25th July 2012
Mind vs emotion – keeping a cool head in volatile markets
Why letting your emotions rule your head when it comes to money can lead you down the wrong investment road.
In times of market volatility emotion can overrule logic when it comes to investment decisions.
Constant media coverage about falling share prices and declining fund performance can help to create enough panic among investors to cause them to sell up and invest in cash, a move that may come at a cost in the longer term.
The problem is that while cash doesn’t suffer from the same ups and downs as shares and other investments, there’s a price for that peace of mind. You lose the advantage of already being in the market when confidence and prices recover. It means that you may have sold when prices were low and, to get back into the market, you may be buying at levels higher than you’d like – far removed from the adage ‘buy low, sell high’.
The cashing up catch
At the height of the Global Financial Crisis (GFC), John Dunbar* was so worried about the direction of share markets that he called his financial adviser and asked that his small investment – a fund put aside for holidays and emergencies – be converted to cash.
That was a major concern to financial adviser Michael MacQuillan from Priority Planners. “John was afraid the markets would keep falling and wipe him out,” he says.
While the market activity appeared frightening at the time, MacQuillan explained that the investment strategy he and John had worked on was sound.
“We had established his objectives, and most of the portfolio was not affected by the crisis, such as his home, an annuity and a small Centrelink pension,” says MacQuillan.
Nonetheless John was adamant about converting his holiday fund to cash.
“It meant that he realised his losses and locked into cash, thinking: ‘Well, I can’t lose any more’. But as I explained to him, if you opt out of the market you can’t take advantage of the recovery that will eventually come,” says MacQuillan.
“The holiday fund was a small part of his total financial assets when you take into account his house, the bank savings and the annuity. So his decision was definitely based on emotion rather than logic.”
Going against trend
Of course John wasn’t alone. The trend is that investors flee the markets in droves when prices are at their lowest. It’s partly fear, as they watch the value of their portfolios drop, and partly the strong desire to follow the crowd, a sort of reverse gold fever.
Then, when markets trend higher, more investors than ever are attracted to the activity. This is often influenced by views of peers as they share their views about buying and selling at that particular time and by increasing media and internet coverage.
When markets are rising the term, ‘irrational exuberance’ is often applied to the frenzy of buying, after the former US Federal Reserve chairman, Alan Greenspan used it in a speech in 1996 causing a strong reaction in global share markets.
“On the downside, during the crisis, we saw ‘irrational pessimism’ when it came to the values of some assets,” says MacQuillan.
But history shows that those who are able to withstand short–term fluctuations in their portfolios can look forward to improved growth over the long–term.
We are our own worst enemy, writes finance guru and economist James Montier in his book The Little Book of Behavioural Investing (John Wiley, 2010). We are all prone to stumble into “mental pitfalls”, according to Montier. “This is true in investing as it is in every other walk of life.”
One example of these mental pitfalls is the attempt by many investors to try to time their entry into the markets as well as their exit aiming to sell at the top and buy at the bottom.
Few succeed, notes Montier, citing an annual US study that compares the performance of the S&P 500 over the past 20 years with investors’ actual returns. While the index increased an average 8 per cent per year, investors in equity funds reduced this performance to just 1.9 per cent as a result of “buying and selling at just about the worst possible point in time”.
Taking out the emotion
It’s not always easy to find the courage to go against the crowd or to hold out while markets are falling, even if it might be the rational thing to do. The point is, you might choose to change your investment strategy, but do it after calm consideration and good advice.
MacQuillan has two tips to help stop the emotional rollercoaster.
- Setting your investment goals with your financial adviser is a good place to start. Then you’re able to put in place a plan for your portfolio that will see it through times of market volatility. That’s because it takes account of the level of risk you’re prepared to take and match investments accordingly. You can calculate your risk profile using our risk profile calculator at wealthgeneration.com.au
- Your planning should also include ensuring that your investments are diverse; covering a range of markets, products and sectors. In that way, when some investments are down, others may be up. Diversification helps to keep your portfolio (and perhaps your response to volatility) in balance.
4 strategies for good decision making
While emotion governs the majority of human decision making, being aware of behavioural biases can help you avoid them.
- Question your decisions: Are you making a choice based on emotion or informed financial analysis? You should always be able to provide a sound justification for your decision.
- Keep informed: Read a range of balanced economic analysis, such as that produced by reputable research houses (eg Standard & Poor’s) or organisations such as the Reserve Bank of Australia. Learn to sort fact from sensationalist media articles. Your financial adviser is a good source of high quality financial information
- Maintain a well–diversified portfolio: Diversification can assist in avoiding investment biases by helping you to see your portfolio as a whole, and part of a long term strategy. Investing through a managed fund can also help you avoid becoming attached to certain stocks and can be an effective way to diversify if you don’t have a huge amount to invest.
- Get advice: Professional financial advice is critical to investment success. Financial advisers have access to a range of material not available to individual investors. When you are making investment decisions, your financial adviser can help by offering guidance and a balanced viewpoint.
*Real names not used
This article was first posted on Wealth Generation Investor Resource Centre