Making sensible investment decisions is difficult. We are subject to a range of behavioural biases.
We have to cope with incessant noise around financial markets. We behave in ways that are inconsistent with our long-term investment objectives. So, what can we do about it?
The first step is to understand that we cannot rid ourselves of bias. Nor can we hope to ignore all noise. However, we can take six simple steps to achieve better outcomes; three dos and three don'ts.
Long-term investment plan.
Automate your saving.
Rebalance your portfolio.
Don't check your portfolio too frequently.
No emotional decisions.
Make doing nothing the default.
These six steps seem simple but are not easy. We cannot remove our biases or ignore the noise. Instead, we must build an investment process that helps us overcome them.
1) Have a long-term investment plan. Writing down the answers to a set of obvious questions about your investments can help you focus on long-term strategy. The answers can help you make considered, consistent decisions.
Why am I investing?
What is my time horizon?
Why have I chosen this particular portfolio / investment / manager?
Am I comfortable with the temporary losses that could result in difficult market conditions? and
What would I do in such a situation?
This approach helps you ensure that your investment decisions are prudent and realistic. Revisiting your strategy can help during times of market stress.
How you think you will act during a sustained stock market decline can be different from what you actually do.
In a cool, rational state you may plan to add money at more attractive prices. Without a clear plan, amid the stress of losses and negative news stories, you might instead sell.
There are no guarantees that referring back to a long-term plan will prevent you making a poor decision. But rehearsing future scenarios can have a significant impact on future behaviour.
2) Automate your saving. Committing to regular saving removes the emotional effect of market moves on your investment decisions. You will reduce your loss aversion. If the market falls sharply, you will be buying more at lower levels. If it rises, your existing holdings will have benefitted. By contributing regularly to your KiwiSaver, choosing the right fund and increasing your contribution every time your wages rise, you will never experience a loss in take-home pay through your retirement saving.
3) Rebalance your portfolio. One simple and effective decision rule is portfolio rebalancing. A structured and consistent approach to rebalancing a portfolio back to target weights removes the need for human judgment. It cancels out market noise. (Indeed, rebalancing can become a source of return when noise temporarily takes prices further away from fair value.) It ensures that your portfolio does not stray too far from its desired allocation.
4) Don't check your portfolio too frequently. The more frequently we check our portfolios, the more short-term we become. This can make us too risk averse.
Today's investors enjoy increased transparency and control over their portfolios. This brings many advantages. Unfortunately, it can also bring with it a range of behavioural problems for the long-term investor. Viewing our portfolios regularly creates the urge to trade, often at the worst possible times.
Investors should focus on setting a sensible and sustainable investment plan. Once this is in place, we should try to restrict our observations to an appropriate frequency. Once a quarter or even once a year is usually sufficient in my view.
5) No emotional decisions. How we "feel" at any given point in time can influence how we perceive risks and assess opportunities. Making an investment decision in an emotional state – excitement or fear – is fraught with problems. If emotion is overwhelming your thinking, postpone the decision. If the idea is a good one today, it is still likely to be tomorrow.
6) Make doing nothing the default. The more we are bombarded with news, information and opinion the greater the temptation to react. This can lead to costly overtrading, and investments being whipsawed between the latest fad or fashion. For a variety of reasons, doing nothing is the hardest decision to make for an investor. But it is often the correct one.
To be clear, "doing nothing" does NOT mean sitting in cash. "Doing nothing" means doing nothing that takes you away from your long-term investment plan and always remembering that we cannot control markets, but we can learn to control our own behaviour.
*Nick Stewart is the CEO and an Authorised Financial Adviser at Stewart Group – a Hawke's Bay-based independent financial advisory firm based in Hastings. Stewart Group provides Wealth Management, KiwiSaver and Personal Insurance solutions to individuals, families and businesses in New Zealand who are committed to pursuing financial planning and wellbeing.
*The views and conclusions opinions expressed in this communication are of a general nature only and should not be taken as an advice or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961.