Your emotions complicate investment decision making

Your emotions complicate investment decision making
Lifestyle asset decisions have a heavy emotional content

It’s not always clear what’s a lifestyle asset versus an investment asset. Recent discussions with a client regarding a proposed holiday house purchase raised some interesting issues not only in relation to this matter but regarding investment assets, more generally.

In this case, the client expected that the holiday house would be available for rent for most of the year, with the family using it only for a couple of weeks during peak holiday periods. Based on previous net rental income figures, the return on the property would exceed the current cost of borrowing.

The client’s reasonable view was that because of the anticipated net income, the property should be regarded as an investment asset rather than a lifestyle asset. Further, given the likely reliability of that income, he questioned whether it could be considered as an alternative to holding low yielding, high credit quality, defensive assets.

We were not comfortable with the “defensive asset” alternative idea, given that prices of holiday homes fluctuate considerably and, in poor markets, there is often little liquidity. However, a typical response to this view is that there is generally no intention to ever sell a holiday home. Often, it’s regarded as an asset for the family to enjoy and, potentially, to be passed on to the children.

But it’s just this emotional attachment to the property, that may be built up over many enjoyable holidays, that for us suggests it should be treated as a lifestyle asset rather than an investment asset, regardless of the income. You don’t ever want to be put in a position to have to sell the much loved family holiday house to support a desired lifestyle. It would be similar to the emotional wrench of being forced to sell the family home.

Emotions also play a big part in concentrated investment choices

The emotion based distinction between lifestyle and investment assets discussed above caused us to review the related questions of:

  • what is the purpose of investing; and
  • what are the characteristics of good investment assets.

According to economists, the purpose of investing (or, more correctly, saving) is to forego consumption now to enable increased consumption in the future. How much you save depends on the satisfaction you expect to receive from current consumption versus future consumption. It’s a pretty cold, matter of fact, proposition.

Our approach to financial planning has a similar notion in mind – you invest today in order to be able to afford your desired future lifestyle. There is a focus on understanding that desired lifestyle and the resources expected to be available to achieve it. When it comes to investing, our hard-headed logic says that you should do it in a way that’s most likely to achieve the desired result. More than 60 years of investment research indicates that the four tenets of our investment philosophy i.e.

should be rigidly adhered to, together with attention paid to costs and taxes.

Investments chosen based on these considerations are simply a means to an end – financing your desired future lifestyle. There is no emotional attachment to any investment.

For example, it’s very hard to get emotionally attached to an international share fund that holds more than 5,000 securities, with Apple Inc. comprising little more than 1% of the fund. Buying or selling such a fund to maintain or transition to a chosen risk exposure is a mechanical task that involves no sentiment or ego.

However, not everyone subscribes to such a cold hearted, rational approach to investment. Many see (and are encouraged by the financial media to see) investment as a type of sport or entertainment, checking out “the form” and, hopefully, making winning selections. Others enjoy the opportunity to invest in obscure or unique situations. And then there are those who feel comfortable buying what they think they know, like an investment property in a neighbouring suburb or the shares of their employer.

From an investment theory viewpoint, all such investments are regarded as inferior because they imply concentration risk, that offers no expected return for the additional risk they entail. But the lifestyle/investment asset discussion above reveals another potential complication with such investments. They all require an emotional commitment by the investor that will, in most cases, affect future decision making.

In this context, I remember discussing the concentration risk of an existing investment property with prospective clients a couple of years ago. It was suggested that to reduce their already very high investment risk exposure, a possible recommendation could be to sell the property. This was not met favourably, with their discomfort with the idea emanating from the admission that they were “fond of this property”. Logic proved no match for emotion.

Emotion influenced decisions may conflict with achieving your desired future lifestyle

Even with an objective, emotion-free investment strategy, investment decision making can still be difficult. For example, when markets fall dramatically, it’s hard to implement the required risk exposure rebalancing by selling safe defensive assets to buy risky growth assets. On the other hand, when markets are doing well it feels like there is less risk and less urgency to rebalance by selling growth assets and buying defensive assets.

But an objective strategy makes it clear what you should be doing, even if it contradicts what you feel. However, when each or most of your investment decisions reflect a heavy emotional commitment, there’s no guiding strategy. While you may derive some benefit from these decisions, you should understand that they aren’t likely to be consistent with giving you the best chance of achieving your desired future lifestyle.

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Your emotions complicate investment decision making

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