While the human brain has evolved to help us make decisions under conditions of uncertainty, nothing could have prepared us for the complexity of the stock market. We are ill-equipped and exposed to emotions and mental biases that have the potential to destroy wealth faster than the worst bear market.

One insight that can make a big difference to long-term financial planning is that, on average, shares have outperformed cash and fixed interest investments by around nine percent annually. Barring extreme events, this basic relationship should continue to hold true. The return above the cash rate from shares is called equity risk premium, but we’ll call it The Prize. It is one of a handful of resilient forces in the world of investing.

Say you invest R50 000 today and received a seven percent return for 30 years, compounded monthly. Ignoring inflation and taxes, and assuming you reinvest all income, after 30 years you would have R405 825.

Now, what if you could turn that R405 825 into more than a million rand? If you invest the same amount of money over the same 30 year period, but this time your average return is nine percent higher (which equates to the lower end of the historical range of the equity risk premium in the USA). At the end of the 30 years you would come away with R5.885-million and suddenly your retirement is a brighter proposition and your ability to make the most of life’s choices improves dramatically.

It is no exaggeration to say that funding retirement aspirations is one of the biggest challenges in the developed world. With planning and foresight most people can meet this challenge. Your future lifestyle will depend on how you want to live and how much money you have to finance your lifestyle.

Difference between success and failure

A good financial adviser can give you a portfolio that is diversified across the asset classes from shares to property, bonds and cash and one that at least mirrors the long-term performance of these markets. The difference between success and failure is not how investment markets behave — we know they generally do well over the long term — but how you, as an investor, behave.

By investing in a quality diversified portfolio of shares (available from any number of competent fund managers) it’s actually quite easy to capture The Prize. Yet, the distractions for investors are becoming greater as volatility within individual stocks increase.

The Strategic Economic Decisions (SED) Group cites the following reasons for increased risk in markets:

• Investor response is more concentrated.
• Greater focus on short-term results.
• Increased uncertainty about valuing stocks.
• Infectious beliefs among investors.
• Greater use of borrowed money to invest.

Research suggests that investors detest the way a loss makes them feel even more than they fear the loss itself. It appears the emotional impact of a loss, in particular the sense of regret, may have an equal or greater effect than the financial loss itself.

Risk-averse investors lose out on the possibility of significant gain

When we take investment risks, we should acknowledge that it involves accepting the possibility both of making a loss and of experiencing regret. We need to work against the brain’s response mechanism, which says it is more important to get through today than to worry about the future. Risk-averse investors may avoid loss, but in doing so they also lose the possibility of significant gain.

Why is The Prize so generous? Leading authorities on behavioural finance, Shlomo Benartzi and Richard Thaler put forward a convincing explanation, which they call the ‘myopic loss-aversion’. Presume you have the choice of investing in either of these two assets:

• A risky asset expected to return seven percent annually on average, but subject to all the ups and downs of the market.
• An asset that pays a guaranteed one percent annually.

Which would you pick? For an investment over a single year, an allocation to the risky asset would be considered a gamble. However, over a five-year period or longer, the risky asset would start to look attractive as the length of time would generally allow markets to recover from a fall.

Time is an important factor influencing investment decisions. Suppose that, even if you have invested for 30 years, you receive a report every six to 12 months from the manager of the risky asset showing you its price. Would these performance updates affect your decisions?

Researchers have found that investors who check their returns over short time periods are likely to be influenced more by their ‘evaluation period’, the frequency with which they check returns, than by their investment time-horizon. If they don’t like what they find, they will sell some or the entire risky asset, despite its long-term prospects.

This is one of the reasons why The Prize from a sensible share market investment is long term as high as it is — a fact that astute, emotionally strong investors can benefit from.

"I have always preferred a bumpy 15 percent return to a smooth 12 percent." — Warren Buffet

One of the keys to Warren Buffett’s investment success has been his willingness to embrace volatility. He recognises that those who have the mental resilience to weather rises and falls will win The Prize. He says, “I have always preferred a bumpy 15 percent return to a smooth 12 percent.”

Arun Abey is a co-founder and international strategic adviser to acsis, an independent financial services group based in South Africa. He is also is a co-founder and executive chairman of the financial advisory firm ipac and Head of Strategy for AXA. He coauthored 'How much is enough?' (distributed by Blue Weaver Specialist Publishers and available in all good bookstores).