Everyone wants to make money from their investments, but few do because they are constantly running in and out of the markets, however, it's easy to do if you follow these 4 keys:
1. Understanding your behaviour. Most of what we do each day is based on habits and mental shortcuts our brains have developed. Here are a few that relate to investing.
- Linear thinking. We think in terms of straight lines. If something is going in one direction it will continue to go in that direction. If house prices are going up, they will continue to go up. If the stock market is going down it will continue to go down. The truth, however, is that just about everything goes in cycles. The economy goes in the cycle of recession, growth, peak, trough, recession. House prices go in cycles. The animal kingdom operates on the same principle.
- Chasing performance. Imagine you have 3 investments and one earns 14%, one earns zero and the 3rd has a -9% return. Instinctively, you would want to sell the loser and buy more of the winner. We do this because we think that the winner will continue to go up in value.
- Mental framing. Let's say you are in the market for some new running shoes and you find a pair for $50, but you then notice an advertisement of the same shoes at a store across the city for only $25. That's a 50% savings. So, would you drive across town to save $25? Most people would. However, let's say that you are in the market for a couch set that costs $3000. Would you drive across town to save $25? It's the same amount of money, but in our minds, we frame things differently. We do the same thing with our investments. Our decisions are based on the research that we listen to, which is usually the media. If the markets are down, the media commentary is negative and it will always be negative. They will go out of their way to find the most pessimistic advisor to support their perspective. The opposite happens after a few good days on the markets.
- Overconfidence. Because we think in straight lines, we can become overconfident when things are going up and begin to think that our good fortune is the result of our good investment skills. At that point, we tend to only listen to and seek out information that confirms our bias. This is also called, confirmation bias - we only listen to information that confirms what we already believe. Alternatively, when the markets correct, as they always do, we feel ripped off and uncertain in our abilities after all.
- Fear of loss. We feel the pain of loss far greater than we do the gratification of gain. Realizing that you have lost the $50 bill in your wallet is far worse than the joy of finding a $50 bill on the street. How does this affect our investment decisions? Well, our appetite for risk is far greater when the markets are going up. When the markets are heading south, we quickly become risk-averse. This leads to the reality of what most people do - buy high and sell low. The reality is that we should be more inclined towards risk when the markets are down, not up. Warren Buffet puts it this way: "Be fearful when others are greedy and greedy when other ore fearful."
2. Understand your investment philosophy and stick to it. Personally, I am a buy and hold investor who likes investments that pay dividends and have continued growth potential. I like to re-invest the dividends in buying more shares. It's a simple process that requires very little work. I like to add in some growth and speculative companies as well. In addition to this, I have a love of real estate and hold some personally owned and managed rental properties as well as some private investments in larger Limited Partnerships.
3. Risk and reward tolerance. Most people think they can handle risk until they start losing money. Perhaps you have completed one of those investor profiles that help you determine your risk tolerance and suitable investments. Most people have a moderate to high tolerance for risk. I bet if you completed one of those profiles while the markets are down you'd get a different outcome.
4. Patience. You can't plant an apple tree and expect it to produce apples right away. Imagine pulling it up every few months and replanting it somewhere else hoping for a better result. It just will not work, but it is what many people do with their investments.
Here's what I know with some degree of certainty. The markets go up over time. A properly diversified portfolio of investments is very important. It's just about impossible to beat the markets. It isn't necessary to take on too much risk as consistently achieving 5-6% per year will most likely be adequate to reach your goals. Consistently saving month in and month out is the best advice you can follow. Invest in what you can understand. There are many complicated structures around, but very few that succeed. I like simple - because it works.
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Retirement Income, Investment & Tax Planning,
Willis J Langford BA, MA, CFP
Certified Financial Planner®
