanne: So establish a strong decision-making process or framework, and that ensures that you will not sell out of positions early. And specify when you will sell and stick to your plan when your investments do appreciate. Again, this is an investment strategy that we were speaking about before.

LaMonica: And if it suits your goals and portfolio, incorporate rebalancing at set intervals to cut from some allocations and add to others.

Jayamanne: All right, so let’s move on to the last one, and that is analysis paralysis. And the example that is always used is your abundance of choice in supermarkets. So I read an article about this, and in the article, I chose Tasty Cheese. So if you find 12 Tasty Cheese blocks that look the same, weigh the same, and there’s not much price difference, sometimes you’re immobilized by choice.

LaMonica: And how do you solve that problem? Did you just go for the same brand? Are you going for the cheapest one?

Jayamanne: Yeah, I normally just go for the cheapest one, to be honest, which isn’t great with cheese. I feel like I might need to switch it up.

LaMonica: Yes, maybe reevaluate your choices. All right. Well, this abundance of choice, of course, is just capitalism, but it also leads to analysis paralysis. So it’s also known as choice overload. It often means investors end up defaulting to the easiest option that might not be the best for them. So when we look at equity markets, there are approximately 56,000 listed companies globally. There are over 12,000 ETFs listed globally, 3,700 managed funds in Australia. The US market has 500,000 corporate bonds, and then there’s private markets and more exotic investments.

Jayamanne: Investors have a lot of choice about where to put their money.

LaMonica: And a common practice we see with, or commonplace we see analysis paralysis is with superannuation. So a large portion of Aussies stick with their default funds. So many people find it overwhelming to change a superfund. The fees, performance, fund options, and sheer number of superannuation providers all contribute to this reluctance to switch. And that’s assuming that all of this information is easily accessible and not jargon filled and it’s not. So it’s not hard to see why people don’t engage with their superannuation or change it.

Jayamanne: Yes. And I’ve written an article and we’ve done a podcast before about why it’s important to engage early and take your super seriously. You can find it in the article that’s linked in the episode notes.

LaMonica: Yeah. And I think one thing that I’ve always found interesting about analysis paralysis is that I think it’s gotten worse as I’ve learned more about investing.

Jayamanne: And that’s not generally how we think about it. It normally impacts younger investors in our minds.

LaMonica: I totally agree. And that definitely happens as well. But I’ve just found that as I’ve gotten more and more nitpicky about investments as I’ve learned more. So if I’m looking at a company or an ETF, I tend to just focus on what is wrong with it. And that’s probably not a great attitude to have about life in general, but it creates this problem within investments because you can find something wrong with everything. And I think there are two different ways of looking at this. One is that it’s good to be picky because we should have high standards for anything we buy. But also we need to understand that investing is about taking on risk. You just have to make sure you’re getting compensated for that risk you’re taking on. And that’s what I try to remember when I find myself getting too negative about an investment.

Jayamanne: And we do have one piece of research that looks at the impact of analysis paralysis.

LaMonica: So we do have research, Shani. And this is research from 2019 pre-COVID. And it’s called Bigger is Better. In this research, they looked at the U.S. market, but of course the results also apply to Aussies. The study was on 500 defined contribution plans, which you can think of as super plans. And each of those had over 500,000 participants, so big pools. So when the core menu of options grew from 10 to 30 funds, they saw that the members that stuck with the default option leapt from 74% to 84%. And I think this just demonstrates that people are overwhelmed by choice.

Jayamanne: So how do you fight back against analysis paralysis? Again, a lot of this behavior can be prevented through an investment policy statement or an IPS, which is another name for writing down an investment strategy. Narrowing down the types of investments that will help you achieve your goals means that you can exclude the others.

LaMonica: Yeah, and I think just in summary, poor behavior has a large impact on your total return outcomes. Market returns are going to be outside of your control for the most part. To a large extent, the taxes that you pay and the transaction costs that you incur are inevitable, although of course they can be limited if you make good choices. But your behavior is entirely within your control.

Jayamanne: And investors are not perfect, we’re certainly not. And there will be times where you deviate from your plan or make poor decisions. However, having a clear strategy and being transparent with yourself will mean that you can limit this behavior. And this includes reflecting on past behavior and understanding the decisions and conditions that made you susceptible to deviating from your plan.

LaMonica: And at the end of the day, good investor behavior means letting your investments supply their returns and you just get out of the way. Thank you guys very much for listening. We really appreciate it. Shani is now off to vacation while I stay at work.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)