Indeed, the anticipation of a soft landing helped markets deliver a superb run into the end of 2023.
But the Goldilocks scenario is far from certain. Risk is ever-present in investing. The delicate balance required for such a scenario to unfold is subject to various economic factors, and unexpected events introduce uncertainty.
Therefore, it’s timely to remind ourselves of the importance of investor behaviour to investment success. This is often discussed when markets are down and the temptation to sell is high, but it’s also important during periods when market enthusiasm and confidence are high.
To paraphrase the words of Warren Buffett’s mentor, Benjamin Graham, an investor’s chief problem, and even their worst enemy, is likely to be themselves. Graham was referring to the importance of investor behaviour and discipline – emotional reactions to market fluctuations, and investor biases, can significantly impact investment success.
These emotions and biases are an inherent part of human nature and influence financial decisions without the investor even being conscious of them. This is why an awareness of what those biases could be is important for an investor to be able to avoid them.
Psychologists and behavioural finance experts have identified numerous biases that influence financial decision-making. Two common biases investors should be cognisant of during periods of high market confidence are “herd mentality” and “recency bias”.
These biases have different causes, but both contribute to irrational decision-making and increase the likelihood of financial loss.
Herd mentality
Herd mentality involves following the majority without individual analysis – and it can lead to exaggerated price swings and asset bubbles. Recency bias is an undue focus on recent market trends, risking an underestimation of potential corrections.
Both biases expose investors to buying stocks at inflated prices, as seen with the dot-com bubble where euphoria led to hype-driven purchases. It’s well known that the resulting inflated prices proved unsustainable, causing substantial financial losses for those investors who followed the herd mentality.
The dot-com bubble is of course an extreme example, but Graham’s principle remains, as does his advice that a great company is not a great investment when you pay too much for it.
Markets overshoot and investors don’t want to be overexposed to risk when they retreat. This doesn’t mean you should attempt to time the market by selling just before capitulation – there’s plenty of material to show how futile that would be. What it does mean is a rational investor would never expose themselves to excessive risk in the first place.
So, if the Goldilocks scenario does play out and stock prices continue to surge as they did at the end of last year, how can you protect yourself from the unconscious bias that may tempt you to court with danger?
The first thing is self-awareness. Be cognizant of our herd mentality and recency bias tendencies, and the importance of adhering to a disciplined investment approach.
Your investment approach should be defined by a clear investment objective based on your long-term financial goals. Each investment decision should align with these objectives and avoid emotional reactions.
Having a long-term goal will help you look beyond short-term market fluctuations. Accept that volatility is a normal part of market cycles, and resist making impulsive decisions based on short-term market euphoria.
If you self-manage a directly held investment portfolio, diversification and asset allocation are critical. Maintain a well-diversified portfolio across different asset classes.
Rebalance your portfolio to keep individual assets and asset classes within range of your predetermined asset allocation – this will help you avoid succumbing to herd-driven asset bubbles.
If your investments are solely in managed funds such as KiwiSaver, you might assume biases won’t impact your success. But this isn’t the case. For instance, moving to a higher-risk strategy solely for fear of missing out on stock growth (as opposed to aligning with your investment objectives) will expose you to more risk than may be required to achieve your objectives and heighten your risk of financial loss.
Finally, seek guidance from financial advisers to gain a more objective and professional perspective. Advisers can provide insights and recommendations based on a broader market view.
Ultimately, as you navigate the unpredictability of financial markets and the potential Goldilocks scenario, disciplined and informed decision-making is vital to safeguard against the whims of emotional biases, ensuring a steady course toward long-term financial success.
Hunter Fullarton is a Wealth Management Adviser at Jarden.
Jarden Securities Ltd is an NZX firm. A financial advice disclosure statement is available free of charge at jarden.co.nz/our-services/wealth-management/financial-advice-provider-disclosure-statement/
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