The past six months have highlighted two common errors that investors frequently make. The first relates to a misunderstanding of the way investments compound over time and the second is the way that emotions can cloud our judgement. With the right knowledge, both can be remedied relatively easily.
The impact of compounding
In relation to the first, the US stock market fell by 13.7% in the fourth quarter of 2018 but has since rallied by 13.9% this year so far (as of 12 April 2019). 13.9 is more than 13.7 so that means investors are up overall, right? Wrong. Investors are actually down by 1.7% over this period.
This very common mistake arises because people often prefer to add numbers together in their heads but forget investments compound from one period to the next.
A 13.9% return on $100 would indeed lead to a gain of $13.90, if the investment was made at the start of 2019. But, in this situation, a $100 investment made at start of October 2018 has fallen by 13.7% by the year end, to $86.30. As a result, you have less capital to earn that 13.9% return on. Instead you only make back $12.00 (13.9% x 86.30). This takes your final amount to $98.30.
While this may seem a bit abstract, understanding the difference between arithmetic returns (i.e. adding them together) and geometric returns (i.e. compounding them together over multiple periods) is key in preparing yourself to make informed decisions. This same oversight can also result in borrowers underestimating how much it will ultimately cost to repay a loan.
Keeping your investments balanced
Think back to the end of 2018. The fourth quarter was a difficult time to be investing in the stock market. There was no hiding place as everything fell sharply. Sentiment was rock bottom and the immediate emotional response would have been to sell.
However, partly as a consequence of the market declines but also because earnings grew strongly in 2018, earnings-based measures of valuations had fallen to their cheapest levels for several years. Although valuations are usually a poor guide to short term performance, markets rallied sharply from that low.
As well as the US market being up 13.9%, Europe, the UK and emerging markets have all risen by around 10%. Even the laggard, Japan, managed almost 8%.
With hindsight, it would have been a great time to invest. But, we are hard-wired as emotional beings so overcoming the urge to sell is not easy. Moving past our tendency to extrapolate the recent past into the future takes discipline.
One relatively easy way to take emotion out of the equation entirely is to follow a rebalancing policy. Rebalancing starts with deciding what percentage of your investments you want in the stock market, bonds, cash and so on. If one asset class outperforms the others, its weight in the portfolio will rise.
A rebalanced portfolio would then sell some of the specific winner, to bring its weight back to where it was initially intended it to be, and reinvesting the gains in assets that have under-performed. Remember to speak to your financial adviser before deciding if this is right for you.
This is “buy low-sell high” in practice. And it could have resulted in you buying equities at the turn of the year, even though your emotional response may have been telling you to do the opposite.
Although it is true that markets have continued to fall, valuations continue to be one of the best indicators of long-term returns. By growing your understanding of these common investment errors, you will be better prepared for volatility in the market.
This document is issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders). It is intended solely for wholesale clients (as defined under the Corporations Act 2001 (Cth)) and is not suitable for distribution to retail clients. This document does not contain and should not be taken as containing any financial product advice or financial product recommendations. This document does not take into consideration any recipient’s objectives, financial situation or needs. Before making any decision relating to a Schroders fund, you should obtain and read a copy of the product disclosure statement available at www.schroders.com.au or other relevant disclosure document for that fund and consider the appropriateness of the fund to your objectives, financial situation and needs. You should also refer to the target market determination for the fund at www.schroders.com.au. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed by Schroders or any company in the Schroders Group. The material contained in this document is not intended to provide, and should not be relied on for accounting, legal or tax advice. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. To the maximum extent permitted by law, Schroders, every company in the Schroders plc group, and their respective directors, officers, employees, consultants and agents exclude all liability (however arising) for any direct or indirect loss or damage that may be suffered by the recipient or any other person in connection with this document. Opinions, estimates and projections contained in this document reflect the opinions of the authors as at the date of this document and are subject to change without notice. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised. Past performance is not a reliable indicator of future performance. All references to securities, sectors, regions and/or countries are made for illustrative purposes only and are not to be construed as recommendations to buy, sell or hold. Telephone calls and other electronic communications with Schroders representatives may be recorded.