Your friends and family may offer you financial advice with good intentions, but you should be wary of basing your investment decisions purely on stories shared “around the braai”. Lettie Mzwinila explains.
People love to give advice, especially the people closest to us – our family and friends. And while we are often able to be circumspect, sifting out what is irrelevant to us, it can be difficult to resist taking financial advice from family and friends, especially when they appear to have done well for themselves.
Several studies in behavioural economics have shown that loved ones can have a strong influence on our investment decisions. This is because money is personal, and when it comes to our hard-earned cash, we tend to value advice from people who we believe always have our best interests at heart. However, while our social circles may mean well, taking investment advice from someone who is not qualified to offer it could lead you down the wrong path and to potentially bad outcomes.
Take the bitcoin frenzy, for example. For many experienced investors, bitcoin is a risky investment because one can’t determine its real value using the usual methods for valuing an asset, such as cash flow, historical prices, and supply-demand analysis. The value of a bitcoin is determined purely by how much someone is willing to pay for it, therefore it is difficult to predict its future value.
...taking investment advice from someone who is not qualified to offer it could lead you down the wrong path...
However, despite the high risk of capital loss, scores of people around the world flocked to buy. Everywhere you went, someone was willing to bend your ear about what a great investment it was. This frenzy drove the “value” of bitcoin to historic highs before it crashed, resulting in significant losses for investors, many of whom had bought at the peak of the bubble.
The bitcoin bubble is a good example of the importance of making well-considered investment decisions. Before acting on investment advice from your social circle, you need to carefully consider what you are trying to achieve on the one hand, and the real value of the potential investment on the other.
There is no one-size-fit-all
Your decision to invest should be based on your circumstances, your appetite for and tolerance of risk, your objectives, and your investment horizon (the length of time you expect to hold the investment). Your social circle may suggest an investment based solely on potential returns, without considering your needs, and this could impact your investment success.
...Your decision to invest should be based on your circumstances, your appetite for and tolerance of risk, your objectives, and your investment horizon...
For example, your friend tells you about a unit trust that has been performing well and that they have enjoyed good returns over the past few months. This is exactly what you’re after. However, what your friend neglected to tell you – and what you would have discovered if you did some research before investing – is that the unit trust’s objective is to deliver returns over five years, meaning that you may experience dramatic ups and downs in performance over the short term.
Now, if your goal is to save to pay your child’s school fees in advance at the beginning of the year, then this investment is not ideal for you. The reason for this is that you may need to access your money sooner than five years and risk withdrawing from the investment during a period of volatility, which could result in a permanent loss on your initial capital.
Your friend doesn’t have the full view of your needs, and you don’t have the full details of the characteristics of the investment. That can lead to a mismatch.
A good story doesn’t equal good value
The investment world is filled with stories about seemingly impressive investments, and many people find themselves getting sucked in and making impulsive decisions to invest without doing the necessary research.
However, just because the news about an investment is good doesn’t mean that it’s a good investment - or that it's the right time to invest. This is because, when the short-term outlook of a company is good, the market tends to extrapolate this into the earnings outlook of the company rather than assessing its long-term earnings potential.
The same goes for bad news: Investors often operate under the assumption that if the news is bad, so is the investment. This is not always true. When market sentiment is negative, you could be looking at an excellent investment opportunity. Bad news pushes prices down – but this is often temporary.
Popular investment advice is often based on short-term performance
Investment advice from our social circles is often based on the short-term performance of a particular investment or headline news. And despite the counsel that it’s "time in the market" that counts and not "timing the market", we are swayed by recent performance to buy investments that are doing well, and similarly, sell out of investments that are performing poorly - a sure way to destroy value.
Investing is a marathon, not a sprint. To give yourself a better chance of success, take a long-term view rather than continually chasing the short-term winner that everyone at the braai was talking about. If they are talking about it, this “sheen” will be reflected in the price. Paying too much for an asset is a sure way of losing money over the long term.
How to make the right investment decisions
To be a successful investor takes discipline. You have to learn to ignore the investment noise – information that is not useful to your long-term goals or that distracts you from them. The following steps will help you sift investment tips to determine what is useful and what you should ignore.
1. Establish the facts
When it's your money on the line, don't assume that your friends have done the research. You should also guard against cherry-picking information that confirms your views. Before investing, carefully investigate the investment to determine whether it is appropriate for your needs. For example, if you are investing in a unit trust, study the factsheet to see whether its objectives and timeframes align with yours.
2. Consider the motivation
Studies have shown that people often encourage their loved ones to take risks that they would shy away from. This isn’t because they have ulterior motives; rather, they simply have not fully considered the implications of that decision.
3. Consider the worst-case scenario
What if your friends were wrong about the investment? Or what if you were investing at the wrong time - buying when the price is high, thereby setting yourself up for poor returns, or worse, losing money? Considering the worst-case scenario will help you make a more considered investment decision.
4. Avoid changing direction too often
You are likely to receive a lot of advice from people around you. Reacting to even a portion of this is likely to lead to poorer investment outcomes. It is much better to be clear about your investment plan and stick to it.
5. Seek good independent advice
Many investors are reluctant to pay for professional advice, but it can be more costly to pursue free tips from someone who is not qualified to give financial advice. A good independent financial adviser can help you select an investment that is right for your circumstances, and help you manage your behaviour while you are invested to improve your investment outcomes. A key consideration in selecting an adviser is trust. In this instance, a suitable starting point in looking for one is to ask for a recommendation from someone whose judgement you value - like family or a good friend.
This article was published on the Allan Gray Website on 29 July 2019.