Two common errors that investors make…and how to overcome them
Understanding compounding and portfolio rebalancing could have helped investors overcome emotion-driven decisions during a turbulent six months for stock markets. Duncan Lamont shares why.
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.
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