The cycle of faulty reasoning – how should you react, when the stock markets fall?

Hannah Goldsmith DipPFS, founder of Goldsmith Financial Solutions, advises what you should look out for when investing in the stock market

Placing your capital into an investment portfolio can offer you an element of control over your financial future returns – if implemented correctly.

However, staying disciplined through rising and falling markets can be a challenge. But it is this discipline that is crucial for long-term success and to ensure that your capital value increases, at least in line with inflation.

The biggest challenge always comes when the markets are volatile and big losses are incurred over long periods of time.

I once attended a seminar on market timing. The suggestion was that if you had invested £1,000 from 1 January 1990 to 31 December 2009 (20 years) only in the FTSE All Share Index you would have grown your investment from £1,000 to £4,712.31 (8.06% per annum).

If you had invested your £1,000 only in UK one month Treasury Bonds you would have grown your £1,000 to £3,301.29 (6.15% per annum).

If by using a crystal ball you, or your wealth manager, could 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 to £205,399.57 (30.51% per annum).

The odds for calling 240 scenarios (each month for 20 years) correctly are: 1 in 1,766,847,064,778,380 followed by another 57 ‘0’s.

As timing financial markets is clearly only available to those blessed with a physic intuition, I believe that if the rest of us wish to become successful investors, we should be disciplined; look beyond the promises of well-intentioned discretionary fund managers and wealth management companies and make our own decisions.

Why investors lose money

It’s a human instinct to run away from the fight we don’t think we will win!

We therefore react quite quickly when we sense trouble without always taking the time to think things through carefully. When we read scary headlines screaming ‘panic’ and ‘sell’… the investor, scared of losing his/her money, sells. The problem the investor then faces is when to buy back into the market.

By rushing to sell 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 am I selling it?

Many investors don’t ask this question they are too keen to get out of the markets and that is why I often hear investors say: “I don’t buy equities I lose too much money.” It’s not the equities that have lost the money; it’s the investor’s behavior based on their faulty reasoning.

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 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.

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

So, why invest?

Why do we invest if we are so scared that we will lose our money? We know that over time unless we do invest in something, that the value of our capital will decrease because of 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. If we are out of a particular global market we may not recoup the lost growth for many years. If we change our stocks again to capture tomorrow’s market returns, then we are just reducing our capital value due to buying/selling fees and taxes – and this is not the way to invest. But unfortunately many investors do just this.

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.

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.

And be patient.  Don’t jump the minute the market starts to drop. Manage your emotions by investing in a risk portfolio that is correlated to your capacity for loss. Not one that is based purely on your search for the highest returns. Remember, investing is for the longer term. History says that you will be rewarded for your bravery – and your patience.

Costs

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 less than 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 profit can be used by you and your family.

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.