Are our brains wired against us?

In a world of always–on smartphones and social media, the need for instant gratification is becoming just as prevalent in investment markets. We want returns and we want them now! Fidelity suggests some ways to try and break that behavioural pattern so that your clients can begin to appreciate the benefits of a longer–term approach.

Key points

  • Investing dials into deeply rooted cognitive biases and studies have shown that the involvement of money can encourage emotional decision–making.
  • We see this in the investment industry where technological advancements and a greater focus on quarter–by–quarter earnings has reduced average holding periods.
  • As the market becomes more short–term, we believe strategies that take a longer–term view provide the greatest opportunity to create and build portfolio wealth.

Our natural preference for short–term rewards – or instant gratification – over delayed gains has long been noted by psychologists as a feature of the human condition. This is perhaps most noticeable in children and many parents will recognise the struggle to encourage their kids to see the value of delayed rewards in spite of the strong impulse driving them to eat their treats immediately.

But this also extends to many aspects of our behaviours as adults, including investing. If anything, this shift to short–termism has only been further exacerbated over recent years by the advent of social media, smartphones and the associated ubiquitous connectivity to the world around us.

In addition to technological advancements, there are also more primal factors at play which could go some way to explain why humans focus on the short–term, particularly when it comes to matters of money. Investing dials into deeply rooted cognitive biases and automatic responses in our brains owing to the involvement of money, the presence of which has been shown to encourage emotional decision–making, particularly during times of stress. 

In experiments, investors routinely value short–term gains more than they value delayed gains. The culprit here is dopamine, a feel–good chemical that our brains release when faced with a short–term reward. In fact, the possibility of imminent monetary reward has been shown to trigger dopamine release in much the same way as food, cigarettes or alcohol can. 

Neuroscientists have shown that different parts of the brain are responsible for valuing short and long–term monetary payoffs. Behavioural studies have demonstrated that while people would take £100 today over £200 in a year’s time, they would not take £100 in six years over £200 in seven. There is no rational reason for this inconsistency; the trade–offs are identical in monetary terms. 

The extent to which short–termism has become a feature of investing in today’s stock market is highlighted by the chart below. It shows how the average holding period of stocks has fallen over recent decades across all major equity market regions.

Holding periods have fallen

Source: Goldman Sachs. Average holding period of all market participants by region, January 2016.

The average holding period globally is now under three months, and this is only partly explained by the entry of short–term, technically–driven investors. It is also a function of how the investment industry operates with most sell–side analysts focusing heavily on short–term earnings projections over the next one to three years, with fewer forecasts existing beyond this.

Avoiding the herd

So how should we tackle this issue as investors? A starting point could be simply to take a longer–term view – in fact data shows that when it comes to investing in domestic or overseas equity markets, the longer you hold your shares, the more chance there is that you will make money.

The charts below look back over the last 25 years of market returns and analyse how many times you would have made and lost money over one, five and 10 years. As you can see, if you held an investment in either UK or global equities for one year only, you would have lost money in more than 20% of instances. However, if you stayed invested for 10 years you would have lost money less than 4% of the time.

Putting time on your side  an illustration

  Mar 14  Mar 15 Mar 15  Mar 16 Mar 16  Mar 17 Mar 17  Mar 18 Mar 18  Mar 19
FTSE All Share 6.6% -3.9% 22.0% 1.2% 6.4%
MSCI World            19.7% 0.3% 32.7% 1.8% 12.6%

Past performance is not a guide to the future.

Source: Datastream, 31 March 2019. On bid–bid basis with net income reinvested. 

So, while taking a long–term view may be a psychologically difficult thing as others focus more on the short–term, it would appear that lengthening our time horizon provides a solid platform to create and build long–term portfolio wealth. 

In this context, the power of compound returns should not be overlooked. This was famously referred to by Einstein as the eighth wonder of the world, but the often–underappreciated fact is that percentage gains and losses are not equal. 

Of course, equity markets from time to time can, and do, experience periods of volatility, but if you can avoid significant drawdowns (i.e. losses) over discrete periods then you can maximise the effect of compounding over the longer–term.

There are various ways to do this but perhaps the key is to avoid overpaying for companies, however positive their prospects may seem. A low price and realistic expectations create an asymmetry of returns that shift the odds firmly in your favour.

A second key building block could be to emphasise dividends as an overall component of total return. Solid dividend–paying stocks may not capture the headlines in quite the same way as the latest consumer or tech sector darling, but history shows that companies that sustainably grow their dividends tend to outperform the rest of the market over the long–term.

This kind of approach is particularly well suited to the current environment. Against a backdrop of high aggregate valuations and stretched corporate profitability, it seems prudent to emphasise dividends – rather than further multiple re–rating or earnings growth – as the most stable component of total return from equity markets going forward.

Short–termism may be rife in markets (and in life), but the evidence suggests investors can use this to their advantage by taking a long–term view and investing in those strategies which are designed to do likewise.

Issued by Fidelity International

Important information 

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority and Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0519/24102/SSO/NA