How to avoid faulty reasoning and improve returns on your investments

If we don’t invest the value of our capital and our purchasing power will dramatically reduce over our lifetime. Inflation will take its toll and our hard-earned the money will buy us less and less. Because of this not investing is not an option.

Deciding to put your capital into an investment portfolio can offer you an element of control over your financial future returns – if implemented well. Remaining disciplined through rising and falling markets can be a challenge, but it is this discipline is crucial for long-term success, ensuring that your capital value increases, at least in line with inflation.

The ideal solution would be to enter the market just as it bottoms and exit the market right at the top. But precisely timing your exit and entry is close to impossible. If it were easy, millions would be doing it and getting very rich in the process. In reality, the only ones getting rich in this scenario is the financial services industry – at your expense.

A useful insight came out of a seminar on market timing which I attended. The presenter suggested that over 20 years a £1000 investment made on in the FTSE All Share Index (from 1 January 1990 to 31 December 2009) would have grown by 8.06% per annum to £4,712.31.

Over the same period a £1000 investment in UK 1 month Treasury Bonds would have grown 6.15% per annum (to £3,301.29).

Had you had the ability to forecast one month in advance whether to place your investment into either the FTSE All Share Index or into UK 1 month Treasury Bonds, yourinvestment would have grown by 30.51% per annum: from £1000 to £205,399.57.

As savvy investors you’ll know that the odds against calling 240 scenarios (every month for 20 years) correctly are massive. In fact they are: 1 in 1,766,847,064,778,380 followed by another 57 zeros.

As timing financial markets is clearly only available to those blessed with a crystal ball, I believe that becoming successful investors requires discipline. This means looking beyond the promises of well-intentioned discretionary fund managers and wealth management companies and making our own decisions.

Why investors lose money

Human instinct means that when we sense trouble we tend to react quickly without taking time for careful thought. When we see the market nosedive, the investor scared of losing his/her money, sells. The problem the investor then faces is when to buy back into the market. This of course means that you may lose any profit you have already made, and you run the risk of greater losses due to fees and the uncertainty of the market.

And remember, when markets are falling, stock prices are falling, you can only sell if there is a buyer to sell too. If a buyer is found, you should then have to ask yourself a simple question. If a buyer thinks the stock is cheap enough to buy today, why I am I selling it?

This is where the issue of the investor’s behavior based on their faulty reasoning comes in to play.

If you stay invested and the markets keep falling, you become anxious about the money you have lost when you could have pulled out earlier. If the portfolio value falls below what you invested you are now in a loss, you may become fearful that you will lose more of your money, but if you sell you will create a real loss. This loss if substantial it creates a real fear. Could you really afford to lose this money?

The worst scenario is that your nerve goes and you cannot hold out any longer and you sell at the bottom. After a few more months the markets begin to turn positive and the time for optimism begins, but you have been burnt and you will not be burnt again so you hold out… just in case it’s a false rise.

The market keeps climbing but you are still nervous about going back into the market. The media is now all excited talking about the ‘Bull’ run everyone’s making money, so at last you get you optimism back which is often too late, because all the gains have been recovered and you still have your losses to make up. You jump into the market.

Another downturn in the market… and the cycle of faulty reasoning goes on.

An alternative approach

The global market is an effective information processing machine; there are more than 98 million trades a day. The real time information they bring to the market helps set the market price.

Instead of buying retail funds selected by a fund manager buy a diversified basket of global index tracker funds and let the markets work for you. Holding a wide basket of stocks from around the world, linked directly to market returns, can reduce the risk of trying to outguess the markets or worse, pay somebody to outguess the markets.

Investment returns are random; they cannot be predicted with any great future certainty. Therefore, no one can say, with conviction, which financial sectors an investor should buy to get the next best return on their investments.

Therefore limiting one’s investment universe to a handful of stocks, or even to one stock market, is a concentrated strategy with high risk implications. Do not try and guess which parts of the world will outperform others, or whether bonds will outperform equities, or if large stocks will outperform small stocks; buy the global market using a diversified basket of index tracker funds and leave the speculation to the gamblers.

Ensure you have a cost-effective, low fee portfolio. Try to keep the costs of managing your portfolio under 1%. The industry average cost of using a conventional financial service company is in the region of 2.3%. If you save yourself even 1% a year you will have made a substantial amount of money using compounding interest over the life of your portfolio.

And don’t forget: be patient or learn to be patient. Don’t leap into action the minute the market starts to drop. Manage your emotions by investing in a risk portfolio that is a good fit for your personal capacity for loss, (rather than one based purely on your search for the highest returns). Always remember that you are doing this for the longer-term and the best financial future for you and your loved ones. A thoughtful and patient approach is the way to go.

ABOUT THE AUTHOR

Hannah Goldsmith is founder of Goldsmith Financial Solutions and author of ‘Retire Faster’. Hannah specialises in Low Fee Investing and is challenging the way financial services are delivered to consumers in the UK, by enabling each client to understand the nature of investment costs and the impact these costs have on their future lifestyle.

Goldsmiths complimentary ‘Second Opinion Service’ reviews investors’ existing portfolios and makes recommendations on Risk, Diversification, Performance, Cost and Tax efficiency, making investors’ money grow in a more transparent and financially efficient way.