If time travel is possible, where are the tourists from the future? – Stephen Hawking
If we had tourists from the future, then investing would be easy. Markets would be completely efficient, and active investment management would add zero value to your portfolio’s performance.
The concept of emotional time travel is important for investors because we have a tendency to be our own worst enemy when it comes to trying to predict the future.
This is often referred to as an empathy gap. In his book, The Little Book of Behavioral Investing, James Montier likens this concept to why you should never go grocery shopping on an empty stomach, where you walk into a store with a plan in mind, then proceed to walk out with a bag full of snacks you wouldn’t have purchased if you just weren’t as hungry.
In the context of investing, if left unchecked, this empathy gap can lead to investing at the top of the market and selling at the bottom. A pattern that is a recipe for perpetual disappointment.
EMOTIONS DRIVE IRRATIONAL DECISION MAKING
Kathleen Wylie explained in her February ’23 article how we have no evidence of time travelling tourists from the future, and active management is alive and well. She noted that a single style of investing does not consistently outperform, and the differences in some cases can be quite extreme. Knowing this, it’s essential for investors to close the empathy gap in order to reduce the risk of irrational decision making or “style hopping”.
In his blog, Ben Carlson recently highlighted examples of erratic investment behaviour in action, this could likely be driven by empathy gaps. He explains the tendency to invest in speculative investments only after it hits record highs at the top of a bull market.
Carlson goes on to outline in his book, A Wealth of Common Sense, that money tends to flow into more defensive investments in bear markets, after they’re proven to offer better capital protection. This delayed reaction has resulted in an average loss of 2% per year.
In a more specific example, in Carlson’s blog he highlights Cathie Wood’s infamous ARK Innovation ETF established in 2015, and emphasizes that only after the fund’s assets tripled to $6 Bn between March and July 2020, did it start to see significant inflows of new money to the tune of $13 Bn by the end of March 2021. Unfortunately, the majority of the investors in the fund experienced poor performance.
Current markets have started to illustrate this same pattern, as many of the fallen stars of 2022 are rising dramatically year-to-date. This phenomenon is common in emotional markets and generally is driven by a fear of missing out.
HOW TO CLOSE THE GAP
So how do you avoid an empathy gap?
Montier suggests preparing and pre-committing to an investment strategy while you’re in a rational state of mind.
We agree. The first step is to clearly define your investment goals, timeline, and risk tolerance. The next step is to create investment policies for how you want your assets managed. This forms the basis for portfolio development and serves as a playbook for dealing with uncertainty and shifting markets.
If you’d like to revisit your goals or refine your playbook, we invite you to reach out to your financial advisor or financial professional.