Risk and/or Regret - The Investor's Dilemma
We are all a mix of biases and flawed decision-making. We tend to seek out information that confirms our beliefs, forget our mistakes, and let emotions cloud our judgment. Nobel laureate Daniel Kahneman aptly observed, "Nothing in life is as important as you think it is, while you are thinking about it."
Consider the financial markets in the second quarter of 2018. Can you recall what happened? Most likely not, and neither can I. Yet, when we're amid such events, they can feel overwhelmingly significant. This tendency to prioritise a new set of current circumstances is natural but can be detrimental for investors with long-term goals.
When investing, we often prove to be our own worst enemies. The allure of reacting to current events is widespread, yet all investments inherently involve risk and uncertainty. Uncertainty is a good thing for investors - you are rewarded for it! If there was no uncertainty and returns were predictable, there would be no difference in your return between putting money in a savings account and investing it in the share market.
It's crucial to resist the temptation to base investment decisions on fleeting trends or attempting to time the market.
Any adviser worth their salt will focus on implementing strategies that will work to capture the fullness of market movements over time. This is almost always the antithesis to targeting ‘hot’ industries or stocks.
It might be thrilling to imagine yourself as the exception to the rule, becoming fabulously wealthy from being in the right place at the right time. You will find good investing very dull by comparison, but also much less stressful should things go south in the global markets.
Significant financial gains without a good strategy and discipline could happen for some fortunate soul. Chances are it will not happen to you.
Consider one academic paper which looked at all listed stocks in the U.S over the past 100 years, numbering over 25,000 in total. The research showed about 4% of these stocks accounted for the entire market return:
Scarily for most stocks (57%), if you had bought the share when it first listed, and held it until it was no longer listed, your return would have been less than the 1-month US Treasury Bill – which is globally regarded as the risk-free asset. That is a dire result for the risk you are taking.
When buying individual stocks, you are more likely to buy a loser than a winner.
If you ignored buying direct stocks and opted for a managed fund and focused only on the top quartile (top 25%) of performers over the past 5 years, this again, sadly, provides no assurances of success. Research shows, on average, only 22% of top quartile performers over the past 5 years remain in the top quartile over the following 5 years:
Source: The Fund Landscape 2024 by Dimensional Fund Advisors
Regret to some degree is an unavoidable emotion when investing. Investing itself is a form of regret minimisation. Some investors regret missing out on the big gains while others experience more regret when they participate in big losses. Some people regret every time something goes wrong.
What to Avoid when Investing
One way of managing risk is to eliminate some of the things you shouldn't do. When you want to improve your health, you might eliminate fried foods, soda, and sweets from your diet, which can increase your chance of a healthier outcome. It's the same with investing. Eliminate bad habits, like attempting to predict the unpredictable by trying to time the market or pick winning stocks.
Think of everything that has happened in the past 25 years, including:
The dot-com bubble
9/11
The Global Financial Crisis and Great Recession
The COVID-19 pandemic
It is natural to want to time when to exit and re-enter the market to avoid the negative impact of these events. To put the implications of doing so into perspective, consider a hypothetical $1,000 investment in the U.S Russell 3000 Index (which tracks 3,000 of the largest listed stocks) made at the beginning of 1999. This turns into $6,449 for the 25-year period ending 31 December 2023. Over that same period, if you missed the Russell 3000's best week, which ended 28 November 2008 (which was right in the middle of the GFC volatility), the value shrinks to $5,382 (17% lower). Miss the three best months, which ended 22 June 2020, and the total return dwindles to $4,546 (30% lower). See what I mean?
What to Do when Investing
Positive ways of dealing with risk include ensuring our portfolios are diversified across regions and asset classes. While it doesn't guarantee making a profit or averting a loss, diversification allows us to reduce our risk and capture the returns of the market.
Whilst our Lorica business cards may call us Financial Advisers, one of the biggest positive impacts we deliver to our clients is being their Behaviour Coach when it comes to investing. One U.S report concluded a good adviser can add 5.3% per annum to your investment returns as noted in this article - https://loricapartners.com.au/insights/2020/12/22/the-value-of-advice-bghd3?rq=behaviour
In conclusion, while the temptation to chase immediate gains can be strong, true investment success lies in embracing a long-term perspective rooted in discipline and strategy. Acknowledging our biases and the allure of fleeting trends is the first step toward making rational decisions that align with our financial goals. Ultimately, it’s not about being the exception; it’s about being the wise, steadfast investor who understands that enduring success is built over time.
Author: Rick Walker
Please share this article with anyone you think would benefit from reading it.
Sources:
https://www.stewartgroup.co.nz/we-love-to-write/the-poor-lucky-fool
What Happened in Financial Markets in the Second Quarter of 2019? | Behavioural Investment