Behavioural Finance

What makes investors happy?

We all want good returns; and we all want to be happy. In investing the two are
closely related, but are there aspects of how we invest that make us unnecessarily
miserable? Or which cause us to focus on the wrong things, make poor decisions,
and get lower returns as a result? Fortunately, we can now shine a scientific light on
these questions.
Back in 2008 we designed a survey that, for two years, we would send to investors
managing their own investments on Barclays Stockbrokers. We measured their Financial Greg B Davies
Personality and every quarter we asked about their attitudes towards investing, and their
+44 (0)20 3555 8395
market expectations. And we asked them how happy they were with their recent returns.
greg.davies2@barclays.com
The first survey went out in September 2008, and was rather overshadowed by the
simultaneous onset of the financial crisis. However, over the next two years we collected
a unique data set on investor attitudes during times of extreme market turbulence, which
we have shared with academics, resulting so far in four published papers1. The most recent
was published in August2 and focussed on understanding Investor Happiness.

Returns do make us happy

Figure 1 summarises the distribution of returns assigned to each rating category, from
1(extremely bad) to 7 (extremely good), over the whole study3. The solid line shows the
average quarterly past return that corresponds to each rating. Gratifyingly, we can confirm
the obvious: higher returns are rated as better.

FIGURE 1: How satisfied are you with your returns?

50%
40%
30%
Quarterly Returns

20%
10%
0%
-10% 1 2 3 4 5 6 7

-20%
90th Percentile
-30%
Median
-40%
-50% 10th Percentile

Rating of Quarterly Returns (1 very low; 7 very high)

Source: Merkle, Egan & Davies, August 2015

When people assign the worst rating of 1, their returns were on average below -20% for
the previous quarter. A neutral rating of 4 corresponds to an average return of 1%, neatly
dividing the ratings between gains and losses. For positive ratings of 5 to 7, returns on
average had to be clearly positive, ranging from 9% (for 5) to almost 25% (for 7).

1
Weber, Weber & Nosic (2013), Review of Finance; Merckle & Weber (2014), Journal of Banking and Finance; Egan, Merckle & Weber (2014), Journal of Economic
Behavior and Organization.
2
Investor Happiness. Merkle, Egan & Davies (2015). Journal of Economic Psychology.
3
Each quarter each respondent was asked: How would you rate the returns of your portfolio over the past three months?

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 Behavioural Finance

However, there is huge disparity in the ratings given to particular returns at different times.
The dotted lines show the (broad) range within which 80% of the responses sit. A negative
return is almost never rated as good (above 4), and a positive return almost never as very
bad (below 3). However, investors clearly vary considerably in what makes them happy at
different times. So, at times, for some respondents a return of 10% is required for a neutral
rating of 4, and at other times respondents will consider even a loss of -10% as a neutral
experience. A quarterly loss of -7% could be given any rating between very bad (1) and
neutral (4) depending on the timing and the individual. What drives these shifts?

Why there is more to it

Firstly, ratings are considerably more influenced by perceived returns than actual returns,
which matters, since investors are frequently inaccurate when estimating their own returns4. Good decision-
We often dont accurately account for the effects of withdrawals and contributions on
making requires
our portfolio, and we fail to integrate returns on individual investments into an accurate
assessment of our overall portfolio returns. So we can easily find ourselves unduly elated, emotional responses
or miserable, which may have detrimental effects on our subsequent investment decisions. that are aligned to
Second, those who think their portfolio will be more risky over the following three months what were trying
tend to give any particular level of return a lower rating than those who think they are in
toachieve
a position of safety. This seems reasonable: if we think our gains may be reversed in the
future, or were exposed to further losses, then we should be less satisfied with past returns.

Third, we are strongly influenced by the markets performance at the time. A return of
5% in a down market is likely to feel much better than the same return when markets are
booming. For example, in December 2008, just after the gut wrenching initial stages of
the crisis, a loss of 1% was, on average, given a positive rating of 5. Investors were pretty
pleased if they had only incurred a small loss. A year later the same return was only rated
on average as a 3. An emotional response to short-term performance relative to the market
is not necessarily unreasonable, but can easily result in poor decisions for long-term
investors (and any other sorts are gamblers, not investors).

