Why itís best to ignore the gremlins in your head

Why itís best to ignore the gremlins in your head

Do you support the All Blacks? If so, think about how you feel after the All Blacks win a test match compared with how you feel after they lose a test match.

If you’re like many New Zealanders, an All Black victory is likely accompanied by a short feeling of satisfaction followed by a sense of ‘not getting too carried away’ and focusing on the game next week. After a loss, the disappointment is palpable, the world ends and we all dissect the performance in the hope of finding someone to blame.

Both reactions are obviously at opposite ends of the emotional spectrum but they highlight some significant themes in relation not only to the national psyche but also to behavioural finance. In the late 1970s, psychologist Daniel Kahneman found that the pain of loss is about twice as great as the pleasure of a gain of the same size. Although we remember the wins, we associate more emotion with a loss, so the goal then often becomes ‘not to lose’.

This phenomenon is known in behavioural finance terms as ‘loss aversion’ and it has a dangerous application to the world of investing. It usually manifests itself in investors jumping into ‘less risky’ asset classes that may not be appropriate for their risk profile or their objectives.

Through the 1990s we saw millions of dollars heading offshore after some stunning returns from international equities. After the dotcom crash from 2000 to 2002 many of these investors - particularly those who did not adequately diversify - got ‘burnt’ as the dual effect of a soaring New Zealand dollar and plummeting share prices conspired to decimate their returns. Investors, unaccustomed as they were to market volatility, reacted as most people would when they ‘lose’ - they made changes. Investors in droves pulled their money out in favour of the seemingly safer asset classes of fixed interest and property. However, they raced into the next ‘sexy’ investment which happened to be finance companies. When the GFC hit, finance companies failed and our dollar rose, many investors raced to cash as it appeared to be a good safe haven.

The difficulty with this strategy is as follows:

  1. There is an opportunity cost in not remaining invested in share markets when they recover. Many investors have now missed out on the recovery in international and local share markets since 2010.
  2. Many investors will have ‘bought high’ and ‘sold low’. This was due to: a) their inability to invest in the market early enough; and b) their inability to remain patient and stay invested over the long term (see picture below).
    investors-bought-high-sold-low
  3. Moving funds to ‘safer’ asset classes, such as cash, may not be appropriate for your required asset allocation. In the worst case scenario, this may mean that you have effectively crystallised a heavy loss and won’t even have the opportunity to meet your goals and objectives due to the low returns associated with cash.
  4. Much of the money has flooded into residential rental properties which may seem safe but are currently under the spotlight of both the Reserve Bank and the government.
  5. Time has proven that it is basically impossible for the average investor to ‘time the market’.

Avoid the flavour of the month type investments. Stick with a nicely diversified portfolio that is easy to sell if money is required and is diversified via asset classes, investment managers and economies. Obviously it’s not sexy and it will never grab headlines but ignoring the gremlins in your head and simply remaining invested in a quality, diversified portfolio could be the smartest investment decision you ever make.

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