The markets can be completely irrational. Anyone who has invested for any length of time knows this. Economic data could be pointing in one direction with the markets reacting in an opposite way. At times investor emotions of fear and greed dictate more of what they actually do versus what they should do. We will call this the psychology factor.
There is so much free financial information available that it can be overwhelming. It is not just that there is a lot of information – so much of it is contradictory. This increases anxiety for many when making investment decisions.
Over time the markets have always gone up and down, but have maintained an upward bias over the longer term. Regardless of the short term prediction we are more confident in the longer term that the S&P/TSX Composite Index will be higher than it being lower. Taking a longer term view of your investments should help reduce the stress of attempting to predict short term performance.
Value investing often involves attempting to pick up companies you feel are undervalued in relation to the current stock price. Value investors feel that if they purchase undervalued stocks, and wait a period a period of time, that the stock will deviate back towards fair value. The main problem that exists today is that so many investors are looking for instant gratification, or quick returns. A value investor may have to develop the patience to wait two or more years for some stocks.
Some people are better able to deal with the ups and downs of the markets. When the markets decline some people view this as a buying opportunity while others fear the worst and look at selling. This is what creates the market. If everyone believed the same thing then there really wouldn’t be a market. There has to be both buyers and sellers to make a market. Investors who are able to handle risk and volatility are typically further ahead. Getting too emotional with your investments can be damaging if you sell quality investments at market lows. In some cases the biggest advantage of dealing with a financial advisor is to ability to reduce the “psychology factor”. If you choose to do it on your own then you are far more likely to get emotional in your decision making.
If someone were to propose a little bet, based on a coin toss. If it’s heads you win $10,000, if it’s tails you lose $5,000. Some people would take this bet, but most people would not, even though they have the chance to win twice the amount that they could lose. We are not trying to compare the stock market to a coin toss, but rather trying to illustrate that everyone has a different risk tolerance. All investments have risk and that ultimately investors have to choose the best educated risk-reward trade off.
Most people who are successful have taken significant personal and business risks. In some cases, there has been failure before successes. The ability to cope with risk is ultimately the largest component of the psychology factor. People who have invested for a longer period of time are typically able to manage the psychology factor better.
If you are in the growth stage of saving for retirement, you may not require funds from your investment accounts to live off of immediately. When you do picture yourself in the near future (five years or less) having to live off of your savings then it is critical that your investments match your time horizon. Stress can be significantly reduced if you ensure that you have invested based on your time horizon.
Not all people are meant to invest in the stock market. Knowing your own comfort level is important, as well as communicating this to your financial advisor.
We feel it is very important for all new investors to discuss risk thoroughly with their financial advisor. How would you react to certain market conditions (overall markets declines 10, 20 or 30 per cent)? We go through a series of questions with all new clients and document our plan, called an Investment Policy Statement. By going through this exercise we hope that new investors will establish a disciplined approach and the investments will reflect their risk tolerance.
Here is an example of one of the questions we ask:
Assume you have just invested $1,000,000 and intend to leave the money where it is for ten years. When you review your first quarterly statement, you see that the value of your investment has dropped to $900,000. What would you do?
- Take advantage of the lower prices and invest more money, if possible, since I am interested in the long term value of my investment and I’m confident that I have made the right choice.
- Leave my money where it is, since some changes in value are a normal part of investing.
- Monitor my investment closely and sell if the value has not recovered in three to four months.
- Sell my investment immediately, since I’m not comfortable with any decline in value.
No one can control the markets but you can control how you react to it. Managing risk and emotions are two important components of successful investing.