This article was first published in the 1st quarter 2018 edition of Personal Finance magazine.
It has been recommended countless times by successful investors that, if we want to become wealthier, we need to take on an element of risk when investing. Either that or winning the lottery, marrying rich or being lucky enough to inherit a large sum, which would probably have arisen as a result of a successful investment strategy with exposure to market risk.
Market risk is simply the possibility that you, the investor, experience short-term losses because of factors affecting the performance of financial markets. Higher exposure to this type of risk can set you up for higher investment returns over the long term. Obviously, these returns are never guaranteed, and herein lies the risk. We as investors want to achieve the highest returns with the least risk. In other words, we love the path of least resistance and prefer to avoid any uncertainty, especially when it comes to our money.
Your investment time-frame has a direct bearing on the amount of market risk you should be exposed to. For those of you who are averse to this game of seemingly risky behaviour, the alternative is not to be exposed to any market risk and rather invest in “safer” assets such as bonds and cash.
Banks are notorious for taking advantage of our concerns about risk and uncertainty by advertising products that are guaranteed, safe and secure. However, while your capital may be protected, you open yourself up to other risks, namely inflation risk and being locked in for extended periods of time.
The less market risk you are exposed to, the higher your inflation risk. Simply put, inflation will undermine your investment performance and erode your wealth. And being locked into an investment for a prescribed period can put you at risk of not being exposed to more lucrative investment opportunities elsewhere.
An example: between January 2004 and January 2016, the average inflation rate was 5.63 percent. Local listed property delivered an average annual real (after-inflation) return of 15.6 percent; equities delivered 11.75 percent, and bonds and cash delivered real returns of 2.32 percent and 0.98 percent respectively.
In this article, I look at the negative effects our behaviour can have on our investment performance and provide a simple strategy that, in all fairness, you probably know or have heard already.
Carl Richards, a Certified Financial Planner (CFP), columnist for the Morningstar Advisor and author of two books on investing, has been instrumental in bringing investor behaviour to light and coined the term “behaviour gap”. Simply put, his argument is that investors are the greatest threat to their own investments and end up with diminished returns because of their own behaviour. The “gap” is between what investments deliver and what investors receive, and it can be substantial. It represents the difference between staying invested over the long term and selling out prematurely or at the wrong time.
The issue is not that market risk is intrinsically bad, but rather we are bad at managing it. Dr Daniel Crosby, in his book The Laws of Wealth: Psychology and the Secret to Investing Success outlines the paradox investors face. He says that although “we must invest in risk assets if we are to survive, we are psychologically ill-equipped to invest in risk assets”. In other words, we are awful at dealing with volatility.
Volatility can be associated with severe highs and lows and linked directly to the “loss” of capital over short-term periods. To the average investor, volatility represents uncertainty, and uncertainty creates fear. As investors, our thoughts may easily focus on specific cases where people have lost large sums of money in market crashes. Our fear is that we may share the same fate. Even well-seasoned investors can attest to the fact that they have their limits when it comes to uncertainty over longer periods.
Our natural desire to preserve our capital in uncertain times and when markets are volatile can result in us making decisions that in hindsight we may regret. In this light, it is worthwhile to take a closer look at volatility and get a more accurate perspective of what is at stake.
Intelligent investors view volatility as an opportunity creator, but, let’s be honest, volatility is seen more widely as a 10-letter swear word. One of the greatest investors of our time, Warren Buffett, said that volatility should be seen as “our friend”, because it creates buying opportunities in the market.
One of the first fundamental truths I learnt about investing was the notion of buying low and selling high. Asset managers are always on the hunt for good quality shares that are either undervalued or at a fair price with acceptable long-term growth prospects. Opportunities to buy quality shares at discounted prices can arise very quickly in a volatile market. A good solid company in your portfolio with great long-term growth potential, run by a solid management team, at a cheap price is an easy win for the intelligent investor. As the price of the share appreciates over time, you are rewarded with a portfolio that grows in value. The main ingredient to this whole process is patience.
The reality we create for ourselves can be quite different. It’s not uncommon to choose a share that has already appreciated in value, as this is seen as a winning share that is doing well. Unfortunately, it’s now more expensive than it was, and potentially overpriced. It may be unwise to buy this particular share at this higher price.
