How to avoid sabotaging your portfolio

30th April 2012

The pendulum swings from one to the other depending on the climate. But commentators agree that it is fear that holds sway at present – whether it's over Europe's future, the ‘double-dip' recession, or other negative newsflow.

However, succumbing to either of these emotions can have a profound and detrimental effect on investors' portfolios and the stock market.

In a perfectly efficient market, all investors would act rationally and consider all available information when deciding on their investment choices – but in reality, this rarely happens.

It's been evident by the internet stock frenzy over the last couple of years that a lot of investors behave far from rationally when it comes to making investment decisions.

Take, for example, the herd mentality. This is well-known for being one of our enemies.

Consider the heady days of 1999 as a prime example. Then, everyone was piling in to technology funds. The FTSE rose to 6930 and no one could think of a good reason not to invest. Jump forward three years and the FTSE was trading below 3500 and no one could think of a good reason why they should invest. Pretty incredible, but true. .

But it takes guts to veer away from the herd and deal with fear and greed.

Of course, there is a place for both when the time is right – fear is not always a negative as it can prevent foolish mistakes. However, an appreciation of these extremes, coupled with the discipline to avoid both, will put you a good way down the road to successful investing.

This is particularly important with the current climate. "If the underlying combination of functions that make up our nervous systems can be fooled into inappropriate emotional responses by mass media and its manipulation then it can also trick itself into dangerously irrational responses to the fear and greed implicit in stockmarkets," says Psyfi blog. "The end result of this can be the emotionally logical but financially irrational decision to cut and run."

Just as greed dominated the market during the dotcom boom, the same can be said of the prevalence of fear following its bust. In a bid to stem their losses, investors quickly moved out of the stock markets in search of less risky buys with low returns.

So what should clever investors do?

Markets thrive on over-reaction to prevailing conditions, and so too do clever investors. But contrarianism is not always enough on its own; you need common sense, too.

Smart investors buy into companies with a proven, robust business model, companies able to generate profits in all conditions and therefore grow their dividend to shareholders. In other words – great companies. No room for fear and greed here. And anyway, a savvy investor expects some volatility along the path to long-term return.

"The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances"; Ben Graham, The Intelligent Investor.

Psyfi blog adds in this post: "This, of course, is why you shouldn't invest with money you may need in the short term: if some of the world's strongest and most stable stocks can drop by 20% or 30% for no good reason over the course of a year you definitely can't rely on getting your money back when you need it.

"All you really know is that, at some point in the future, you will get a decent return, and that you have no realistic chance of a permanent loss of capital…Tesco is not going to go bust and providing you don't pay too high a price to purchase their stock you should do OK in the long-term."

The investment guru Warren Buffet has provided more than a few words of wisdom over the years, many of which relate to market conditions. "Never invest in something you don't understand'' (technology)."You only find out who is swimming naked when the tide goes out'' (credit crunch). But a particularly popular one is "risk comes from not knowing what you are doing''.

Another gem is his recommendation of "seeking only to be fearful when others are brave, and brave when others are fearful''. In other words, to be contrarian and avoid the herd mentality at all costs.

If we adhere to these principles, to stick to what we know and understand, and temper fear and greed, then we have a greater chance of being successful investors going forward. So consider what type of emotional traits you have a tendency for that might hinder investment decisions, and take an intelligent approach.

 

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