By Jack Roberts, Investment Analyst at IBOSS, part of Kingswood Group
The French writer Voltaire once observed, “Uncertainty is an uncomfortable position, but certainty is an absurd one.” With volatile markets and an unpredictable future, navigating the world of investment can be a daunting task. So, it is imperative for investors to understand the nature of this uncertainty, learn to manage risk and overcome any behavioural biases. By learning about common investment mistakes and misconceptions, investors can make more informed decisions and improve their chances of achieving their financial goals.
Short-term decision making
The most notorious emotions to affect investors are fear and greed. Panic selling during a downturn or buying into the latest hype cycle is rarely a sensible approach and can often lead to buyers’ or sellers’ remorse. Investors should ask themselves: am I a longer-term investor or trying to make a fast buck and move on?
Longer-term investing requires significant research and due diligence, and that doesn’t mean just looking at the last five years’ investment data. The key to longer-term investing is understanding the conditions that have affected an investment thus far and assessing whether they persist today.
Getting too emotionally attached
Though longer-term thinking is essential, investors can be prone to becoming emotionally attached to an investment or the story behind it. It can also be tempting to search out people who support your original investment thesis and dwell in echo chambers, which can cloud an investor’s judgement and destroy their objectivity. Investors – even experienced ones – can find themselves accidentally taking in information that has no basis in fact due to the effects of social media and clickbait news headlines.
With limited capital available to most of us, it’s crucial to recognize and accept poor decisions, reassess the facts, and reposition the affected assets if necessary. As the old Wall Street adage goes, cut your losses short and let your winners run.
Inflexible asset allocations
While reacting to short-term effects can be costly in the long term, remaining static in the face of changing market conditions can be equally dangerous. Market dynamics may sometimes change quickly or develop slowly over an extended period. In either case, investors must regularly assess the market landscape, any changes and new information and ask themselves whether this alters their longer-term outlook.
A notable example can be seen in the IA UK All Companies sector. On November 30, 2021, the market experienced a significant shift, moving away from SMID and growth-style equities toward large-cap value equities. This change coincided with central banks raising interest rates to combat inflation, marking the end of the previous decade’s low inflation and interest rates. From November 30, 2021, to August 5, 2024, 84% of the top-performing funds from the preceding three-year period have now fallen to the fourth quartile, with only one fund remaining in the top quartile. We have seen similar outcomes for the different geographies. It was all about your allocation to Japan in the eighties, and anything you allocated anywhere else detracted from your returns. Nobody could see it ending at the time, but then, as it always does, it ended, and similar conversations concerning America can be heard these days.
Portfolio construction, recency bias and protecting to the downside
Whether it’s the Tech bubble of the 2000s, the Nifty Fifty stocks of the early 1970s, or the current dominance of the Magnificent 7, investors have always crowded into sectors and areas of the market that have performed the best most recently.
The lack of sufficient portfolio diversification can lead to significant losses when, for whatever reason, things inevitably go wrong. Some may find this point obvious, but portfolio drawdowns have an outsized impact on longer-term returns. After all, if you lose 50% of a portfolio’s value, you must make 100% back just to break even. As such, a prudent investor will ensure that all their eggs are not in one basket and maintain diversification across their portfolio.
Focusing on 1, 3 & 5 year performance
When assessing a manager, you must look at what they have done through multiple market conditions. If an investment has ony experienced one set of market conditions, then you cannot possibly know how it will perform in a different set of market conditions.
Even if you believe that the prevailing conditions will be the same in the next few years, the prices you now have to pay for this kind of stock are considerably higher than five years ago. The price paid for an asset is a crucial part of an investment case. Still, the additional risks associated with assets that have seen their prices rise significantly will never be captured by concentrating on arbitrary rolling data periods like 1, 3 or 5 year data.
