Take The Emotion Out of Investing

STRATEGIES TO HELP MINIMIZE THE CYCLE OF EMOTIONAL INVESTING

Market Volatility has become part of the landscape we live in. Triggers from the economic front van send the markets up one day and down the next. If you’re thinking about recent market volatility and the alarm you may have felt as you watched the markets lose value, you may be relieved to know that your reaction was only human. In fact, there’s an entire body of scientific evidence that suggests the human brain tends to respond in fairly predictable ways to moments of extreme stress.

Walking, breathing, feeling and reasoning seem like they should be automatic. You trust your brain to keep these processes running smoothly – and most of the time it does. However, there are times when the different parts of your brain operate on their own. For example, in moments of intense emotion, the reasoning part of your brain shuts down completely. Your braid sense the need for survival and all the blood flows to other parts of the brain that keep you alive. That’s not such a bad thing if you encounter a bear on a walk through the woods, but it may not work as well when the bear you meet is in the markets.

Letting emotion control your investment decisions can be problematic, as the tendency can be to sell during periods of market decline and often this behaviour occurs at the wrong time – after experiencing significant losses. The solution seems simple: take emotion out of the equation. Unfortunately, when fear takes over, this is much more easily said than done.

BUY HIGH AND SELL LOW?

The number one rule of investing is to “buy low and sell high”. It may appear to be a simple concept, but it takes extreme discipline. That’s because humans have cognitive biases, which at times may lead to poor investment decisions. When the stock market is performing well, investors continue to pour money into the market. However, when the market goes down, as it did in 2008, investors appear to abandon principles and sell. The problem is that investors often sell after the market has already experience significant declines.

How do you explain this irrational behavior? Looking at a full market cycle makes it easier to understand why investors may react this way. Investors who exit the market during significant market declines also tend to be hesitant to get back in. Many remain “on the sidelines: until they feel assured that the stock market is once again gaining momentum in an upward direction. Unfortunately, at this point prices have risen considerably from the bottom and the market offers less upside potential. In other words, investors wait too long and buy in after the market has already experience a substantial amount of the rebound.

So how do you avoid making investment decisions at the wrong time, and position yourself to sleep better at night? The first step is to remember that investing involves risk. Keeping this in perspective can go part of the way towards helping you weather the emotional rollercoaster. Secondly, by working with your advisor to combine a number of difference types of investments, you can smooth out the ride and be in a position to take advantage of the opportunities that market declines can present.

DIVERSIFY, DIVERSIFY, DIVERSIFY

Diversification is a lot more than not putting all your eggs in one basket. For some Canadian investors, asset allocation can be as simple as having some money invested in bonds. What many investors may not realize is that there are many different types of stocks and bonds, each reacting differently to market conditions.

By investing in different asset classes, investment styles, market capitalizations, geographic regions and sectors, you can improve the risk/return characteristic of your portfolio, reating a diversification benefit that, in turn, can help insulate your portfolio during times of market turbulence.

For example, large-cap Canadian equities respond differently than small and mid-capitalization Canadian equities. Having exposure to both asset classes has the potential to smooth out and potentially increase investment returns over time.

There are many different types of bonds an investor can access including Government of Canada bonds, corporate bonds (of both high and lower quality) and bonds from various sectors of our economy. Spreading your investments across a number of bond asset classes is another means of diversifying your portfolio to lower volatility while increasing potential returns.

Beyond traditional asset classes or sectors, there are also a number of non-traditional asset classes – often referred to as alternative or diversifying asset classes.

Some examples on the equity side include commodity-based companies and global real estate. On the fixed-income side, there are even types of bonds that can help protect portfolios against inflation and rising interest rates.

Once you and your advisor have determined the optimal mix of asset classes for your portfolio, consider selecting mutual funds run by managers with a track record for outperforming their peers during market downturns. One way to help determine if a manager is proficient in this regard is to look at what’s called an upside/downside capture ratio. This ratio shows how a fund performed in rising markets and how it performed in declining markets. Making sure your portfolio has exposure to managers with strong upside/downside capture ratios is another way to help mitigate losses during challenging market environments.

IT’S TIME IN THE MARKET, NOT TIMING THE MARKET

Remaining invested can leave you better off than trying to time the market. Periods of low returns are often followed by periods of higher returns. This is because stock markets tend to overcorrect during time of heightened volatility. When the markets return to growth, the period immediately after a dip tends to produce much higher returns. By trying to time when to get in and when to get out, you risk missing the days that produce big gains, which in turn will undermine your long-term returns.

SPEAK WITH YOUR ADVISOR

You can’t control the markets but if you remember that investing involves risk (some of which can be mitigated), and you understand the way your brain works (and the biases that can work against you), you can help keep your long-term investment goals on target. A little planning in calmer times can go a long way towards ensuring that you stay the course and sleep better at night when market headwinds pick up again.

Consult your advisor to review your portfolio and discuss which options might be appropriate for you given your risk tolerance and investment goals.

Neal Owen POSTED BY: IN General News