Why you should listen to your little voice and do the exact opposite to become a successful investor
losing hurts more than winning
No one likes to lose, in fact losing has a bigger impact on us than winning. Studies on “Loss Aversion” which show that incurring losses may be twice as powerful psychologically as the equivalent gain. From an investment perspective this makes us act in ways which can be contrary to our long term benefit. So let’s look at what we do and how we do this.
Taking our medicine
When there is a market correction our gut instinct is to get out, sell our positions and move to cash. What does this actually do for us? Nothing! well really it does more than nothing it puts us back with no hope of moving forward. It makes losses real and takes us out of the market excluding us from the inevitable recovery that will come. Markets recover, sometimes this is a quick bounce, other times it can be a long slow protracted recovery.
This is the situation that we seem to struggle with preferring instead the safety of cash. The key here is that markets do recover and our investment in them should be money that we don’t need in the near future. So why not just leave it alone?
the best option
Actually the best thing that we can do in these situations is to add more money. During these twitchy uncomfortable market maladies when the last thing we feel like doing is investing is when we should.
Adding additional capital when markets are down does a couple of things. Firstly it means markets don’t have to come back to pre-crash levels before we’re back in the black. Second the losses don’t look as bad thus abating our internal angst. This is one of the reasons that regular contribution investment are so effective for long term savings goals.
the next best thing
If making an additional investment isn’t an option then don’t do anything except rebalance your portfolio. Sell what has made money and buy what has lost money. We don’t mean sell everything we hold in the money making assets, only the amount over and above the original allocation percentage. If an asset should make up 5% of our overall portfolio and it has grown over the past year and now makes up 7% of the portfolio, then we sell the additional 2%. Reallocate this surplus to holdings that have fallen below their original allocation rates. This has a similar effect to adding more money into the assets that have fallen in value during market corrections.
As a side note even if you are adding more money into your portfolio when markets fall you should also rebalance your portfolio once a year. This will only enhance your long term performance further.
it's not all the same
Just because there is an asset in your portfolio that is losing money right now doesn’t mean that you need to sell it. There is a common reaction from investors to want to sell assets that they see as being “underperforming ”. Sometimes this may well be very true (though proper asset selection prevents this), if it is then the asset should be sold. Though more often than not the issue is that the asset is in a down cycle.
So why isn’t this an underperforming asset? Every asset is cyclical whether it be bonds, equities (shares), property or commodities. This cycle can be influenced by external factors such as interest rates, government policy, climatic or conflict. They influence each asset type in different ways and a positive outcome for one may be negative for another.
too much of a good thing
If everything in your portfolio does the same thing at the same time, you could make some great returns, well, if you have the balls for it! If you don’t have a strong constitution then you have a problem because you will be in for a rocky ride.
a bit of variety
So if you are of the more conservative persuasion and prefer a smoother ride you are going to need diversity in your portfolio. This will mean that you have assets that do different things at different times. Whilst some holdings are going up in value others will go down and vice versa. The ones that are going down will do the job that you need them to do at some point in the future.
beware of fortune tellers
I here you say “well why don’t we buy these assets when we need them?” Well the reason for this is that market timing is a mugs game. Even if they know what is going to happen the most advanced predictive modelling systems can’t tell us when it will happen. Market timers generally buy high and sell low. This is because they get in after an asset has gathered upward momentum and sell as markets are on the way down. Plus how do you know we’re not experiencing a short term consolidation rather than a full blown downturn? The answer to that is, you don’t know and neither does anyone else irrespective of their personal opinions.
This is essentially why we should allocate in this way and accept that not all assets are going to go up in value at the same time. So if you think an asset is underperforming, before you do anything else check what it is doing against its peers and you may find that you have an asset that is outperforming in a downward market which is a very different thing. If it is underperforming then replace it like for like.
The conclusion to all of this is that if you have allocated correctly in the first place. Made investment decisions based on your investment timeframe and good asset selection. Then market corrections and cycles shouldn’t cause you enormous concern. Put the little voice in it’s place and do nothing.