Working with Emotions
It is unrealistic for most investors to completely set aside their emotions when making investment decisions. Rather than trying to fight against emotions, it is better to be aware of them and cognitive biases that may be experienced when investing and put these into context to help safeguard against potentially impulsive or irrational decisions.
On March 9 2020, I divested between 50-60% of my portfolio. Many of those were energy names — some of which have come above the price I sold at, other still lagging below. At that time, fear had just begun to set in, and fear maximized around March 24th. It felt like the world was about to collapse and we would see 2008 prices within a week. Needless to say, the best time to invest is when fear is at its peak. In hindsight, more money should have been invested, but I continue to be bearish on the global economy and am in no rush to re-invest prior to the Nov 2020 elections and a potential second wave during flu season.
However, it is important to be aware of how cognitive bias impact investment decisions and gets us all in trouble by selling low and buying high. Cognitive biases that are potentially harmful to investors, particularly in the current climate, include (but are not limited to):
- Recency bias – emphasising recent events over historical events. Recency bias can cause investors to think that a rising market is likely to continue to increase in value or that a declining market will keep depreciating.
- Confirmation bias – interpreting or favouring information that confirms or strengthens your own beliefs. Confirmation bias can cause investors to be overconfident in their decisions if the information they are analysing appears to support their beliefs.
- Anchoring bias – relying too heavily on a piece of information or past event when making a decision. An investor with an anchoring bias may focus on historical prices when deciding whether to buy or sell an investment at the current price without considering the intrinsic value of the investment.
Stick to your long-term strategy
During a market cycle, it is common for investors to be optimistic or even euphoric when returns are positive and to be pessimistic when there is a market downturn. In reality, the peak of the market cycle when investors are feeling positive is the point of maximum financial risk and the trough of the market cycle when investors are feeling despondent is the point of maximum financial opportunity.
Six of the ten best trading days of the S&P 500 Index, which tracks the 500 largest US-listed companies, over the 20 years from January 1996 to December 2015 were within two weeks of the ten worst trading days (J.P. Morgan, 2016). This index returned an average of 8.2% p.a. during this period, however missing the top ten trading days (by being out of the market) reduces this average return to just 4.5% p.a., while missing the top 20 trading days resulted in just a 2.1% p.a. return (J.P. Morgan, 2016).
Take the time to reflect on the goals you are trying to achieve rather than on short-term market fluctuations. As has been the case in previous market cycles, investors who stick to their strategy during a downturn are rewarded with above average returns in the long run. As the old saying goes, “It’s not timing the market that allows for investment success, but instead, time in the market.”
Maintain a diversified portfolio
Diversification is an important risk management strategy and means investment success is not reliant on the performance of a single investment.
A diversified portfolio would typically be invested across a range of different investment classes such as fixed interest, shares, property, and infrastructure. This can be done through various investment vehicles including ETFs. For an idea of my portfolio diversification, check out my post on how I manage my portfolio.