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Overcoming fear

04 April 2019

3 minute read

We examine and address the tendency we have to overreact to negative sentiment and the implications it can have on our portfolios, as we exaggerate the negative scenarios making investing all the more anxiety-inducing.

Who's this for? Confident investors

What you’ll learn:

  • Why we place higher importance on things that we can more easily recall
  • Why taking action to try to limit short-term losses may also, in many cases, be at the expense of long-term gains
  • How to adopt a disciplined way to tackle more emotionally-driven decisions that lead us to buy high and sell low

The surging stock market recovery at the start of this year may have calmed the nerves of investors but the outlook for the world economy has weakened a little. Market sentiment is currently positive, creating the risk of a negative shock for investors if the mood was suddenly to turn again. We examine and address the tendency investors have to overreact to negative sentiment and the implications it can have on their portfolios, as we exaggerate the negative scenarios making investing all the more anxiety-inducing.

Keeping a long-term perspective

As we look ahead in 2019, we cannot rule out a recession. While we believe that the cycle has room to run, the global economy has weakened. The causes of many past global recessions were also not predictable ahead of time, such as oil shocks and wars.

For those with concerns, it is important to point out that the last financial crisis was extremely deep and unusual in nature, and that shallow or mild recessions have, historically, occurred more frequently. There is a risk that investors have been conditioned on the recent past and therefore see the last financial crisis, which was largely unexpected, as a representation of the next downturn.

From a behavioural point of view, there is a rule of thumb which makes this a risk to investors. Ask someone what they think is more likely, that a random word taken from an English text starts with the letter ‘K’, or that ‘K’ is the third letter, and studies show people choose the former. The latter is actually twice as likely, but people find it is easier to recall words that begin with a K than to take a more concentrated effort to think of words in which ‘K’ is the third letter. This leads us to place higher importance on things that we can more easily recall.

Apply that mental shortcut to when investors hear the words downturn and recession, and many will experience flashbacks to the 2007-2008 financial crisis before their mind focuses on the great recession which followed. This is only natural; the last downturn was extremely deep and prolonged, and it was also the last (perhaps only) downturn that investors will have experienced.

At the same time, there was an unusual calm through most of 2017-18, with particularly strong returns. There is a risk that investors place lesser importance on decades of robust market performance data, and lend more weight than is warranted to periods of volatility when they arrive, and to the likelihood of an extreme downturn.

Weathering the storms

Financial losses hurt us more than gains, so for many investors when fear strikes, no matter their stores of composure, there is an overwhelming desire to take mitigating action to sleep better at night. Taking action is empowering and reduces our perceived future regret suffered from not doing anything. However, in investing, we often see that action for action’s sake proves more harmful than the status quo.

Taking action to try to limit short-term losses may also, in many cases, be at the expense of long-term gains. As recent market moves show, some of the worst periods of market performance are followed by some of the best. Many investors who make a decision to sell in volatile markets wait for a period of stability before dipping their toe back into the market and may miss out on gains while they wait for the right moment to invest again.

Good investment decision-making requires asking yourself whether market events are likely to affect your ability to reach your goals. Much of the daily news reporting will simply not be material to a well-diversified portfolio, and should be dealt with by simply turning the volume down on market commentary or looking at your portfolio less frequently.

Some market events have the potential for significant impacts on a portfolio, such as a period of large drawdowns (a peak-to-trough decline during a specific period) or recession. A way of tempering our reaction is to take a step back and keep a historical perspective.

A period of volatility or drawdown does not necessarily imply a recession, or one as deep as the one burnt into our memories. It is important to remember that, in investing, there is no such thing as a typical year, and prolonged periods of either positive or negative returns are not the norm. Like the inevitability of the seasons, investing is a journey with both sunny spells and storms.

In the same way that it would be unwise to buy a new wardrobe because of a week of exceptional spring weather in winter, we should try to refrain from making any investment allocation decisions based purely on the recent drawdown or rebound. If you need to make changes then look at it as an opportunity to re-balance, selling some of the assets that have appreciated and buying those that seem cheaper. This is a disciplined way to tackle more emotionally-driven decisions that lead us to buy high and sell low.

A multi-asset portfolio which invests across a range of asset classes and regions offers a globally diversified one-stop solution for investors. Building a diversified portfolio may sound like an onerous task, but there are simple solutions available, such as the Barclays Ready-made Investments. Furthermore, investors get to choose the level of risk they are comfortable with. But remember, higher potential rewards tend to mean a greater risk of loss.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

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