The other day I overheard a young broker talking loudly on his cell phone. Apparently, he was calling clients to tell them he was selling their investments and waiting until the market improved.
Of course, I understand how the broker and his clients feel — this difficult market has shrunk most of our account balances, to be sure. But in reality, he was about to make their problems worse by allowing emotions to steer his investment decisions.
Emotions can definitely hinder rational thinking when it comes to financial dealings.
For instance, this broker sold securities whose prices had fallen, and then made the choice to wait for the market to rise before buying again. He was waiting to feel better before buying again.
And when would he feel better?
After security prices had already gone back up, presumably. The problem is, by moving to cash in a down-market, we are actually making a conscious decision to sell low and buy high.
Sounds like terrible behavior, doesn’t it?
And that is precisely why many investors fail to earn market rates of return. They move immediately to cash, CDs, or bonds when stock prices are low, and repurchase stocks to join the recovery well after it is underway.
The evening news rants about worried investors “losing” their money in the stock market, when the reality is that investors who diversified across the global equity markets will take an active role in the recovery.
Unfortunately, some investors won’t.
This group includes investors who sit in cash, and those who have held concentrated positions in Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, or similar companies. These single stock investors took uncompensated risks… and paid dearly.
What is uncompensated risk?
“Uncompensated risk” simply refers to the idea that investors don’t earn higher risk-adjusted returns by investing in individual stocks. Single stocks, in actuality, present the risk of permanent and total loss.
Prudent investors, on the other hand, accept only compensated risks, seeking long-term returns that correlate with the market risks they take. They hold baskets of more than ten thousand securities — and diversify away any uncompensated (or single stock) risk.
The quickest way that investors can amplify the negative effects of bear markets worse is to panic and act without the common sense realization that markets do, in fact, periodically go down.
How can confidence help me invest more effectively?
If you’re determined to act pragmatically, you’ll know how to respond when markets fluctuate and recover. Don’t get caught in the trap of crafting a a well-researched, disciplined investment plan — and then abandon it as soon as any of your investments experience fluctuations.
Recoveries are not easily foreseen – any longtime investor can confirm this to be true. But the resilient investor takes part in market recovery — and in doing so, earns long-term returns, and ultimately, accomplishes their investing goals.
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