May 1, 2020
Why do investors make poor decisions in down markets?
Guest author: Nick Carr from Your Money Blueprint . Re-published with his permission.
Judging by many of the questions I receive, and the posts I see in community forums, investors make much worse decisions in down markets than they do when the markets are increasing.
I’ve seen all the below mistakes:
Moving from a growth fund to a conservative fund, even when you don’t need the money for over 20 years.
Selling your shares and locking in your losses.
Large chunks of money going towards individual stocks.
Remaining out of the market.
Putting down a significant lump sum because someone said stocks were on sale.
Looking at the share market value every day.
Common investor mistakes in a bear market
We will address why I consider each of these a mistake. When discussing these we will assume that the investor was originally invested according to their goals, risk tolerance and time horizon.
1. Moving from a growth fund to a conservative fund, even when you don’t need the money for over 20 years.
This is one of the most common mistakes. The range of thinking here is “I am scared and don’t want any more losses” to “I think the market will continue to drop and I will just buy back in when the market recovers.”
By moving to a conservative fund there are two problems. Number one – You have locked your losses. Made them real. If you don’t sell, there is every chance your balance will return to beyond its previous high. By not selling, you don’t crystalise any losses. Number two – When do you make the switch back to growth? There is no one ringing a bell to tell you “now is the time”.
2. Selling your shares and locking in your losses.
Touched on above. You don’t have to realise your losses if you have the time to ride them out. Eventually, the economy will move forward again. It never feels like it at the time, but it is true. Progress is a natural act of humanity.
3. Large chunks of money going towards individual stocks.
When the markets drop out come ALL the punters trying to pick an individual company that will do better than anyone else out of the downturn. In volatile markets such as what we are seeing during the covid-19 pandemic, you will even hear stories of how someone has doubled their money in a week through an individual pick.
It has been shown time and time again how risky picking individual stocks is, and how few active investors outperform the market.
What do you know that the thousands of professional investors don’t know?
4. Remaining out of the market.
So you have sold your stocks and are staying out of the volatile market. You are now missing out on investing each month at lower stock market values. That is where the real returns are made. When stock prices are lower, you can buy more stocks. You will realise the returns once the market recovers. If you buy back in once the market recovers, you have missed out on the good value. You will be buying less stocks for the same price, than someone that stayed in the market.
The other point to be made is how will you know when to come back in? With Covid 19 there was a sharp recovery after the initial 30% drop. If you sold after a 20% drop, the markets recovered to that point very quickly. Blink and you missed out. Now you are in a position of deciding whether to buy back now at higher prices than you sold, or waiting it out some more. What if you are waiting, waiting, waiting, and the price never comes back down to your sale price? You are now missing out on some great returns.
They say the best investors are the accounts of dead people because they don’t touch their investments. Their money remains invested. Riding the highs and lows, instead of trying to time them.
5. Putting down a significant lump sum because someone said stocks were on sale.
I frequently see people saying “stocks are on sale” when they go down by just 5% or 10%. Even though they went up 30% the year before. So they are only really the same value as they were a few months earlier. That is not a sale.
Step back, take a look at the big picture. We tend to ignore the markets when they are doing well and forget they have done so well. It’s become so common that everyone is shocked when the markets drop by even a bit, that they call it a sale. What the markets did between 2010 and 2019 was not normal. That was a huge bull run that is unlikely to be experienced anytime soon. It’s not just the fact that the bull run lasted so long, but more how calm the run was. There was hardly any volatility. Typically, markets will go up and down on a more regular basis, but not the latest bull run. It was a pretty calm ride.
This has resulted in people thinking drops are not normal. They are normal though. This is not a sale. This is normal. This is Briscoes normal.
Sure, put down a lump sum if you like, but if you do, don’t be surprised for prices to go lower still. And why do you have so much sitting on the sidelines? Which goes back to point number four.
6. Looking at the share market value every day.
I see a lot of people looking at the markets every day. If you are invested for the long term then what favours are you doing yourself by looking at the markets so frequently. The more frequently you look at the markets, the more likely you are to see losses. The more often you see losses, the more likely you are to do something stupid.
Check your investment account daily and you are about 45% likely to see a loss.
Check your investment account quarterly and you are about 30% likely to see a loss.
Check your investment account yearly and you are about 25% likely to see a loss.
Check your investment account every 5 years and you are about 15% likely to see a loss.
Check your investment account every 10 years and you are about 5% likely to see a loss.
Check your investment account every 20 years and you are about 0% likely to see a loss.
The more often we check the value of our portfolio or watch the market movements on the news, the more we will feel like we have to do something. Heat of the moment emotions can make us do non-rational things. If we only look every few months, we will save ourselves plenty of stress and from doing something we may regret. I will say it again, if we don’t sell we can’t lose money.
