19/11/2013

Whenever investment markets are sharply rising or falling, do you feel a powerful urge to do something?

If your answer is “yes”, you are acting in a manner that is widely recognised by behavioural economists. And chances are that such an emotive response to market movements will be detrimental to your financial wellbeing.

When markets are moving rapidly, many investors become either frightened that they will lose money if asset prices are falling or afraid they will fail to make money when prices are rising.

Jeff Molitor, chief investment officer for Vanguard in Europe, recently wrote an investment commentary describing knee-jerk reactions to market movements as “reactionary investing”. It is an extremely apt description.

“Fear and greed are two powerful emotions that represent major obstacles to investment success,” Molitor writes. “Worried that they might be on the wrong side of a trend, some investors fall into the trap of ignoring their long-term plans and disciplines and instead react to the noise of the market.”

And he emphasises: “The reality is that successful investing requires discipline and a clear set of objectives.”

Rather than being swayed by the “noise” in the market into following the investment herd, investors should ideally focus on:

Setting clear investment goals. Investors can concentrate on achieving these goals, regardless of changing investment conditions. Developing an appropriate long-term asset allocation that is designed to meet your investment objectives. (A landmark research paper – Determinants of Portfolio Performance by Gary Brinson, Randolph Hood and Gilbert Beebower – confirmed in 1986 that asset allocation was responsible for the vast majority of a diversified portfolio’s return over time.) Keeping investment costs to a minimum. In short, high investment management costs really handicap a portfolio’s real returns. Maintaining a disciplined approach, focussing on long-term investment objectives. This should discourage investors from making emotionally-driven decisions, particularly in times of high volatility. Part of having a disciplined approach involves regularly rebalancing a portfolio to bring it back in line with its long-term target or strategic asset allocation.

The inevitable times of uncertainty and high volatility in the market can serve as a useful prompt to ensure that your investment basics – concerning long-term goals, asset allocation and low cost- are in the best possible shape. This is a much superior approach to “reactionary investing”.