By Paul Hutchinson, Sales Manager, Ninety One Loss aversion is a powerful concept in behavioural finance*. Simply put, investors are believed to feel the pain of loss twice as strongly as the pleasure of gain. Unfortunately, this theory is proven true time and again during market corrections such as we experienced this year. Unable to stomach losses, many investors panic and switch from their growth investments to cash, thereby crystallising what was until then only a paper loss. An analysis of the Association of Savings and Investment (ASISA) industry flows reinforces this. ASISA data for the periods around the last two bear markets (2002 and 2008), reveal that in the final stages of the bull market, investors were pouring money into equity funds. In the year following the stock market collapse, they were withdrawing money from equity funds and investing the proceeds into money market and income (lower risk/lower reward) funds. We considered the investor experience following all SA equity market corrections of more than 20% over the past 50 years, including this year’s correction. Since 1965, there have been no fewer than nine corrections where the market fell by more than 20%. Some observationsBear markets are often deep, but importantly short. Bull markets take longer to play out, giving rise to the over-used phrase; ‘bull markets climb a wall of worry’. Importantly, bull markets more than not reward those investors that stay invested. The recovery from the bear market is often very swift; anyone sitting on the sidelines is unlikely to benefit. With the benefit of hindsight, was the decision to switch to cash the right one? We considered the outcome of two investors who both invested R10 000 prior to each of the last 8 bear markets (i.e. at the market peak). Let’s call them Mo’ Money and Lo’ Money.While admittedly concerned about the impact of the market collapse, Mo’ Money weathered the storm, remaining invested throughout. Lo’ Money unfortunately could not stomach the impact of the collapse and switched to cash at the market trough. Then, true to the psychology of many investors, noticing that the stock market was recovering and not wanting to miss out, he reinvested into the market a year later. Lo’ Money subsequently repeated this behaviour in each subsequent bear market. The following table illustrates just how punitive Lo’ Money’s decision to switch to cash was on his potential retirement capital. Figure 3: Comparing staying invested versus switching to cash Bear marketMo’ Money experience (stay invested)Lo’ Money experience (switch to cash and repeat) Value of R10 000Annualised returnValue of R10 000Annualised returnOPEC increase ‘7115,407,97415.7%1,043,9529.7%‘739,754,81215.9%1,194,26810.8%Oil price shock ‘767,820,32115.6%1,568,15011.6%Rise in interest rates ‘822,095,30714.5%378,0589.7%Black Monday ‘87439,14312.3%153,7158.7%Russian Debt Crisis ‘98110,92011.7%53,3718.0%Dotcom Bubble ‘0267,71711.3%38,3267.8%Financial Crisis ‘0820,7046.3%15,1403.5% Some observationsIn every instance, the switch to cash was detrimental to Lo’ Money’s total investment return. The power of compound interest is evident over the long term; R10k grew to R15.4mn over approximately 50 years. A 6% p.a. higher annualized return over a 50-year period results in 15 times more money at the end of the period. Many may argue that 50 years is too long an investment time horizon but consider someone starting work in their early twenties; he would (should) save for retirement for forty years and then expect to live off his retirement savings for a further 25 or so – a total investment period of 65 plus years! All the above returns take into account this year’s significant fall in equity markets. This is most evident in the relatively low 6.3% p.a. annualised return for the investment made prior to the 2008/9 Global Financial Crisis – this shorter time frame also included two major market corrections. When the market recovers so the annualised return will improve. As a final point, we considered the case where Mo’ Money invested R10 000 at the peak prior to each of the last 8 bear markets (i.e. a total investment of R80 000) and compared that to Lo’ Money making the same investments at the peak, but then at the trough of each bear market switching his accumulated investment to cash for a year before switching back to the market. The results are astounding. Over 50 years Mo’ Money’s investment grew to approximately R35.7 million (an annualized return of 15.6%), compared to Lo’ Money’s R4.4 million (an annualized return of 10.4%).There are several behavioural biases that lead to investment mistakes. During these uncertain times, together with your financial advisor, you need to revisit your long-term financial goals and stay true to the plan you have in place together to achieve them. In our view, the optimal investment solution for many investors may be an inflation-targeted multi-asset fund that also seeks to shield investors from negative market corrections. *First articulated by Kahneman & Tversky in 1979This post and content is sponsored, written and provided by Ninety One.