I almost felt like selling my shares after the Brexit votes came in, and again when the new coalition government came into power. If I did though I would be missing out on the market gains that have occurred since. It can be hard to ignore the news and doom and gloom merchants, and I deliberately don’t pay attention. It is common for someone to say to me “the sharemarket is going well isn’t it?” It’s a bit embarrassing to admit but I don’t actually know how the sharemarket is doing at any given time. I don’t pay attention to it because my buy and hold strategy does not care for day to day price movements. My only concern is making enough money over 20 plus years.
Why do investors act so irrationally in bear markets?
Most people hurt more from losses than we gain pleasure from equivalent gains. We tend to dwell on the bad and gloss over the good. This results in overestimating bad times and underestimating good times which means thinking we are doing worse than we really are. This tends to translate to panic selling to stop the pain.
We put far more emphasis on the present than the past. Let’s say the market has returned 150% compounded over the last 9 out of 10 years. But on the 10th year the markets drop 40%. That is still a 10-year return of 50%. Not too bad. Yet we dwell on the last year, thinking it is the end of the world. This is because it was unexpected, we are not ready. Not prepared. We don’t know what to do and act irrationally. Then we start thinking this is the new normal.
Many investors who started investing after 2010 have never experienced a recession. Up markets to them, were the norm. Now we are experiencing a slight drop and these same investors are now starting to think down markets are the new norm. What happens most recent is given too much weighting in our minds resulting in sub par investment decisions.
It is hard to go by a day without seeing or hearing what is happening in the sharemarket or with your Kiwisaver account. The more you see or hear, the more you think about things. The more you think about things, the more you tinker.
One recent example is the recent unemployment numbers announced both here and in the states. One would expect the markets to drop after such an announcement, as a result sell off a lot of their investments. Yet, the opposite happened. Markets actually went up. Same thing happened with the announcement of Brexit. Markets were predicted to tank. They in fact went up. Likewise with the announcement of the labour led government in 2017. Everyone was saying markets plummet under labour governments. They continued to climb.
The point is, news is irrelevant. By the time something is news, the collective opinion of investors has already been priced in. In the case of unemployment during covid 19, everyone knew it would be bad. Maybe the markets went up because it was not as bad as most people thought. Once new information comes to light, the markets will respond accordingly. In other words, the market is priced based on future expectations. Current day events only have a drag effect on the markets if those future expectations are exceeded by reality.
When we look at the last couple of months it looks bad, yet when we zoom out to the last 19 years, the last week’s drops are not even recognisable. Even when we zoom out a year it is barely recognisable.
The point is investing in the sharemarkets should be a long term investment, so why look at short term results?
It is well publicised that investors that try and time the market because of what is being said by “experts” and talking heads, have much worse results than investors that stay the course and ignore the noise.
When ignoring the noise, not only is your investing performance better, but it is also easier. Basically set and forget. That really is the key to life and financial independence. Stay the course, ignore the noise, form good habits. Life becomes so much easier when you are true to yourself, have confidence in your decisions, and stay the course.
People start to see company values dropping and think it is a great opportunity to buy. Even though this company was never part of their original investment plan. They deviate thinking they are getting a bargain. They may very well be. But to think that you know better than everyone else is more luck than skill in my opinion. There is a very good reason why company value’s go down and you are taking on huge risk taking on such investments.
In the last 10 years I have never seen as many people as I have now asking about which individual companies to invest in. A lot of people are going to get burned by greed.
People moving their investments around from growth to conservative for example, are acting on fear. The result is locking in your losses and is not good. This is the best time to buy shares, not sell them.
6. Needing control
We like to think things are in our control. When shares are increasing like they have been for the last 10 years we feel like things are in our control. As soon as the brown stuff hits the fan all feeling of control is lost. We look for answers and can’t find them. To get some control back we might sell our shares to reduce some of that sharp volatility and feel like we have some control back.
In an ideal world we should act no differently in bad markets as we do in good markets. We can’t know when the good turns bad and when the bad turns good. If you can name someone that can do this accurately then I have bridge to sell you.
Assuming you are invested according to your risk profile, time horizon and goals, then you shouldn’t be making the above mistakes. Decisions on your investment portfolio should be made during good times when your head is more rational, not down markets when you’re emotionally charged.
A portfolio that will stand the test of time is key, that will survive good times and bad. Not getting too greedy during the good, or too fearful during the bad. This is achieved by following the plan. Investing every month through good and bad. Holding a widely diversified portfolio across many assets, countries and industries. This includes staying in the market at all times, buying at all times, and ignoring the noise. If you are widely diversified you should be confident that society and companies within that society will progress. We always have and always will.
And don’t be surprised by downturns. Expect them. They happen. It shouldn’t be a surprise. The biggest risks are always the ones we don’t see coming. Be prepared and you will act accordingly.
I’m actually hoping for a bigger drop in the share market. I only have another 7 months of share investing before I change my portfolio to a conservative mix to prepare for our house build in a few years. It will be a shame to not to pick up some cheaper shares before then.
With investing, simple really is best. Sticking to the plan, instead of chopping and changing, will see you very well. Why make things more difficult, costly, and time-consuming than they need to be?
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