Is your emotional response stopping you being a good investor?

Do you have capital to put into an investment portfolio? If so it can offer you an element of control over your financial future returns.  However, staying disciplined through rising and falling markets can be challenging – but it’s necessary to ensure your capital value increases, at least in line with inflation.

If we don’t invest our capital value, then our purchasing power will dramatically reduce over our lifetime; as inflation creeps up, our money will buy less. This means not investing is not an option.

The ‘Holy Grail’ of investing is ‘to buy low and sell high’. Wealth management companies claim they stand a better chance of doing this for you than you would yourself – and charge accordingly. However, often you can do better than them – if you set up your portfolio correctly and you hold your nerve.

The biggest challenge always comes when the markets are volatile and big losses are incurred over long periods.  Obviously, the ideal solution is 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.

I went a seminar once, which focussed on market timing. I found the following quite enlightening. The suggestion was that if you had invested £1000 for twenty years (from the 1^st January 1990 through to 31^st December 2009) only in the FTSE All Share Index you would have grown your investment to £4,712.31 (8.06% per annum). 

Had you chosen to invest your £1000 in UK 1 month Treasury Bonds you would have grown your £1000 to £3,301.29 (6.15% per annum).

If you or your Wealth Manager had a crystal ball which let you forecast one month in advance whether to position your investment into either the FTSE All Share Index or into the UK 1 month Treasury Bonds, your £1000 investment would have grown at 30.51% to £205,399.57.

‘So what would the odds be for that successful scenario?’ I hear you cry enthusiastically.

The answer is if you could call the 240 scenarios (each month for 20 years) correctly the odds of success would be: 1 in 1,766,847,064,778,380 followed by another 57 ‘0’s.

So unless you have psychic powers I believe that if we wish to become successful investors, we should look beyond the promises of well-intentioned discretionary fund managers and wealth management companies and make our own decisions. Investors should consider buying across the global market at the most financially efficient cost and sit tight.  Paying additional fees for somebody to make guesses in a random market seems a little pointless when the object of investing is to make more money so you can live the lifestyle that you want to live.

Why investors lose money 

It’s a human instinct ‘fight’ or ‘flight’ to make sure that we run away from the fight we don’t believe we’ll win! When we sense trouble we tend to react quickly rather than pause and think things through.

When we read dramatic financial headlines the investor, scared of losing his/her money, sells. The problem the investor then faces is when to buy back into the market.  If the stock has started going down, then you may already have made a loss, so you’ll be looking to recoup it. But, how do you know when it has hit the bottom?

Once it starts going up, can you predict it will continue or if it’s just a short-term rally? Leave it too long, and you’ll miss out on any potential gains to make up the earlier losses, and jump back too soon and you risk losing even more.

And remember, when markets and stock prices are falling, you can only sell if there is a buyer. If a buyer is found, you should ask yourself a simple question: If a buyer thinks the stock is cheap enough to buy today, why sell?

Without this question this is where investors can get caught up in faulty reasoning. Like this:

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, you cannot hold out any longer and you sell at the bottom. After a few 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 in. The media is now all excited talking about the ‘Bull’ run, everyone’s making money, so at last you get your optimism back.  This 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.

And then the markets fall… and the cycle of faulty reasoning continues.

It is tricky!

Despite our fear of losing money we know we need to invest to protect our capital from inflation. The problem we have is that it’s impossible to make good money decisions all the time. If we invested for today’s market conditions, tomorrow it could all change.

What’s the solution?

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.

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.

Don’t jump the minute the market starts to drop – be patient. Manage your emotions by investing in a risk portfolio that is correlated to your capacity for loss.

Finally, ensure you have a cost-effective (i.e. low fee) portfolio. It’s the hidden fees and costs which are taken from your fund in the name of service costs, annual management charges and discretionary management that are often unnecessary. Try to keep the costs of managing your portfolio at 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.

For example; if you invested £100,000 with a traditional financial services company paying a total fee of 2.3%, and you received a 7% return on your money for 25 years, you will have a projected future value of £329,332. As £100,000 was yours to start with you will have made a £229,332 profit. The overall cost to you, to make that profit, will have been £109,912.

If you invested £100,000 in a low fee portfolio, paying a total fee of 1.11% and received a 7% return on your money for 25 years you will have a projected future value of £441,601. As £100,000 was yours to start with you will have made a £341,601 profit. The overall cost to you would be £63,718.

This additional £112,269 can be used by you and your family, rather than just giving it away to an industry that feeds the ‘fat cats’. Remember it’s your money … don’t give it away.

In summary; be an investor, be disciplined, buy a diversified basket of global index tracker funds and keep your fees below 1%.

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.