Striking a balance

03 July 2020

6 minute read

By Alexander Joshi, London UK, Behavioural Finance Specialist

Are you a trader or an investor? We examine the differences between the trader and investor mindsets, and how striking the right balance between the two may help to maximise long-term investment returns.

Market participants continue to assess the full extent of the potential implications of the pandemic on economies and financial markets. There was a surge of buying in June into a small pocket of the market in companies recently filing for chapter 11 bankruptcy protection. This was partly driven by novice investors signing up to commission-free trading platforms, seemingly chasing large short-term gains. What might be regarded as day traders.

Given the high risk of participating in such markets, where moves are driven by factors other than company and economic fundamentals, this behaviour is more akin to speculating as opposed to investing. While trading and investing are sometimes used interchangeably, they are very different approaches. That said, we explore why a mix of both approaches might be worthwhile for a disciplined investor.

Tale of two mindsets: the trader

While trading and investing both seek to make financial returns, trading focuses on short-term profits, whereas investing generally aims to provide long-term gains.

The trading mindset typically involves looking for short-term opportunities, which may be created by changes in economic data and stock market sentiment. This may involve continually evaluating the incentives offered in different parts of the market relative to a range of plausible eventualities.

For example, in the midst of a sell-off, a trader may feel that the market is too bothered by the negative possible scenarios instead of having a more balanced view of the potential outcomes. A trader may add exposure to stock markets, seeking to prosper from a market reversal once sentiment improves.

The investor

An investor, on the other hand, may view success in protecting and growing their assets over the long term as being determined by asset allocation and the quality of the assets in that allocation.

The above allocation is generally based on a view of how different investments are likely to perform over the longer term. The approach is built on the premise that a well-diversified portfolio that aims to weather the full range of market conditions can provide an investor with a higher chance of success than trying to avoid the next downturn.

The investor tends to be less focused on short-term events and news flow, which while leading to short-term movements, may not be material to a diversified portfolio held for the long term. As discussed in May’s Market Perspectives, a portfolio diversified across asset classes, geographies and sectors, is unlikely to fully experience the impacts of headline market moves.

The costs of doing too much

While the investor and trader approaches have the potential to create financial gains, in markets, as in all aspects of life, there can be too much of a good thing.

An over-reliance on a trading approach can create risks. Firstly, not every market call will go to plan. Indeed, markets can behave very differently to how we may expect, based on the headlines. Secondly, a trading mindset can introduce behavioural biases into the decision-making process, which while not always visible to the trader, can be a drag on returns.

A trading mindset can introduce behavioural biases into the decision-making process, which while not always visible to the trader, can be a drag on returns

The disposition effect

One behavioural bias is the disposition effect – the tendency to hold on to assets that have fallen in value, and sell those that have risen in value. This is usually driven by not wanting to realise losses while wanting to realise wins. It is motivated by the pain of losses, which has been shown to have twice as large an impact on us than equally sized gains.

The larger number of decisions being taken, over short periods of time, introduces more decision-making points and can increase the likelihood of biases. Behavioural studies show that investors who hold common stocks directly pay a significant penalty for active trading. Overconfidence is often cited to explain high trading levels and the resulting poor performance of some investors. Due to a tendency for people to act in fairly systematic ways, behavioural biases can be exploited by other market participants.

The costs of doing too little

In his annual letter to Berkshire Hathaway to shareholders in 1996, Warren Buffett remarked that “Our portfolio shows little change: We continue to make more money when snoring than when active. Inactivity strikes us as intelligent behaviour.”

While a focus on the long term may protect an investor from the risks associated with making short-term market calls, giving less weight to short-term signals can also create risks. Missing out on potential additional returns from seeking to capitalise on short-term moves may seem like small percentages, however these can compound. Over time, they may have far more significant cumulative impacts on portfolio returns than initially thought.

As asset values change, so asset allocation can shift considerably from what was originally planned by the investor. A buy and hold portfolio can then become less diverse over time on its own, and that is before the potential opportunities for diversification that may be missed.

Striking the right balance

One of the best ways to increase the likelihood of success when investing is to follow a robust process which strikes the right balance between long term thinking to generate the core investment returns, and the more reactive and opportunistic short term tweaks to allocations to maximise overall returns. As well as robust asset allocation, a strong investment process will involve reviewing and selecting the best fund managers for a mix of investment styles, and the right mix of quality funds and securities to most efficiently and effectively implement the allocation views.

A robust investment process creating a diversified portfolio for the long term and investing in quality assets should make it easier to stay invested and reap the benefits of time in the market. It can help an investor to protect themselves from behavioural risks in what may be volatile and unnerving market conditions.

A particularly volatile period in an uncertain, post-pandemic, world may create potential market dislocations. Most likely providing opportunities for active managers to capitalise on. By additionally monitoring current investments with the changing economic and market conditions, portfolio risk can be managed. Additional opportunities to enhance the risk return profile can also be capitalised on, creating the best of both worlds.


Market Perspectives July 2020

Financial markets have had a very strong second quarter, despite geopolitical tensions and fresh outbreaks of COVID-19 in US and German states and in Beijing.


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