Most people just invest to make money, but with huge gains in stocks, shares, bonds and property since the deep bear market of 2007, now is perhaps a good time to review investment portfolios, consider taking profits and diversify investments. In financial jargon this is known as rebalancing your asset allocation, which will be the topic of future blogs here at International Financial Advice.
But when things are going well, and profitably, investors sometimes don’t pay as much attention as they should to the most common mistakes that investors make. financial jargon like asset allocation or investment diversification when making money.
One of the greatest investors of all time is Warren Buffet, who reminds us:
“Be fearful when others are greedy and greedy only when others are fearful.”
In other words, when everybody has made a lot of money, it’s time to reconsider investments, take profits and become more cautious.
But this is easier said than done!
Most of us cut short our winning investments too soon but hang on to our losing investments for too long because of the way our minds are (literally) wired. It’s known as the disposition effect. Understanding a little more about how human minds work when it comes to investing is known as behaviourial finance. Getting to grip with our minds is the first step towards helping us understand and potentially alleviate the psychological pain of a market downturn when it eventually comes. We know from experience, it always does. We’ve made a beautiful infographic on investor psychology, to try and help our clients avoid making common investment mistakes.
Let’s think about risk tolerance, or the ability to absorb pain when it comes to investing. Most investors are not comfortable at the edge of their tolerance to pain, which means losses! For many of us, it’s difficult to remember what investment pain feels like because not many of us have suffered any pain in recent years as almost all markets have boomed.
Therefore, it is highly likely that many of us are currently in a period of over-confidence with our investments, believing that their investment decisions are superior to those of others. As a result, they may be more inclined to make risky investments, encouraged by the long period of the bull-markets. Perhaps a reminder from one of the world’s greatest investors again rings some bells:
“The line separating investment and speculation becomes blurred when most market participants have recently enjoyed triumphs.”
And so back to psychological pain.
Simply taking on more and more investment risk does not guarantee more return, but it does pretty much guarantee more pain. However, if we hold investments long enough, and that can mean 20 years, we should make a positive return. The ride to get there could be very uncomfortable though: most private investors will suffer from a combination of fear, desperation and outright panic, leading them to sell investments, thereby NEVER achieving the long term profits that they could enjoy if they just held on.
So what can investors do to reduce the psychological pain of losses when investing?
There is one strategy that private investors and their financial advisers should follow. It’s the closest thing to a free lunch and it’s called asset allocation or investment diversification. This asset allocation (or weighting of different assets in your portfolio) will make the biggest difference to returns and should match one’s psychological tolerance to risk, or an investor may be in for a very uncomfortable journey.
Article by Carlton Crabbe ©