Two common errors that investors make…and how to overcome them

The past six months have highlighted two common errors that investors frequently make. The first relates to a misunderstanding about the way investments compound over time and the second is the way that emotions can cloud our judgement. 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 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 really important. This same mistake can also result in borrowers underestimating how much it will ultimately cost to repay a loan.

Keeping your investments balanced

Turning to the second common error, think back to the end of 2018. The fourth quarter was a horrid time to be investing in the stock market. There was no hiding place as everything fell sharply. Sentiment was rock bottom and the 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 nadir.

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. Getting over 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.

For example, decide (or use an independent financial adviser to help you decide) 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.

Rebalancing involves selling some of that winner, to bring its weight back to where you intended it to be, and reinvesting the gains in assets that have performed less well.

This is “buy low-sell high” in practice. It’s not rocket science. And it could have resulted in you buying equities at the turn of the year, even though the voice in your head may have been telling you to do the opposite. Again, if ever unsure whether an investment is suitable for you, seek advice from an independent financial adviser.

Of course it is true that markets may have continued to fall but valuations are one of the best indicators of long term returns. Long term investors should heed their messages.