Less reasonable, though, is a related effect. Respondents were also asked: compared to
other investors, how well do you think your portfolio performed in the past three months?
Responses to this question had a substantial effect on happiness, over and above perceived
performance relative to the market. Indeed, adding this better than others feeling of
superiority or inferiority means that investors on average care more about performance
relative to something else (the market, or other investors) than they do about their actual
returns. This keeping up with the Joneses effect can lead both to unnecessary anxiety over
the investment journey, but also to making decisions on overly short time frames, and in
response to signals that are essentially irrelevant to good investing.

What should make us happy?

Good decision-making requires emotional responses that are aligned to what were trying
to achieve. In particular, in the uncertain world of investing even the best-constructed
portfolio will experience numerous short-term moves dictated by essentially unpredictable
random events. If we are overly satisfied with good outcomes, we may fail to rebalance, be
tempted to chase the trend, or buy high. If were excessively dissatisfied we may sell low,
or be tempted to make unwise changes to our portfolio. What information should we focus
on, and what should we avoid, when evaluating our investment performance?

For example, see Glaser & Weber (2007), Finance Research Letters.
4

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 Behavioural Finance

What really matters is a) how your total wealth has performed, b) over the long-term, c)
relative to the risk levels you were prepared to acceptso the focus should be firmly on
long-term absolute returns to overall wealth. Worrying about anything else is likely to be
a distraction. In particular, worrying about how one has done relative to others leads to
stress and anxiety (if your glass is half empty), or over-confidence and irrational exuberance
(if half full). In any market, some investments or asset classes will (unpredictably) do much
better than others, and some much worse. For any sensible diversified portfolio there will
be alternatives that performed better, or worse. Stop worrying about them. All that should
matter to you is how your portfolio is doing relative to the risk-return expectations that are
appropriate for your Risk Profile.

Does this mean that comparing your portfolio to a benchmark is never advisable? Not quite:
if youre seeking to outperform a passive index on sub-components of your portfolio (or
All that should matter
paying for a manager to do so), it is reasonable to ask whether this has resulted in better
performance than you could have got from a simple, cheap and passive portfolio. So, using to you is how your
a benchmark to judge the value of investment skill for a particular part of your portfolio is portfolio is doing
valid.
relative to the risk-
Using a benchmark to judge total wealth outcomes is not. For your total wealth there is no
perfectly appropriate benchmark: any choice, even of approximately equivalent risk level,
return expectations
could result in better or worse returns than your portfolio, for entirely random reasons. For that are appropriate
example, during the internet bubble at the turn of the millennium, sensible investors who for your Risk Profile
didnt get caught up in the frenzy significantly underperformed any market benchmark
for several years. This comparison led many to feel dissatisfied and left out, resulting in
dangerous and costly herd investing.

Eliminating unnecessary distractions

Instead of comparing performance of your overall wealth to an (always more or less arbitrary)
benchmark, investors would do better to ensure they accurately understand their absolute
increase or decrease in wealth over sufficiently long periods of time (at least 3 years, but ideally
longer), and compare this to just one thing: where does this value sit in the range of outcomes
that would have been anticipated for their risk profile over the same time period. Only if your
wealth is outside the upper or lower ends of this range do you have real cause for exuberance,
or misery. This stops us focusing too much on short-term fluctuations; it stops us focusing too
much on sub-components of our portfolio, rather than our wealth as a whole; and it stops us
worrying excessively about how everyone else, or the market, is doing.

Fretting about your returns relative to other people, or the market, will only make you anxious,
and prone to herding or inaccurate beliefs about your skill and inevitably, worse decisions.
Instead, avoiding the lure of benchmarks and the Joneses will lead to better alignment between
your emotions and what really matters, and to better investing decisions over time.

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Item Ref: IBIM5132 December 2015 | CP 53171-15