The same goes for the selling of shares and moving to cash. The best time to sell a share is when it is trading at its highest value. However, our natural tendency is to sell when we have already witnessed a fall in value and want to offload this non-performing share in our portfolio. Unfortunately, it may already be too late. In these cases, it’s better to rather wait until the share has appreciated again before selling.
It is important to remember that a loss is only realised when you actually sell. A paper loss on your monthly or quarterly statement is not an actual loss until you pull the trigger and sell the shares. Volatility is temporary, but an actual loss is forever.
Our natural inclination to remain in control of our financial wellbeing is both understandable and commendable. Taking responsibility for our finances is important, but making decisions such as liquidating current positions during volatile market periods may go against the responsible behaviour we are trying to uphold. Our efforts at minimising these risks often increase the probability of those risks materialising. Our desire to time the market based on our emotional state increases the very risk that we are trying to avoid: the loss of our capital.
Dalbar, a research house in the United States, has been studying the effects of investors’ decisions since 1994, and they provide annual reports on investor behaviour. Their 2016 report shows that while the gap between the return of the average equity investor and the market represented by the S&P 500 has reduced over time, investors staying the course and holding their position in the S&P 500 earned almost double that earned by their counterparts who did not.
Market noise and loss aversion
Daniel Khaneman, winner of the Nobel Memorial Prize for Economics, in his book, Thinking Fast and Slow, discusses how our brains interpret information, and he applies this to behavioural economics.
Khaneman and Amos Tversky created and developed what is known today as Prospect Theory. Prospect Theory states that people make decisions based on the potential value of losses and gains rather than the final outcome. Their findings on loss aversion reveal that people are, on average, doubly affected by market losses than by market gains. This increased sensitivity to losses (perceived or real) provides more insight into investor behaviour and the potential knee-jerk reactions that follow losses.
Khaneman suggests that you can “save time and agony” by reducing how frequently you check on how your investments are doing. Observing portfolio performance daily and even monthly can be highly stressful if the performance is not meeting your expectations.
Today more than ever, we are subjected to information from every angle in the form of news, fake news, people’s opinions and market commentary. This information is readily available on our electronic devices 24/7 every day. It shapes our consciousness and our thought processes, directly affecting our mood and often leading to decisions that we regret later. Much of the information we are subjected to is not relevant to our situation and doesn’t add any value to our lives. Removing this noise is crucial for sanity to prevail and for you to make healthier decisions. A trusted financial adviser will help you to remove the noise and remind you of what is important and relevant.
Reducing the behaviour gap
All investors, even those with years of experience, need to be kept reminded of the fundamentals of investing. Jumping in and out of the market when we think the time is right is undeniably a powerful temptation, but we can’t afford to be influenced by our emotional state and need to remain objective. Timing the market is a fool’s errand and doing the same thing over and over and expecting a different result is just insanity. We need a paradigm shift in how we think about investing and how we perceive volatility.
Ideally, the best course of action is to take emotion out of the equation altogether. Emotion confuses issues, clouds judgement and has the potential of diminishing your investment returns. Often,m the best financial advice doesn’t make much sense at the time because your emotional state is telling you to take a different path.
Ben Carlson, in his book, A Wealth of Common Sense (Bloomberg Press), recommends six courses of action to follow throughout your investment career:
- Think and act for the long term;
- Ignore the noise;
- Buy low, sell high;
- Keep your emotions in check;
- Don’t put all your eggs in one basket; and
- Stay the course.
These simple principles are what separates successful investors from unsuccessful ones. Our avoidance of market risk during volatile periods can be one of the riskiest decisions we make if we are long-term investors. It is one thing being a successful investor over a year or two, but it is another thing staying successful over the long term.
Seeking objective, sound financial advice, particularly in uncertain, volatile times, is crucial for a successful investment strategy. A financial adviser can provide the right coaching today so that you are mentally and emotionally prepared for what is to come tomorrow.
Paul Roux, who has the CFP designation, is a trust officer at Personal Trust in Cape Town.