Emotional decisions lead to losses; invest in the long term
March 4, 2016
Most often the stock market sleeps. Small gains and small losses and the bottom line is that not much happens.
Then the market awakes and all bets are off. Volatility brings out the worst in investors. Markets today are very volatile and therefore more people will be making mistakes.
Recent research from Rui Yao, an associate professor of personal finance at the University of Missouri, concluded people are “more likely to make investment mistakes during a down market.”
Investors that have an aversion to losses are most likely to incur losses. The main problem is converting financial assets into cash during a down market.
Yao said that people go to cash to avoid losses but when they sell, values have already declined and they don’t buy back until values have increased. That is exactly backwards.
If your portfolio has declined in value then you have already incurred the loss. Selling now does not erase your loss.
Selling means you will not participate in future gains when the markets recover their value.
Stock markets rise and fall. It is financially disastrous to participate in a stock market decline and not have the discipline to remain invested so you can also participate when markets rebound.
The theory is to buy low and sell high; however, human behaviour is our worst enemy. We do things backwards.
Yao based her research on the 2008 financial crisis by studying financial transaction data. She said “the real mistake is being inconsistent.”
Her recommendation was to have an investment strategy in place to protect yourself and then follow that strategy whether the markets are up or down.
In financial planning terms we refer to this as investing for the long term. Investing is risky and without the security of a long-term strategy and the discipline to follow it, individuals will have far inferior returns.
Investors have to anticipate how they will react to declining stock market values and if they are likely to sell at a loss it is our opinion that they might not be suited to make these kinds of investments in the first place.
A good measurement of your ability to stick to a long-term investment plan is to consider how you reacted when your portfolio decreased in value during 2008.
Managing your emotions is a critical ingredient to successful investing.
Being defensive with your investments should be based on evidence. Do what research shows to be the best solution.
Diversify your investments by maintaining an appropriate asset allocation mix between stocks and bonds. Strong diversification is necessary in managing risk.
Stock diversification should include having a significant part of those assets outside of Canada. Not all markets are identical so normal ups and downs are often less volatile when they are mixed together.
We know that stock markets are volatile. Stock markets are not predictable but your behaviour should be.