Vulnerable in the season of volatility
The fall season of volatility is here again. This year, however, stock markets may be susceptible to even more gyrations than usual, given the vagaries of the Covid-19 pandemic and its effect on economic growth, the U.S. presidential election cycle, and the massive injections of monetary and fiscal stimulus to help keep economies afloat. Most recently, we saw stock markets sell off on Oct. 2 on the news that U.S. President Donald Trump had tested positive for Covid-19 and had been admitted to hospital for treatment. But any sustained correlation between market activity and the political cycle is tenuous at best, and is typically very short-lived. So it proved to be, as markets rebounded sharply on the following Monday.
What about those unfortunate investors who pushed the sell button on Friday, only to be whipsawed by the market recovery on Monday? They very likely made three of the most common mistakes that self-directed or do-it-yourself investors are vulnerable to. Here’s a quick look at these blunders along with some suggestions for avoiding them.
1. Panic selling
Panic selling take investors off track from achieving long-term goals. Quick reactions can yield poor financial results, and it’s important to remember that if the market is going down, it doesn’t mean it’ll stay that way forever. Here are some tips on how to avoid being whipsawed by the market.
* Don’t sell on emotion. The market is an emotional place. If you get the urge to sell an asset, ask yourself why. Have its fundamentals deteriorated badly – revenue, cash flow, earnings? Has the company declared bankruptcy? Has the stock reached your pre-determined sell target level? If you have no good reason other than “the market is falling,” you’d better re-check your risk tolerance and your ability to withstand market volatility.
* Don’t obsess about the business news. Novice investors fret way too much about the “news.” Tuning out the daily business news “noise” goes a long way to restoring peace of mind. Remember, all those “crisis” headlines change by the minute – and there’s never a time of no crisis. Check the news if you must, but take it with a huge grain of salt.
* Have a plan…and stick to it. The best way to keep that urge to emotional trading in check is to have an investment plan in place. Decide what your goals are, what your risk-tolerance level is, and allocate your assets according to a realistic assessment of your investment temperament – before you jump into the market.
2. Unrealistic risk tolerance
Having an inaccurate view of risk tolerance can lead to panic selling. Investors must have a true fix on what they’re comfortable losing in their portfolio’s value if there’s a sudden drop in the market. So how do you deal with the issue of false risk tolerance? The key is to ensure that your investment portfolio aligns with your true tolerance for risk.
When your advisor first asks you whether you are comfortable losing 10%, 20%, or 30% of your portfolio’s value due to a sudden drop in markets, they’re not just playing a game of “let’s pretend.” Take the full value of your portfolio across all accounts and apply the percentage drop to it. That way, you’ll get a precise dollar value of your loss. As amply demonstrated over the past few weeks, if you admit to a high tolerance for risk, able to withstand a 30% decline in portfolio value, that amounts to a $150,000 loss in a $500,000 portfolio. Think about it long and hard.
3. The crystal ball trap
Many investors have an unfounded confidence in their ability to buy and sell an investment at precisely the right time to maximize profit and portfolio performance. They believe they have some acute insight into the future. In practice, this is almost impossible to achieve consistently. Here are three of the most common examples of the “crystal ball trap.”
* Market timing. Attempting to “time the market” leads to frequent trading, incurring trading costs on both the buy and sell side. In addition, because no one has a crystal ball, chances are good you’ll miss both the top and the bottom. Overall, you’ll have incurred trading commissions, and you’ll typically be no further ahead than if you had stuck with a disciplined price-target strategy.
* Wishful thinking. Novice investors will often buy an investment because it has recently gone up in price, in the expectation that it will go up some more. Investing solely on the basis of recent short-term past performance doesn’t work. In fact, it can actually magnify subsequent losses if the investment has already been gaining steadily for 12 months or more. Such investments very often wind up in the media spotlight, attracting a lot attention. By then, however, the smart money has already left, and the investment (a high-flying company or a hot commodity) is ripe for a steep slide.
* Don’t follow the herd. Investors often stampede into or out of individual investments, sectors, asset classes, and entire markets at the same time. In fact, “the market” is nothing more than the combined actions of millions of individual investors. If you sell only because the market is declining, you’re just following a herd mentality in the belief the herd actually knows what it’s doing. It doesn’t. And you may end up following it over the cliff.
Your best bet for avoiding these three major investing blunders, always, is to have a well-thought-out financial plan that guides your portfolio asset allocation to match your true risk tolerance and financial objectives.