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RP: One of the most testing times for an investor is when markets fall sharply — usually in response to some sort of crisis.
It’s very important not to act in haste in those situations.
Greg Davies is an expert in investor behaviour.
GD: So when moments of stress arrive, when markets start falling, what effectively happens is our attention gets focused, and it gets focused on the short term, and it gets focused on the detail, and that means it starts to drive a wedge between what we as investors are trying to achieve – growing our wealth over time for the long term – and what we are emotionally paying attention to, which is: what is happening in the markets now? What is happening to this asset and that asset, et cetera?
And that wedge that gets driven in there basically means that our decision making is pulled away from our objectives. And so we start to make decisions that are no longer about achieving what we are trying to achieve in the long term, and that are much more about satisfying our short term need for emotional comfort.
RP: It’s not irrational to need comfort in a market crisis.
The problem is, investors often pay too high a price for that comfort. For example, they sell all their equities after prices have already fallen.
But what’s the answer?
GD: The best way to make better decisions in a crisis is to have prepared for that crisis in advance. It’s to have a set of rules that goes, I know this is going to happen at some point, and I don’t know exactly what’s going to happen but I definitely know that there are going to be times when the markets crash, when times get volatile, when there is some form of crisis in the world. And I don’t want to have to make decisions from scratch in the heat of the moment, under stress at that time.
RP: Another test for investors comes when markets are riding high.
That’s when they feel least in need of comfort.
Sometimes excitement or even greed takes over, and they decide to take on more risk.
But that’s not a good idea.
GD: So I think the advice for anyone attempting to take additional risk is exactly the same as the advice for anyone tempted to jump out of risk at times when markets are crashing.
You should not be basing the amount of risk you take on your current opinions of where the market is. Because we don’t have a crystal ball, we can’t predict it, we can’t control it. So, if you are tempted to take additional risk in good times, first go back and ask yourself: what are my long term plans? What is the level of risk I have previously decided was appropriate for those long term plans, and am I taking that level of risk now?
And if you’re below it then by all means increase your risk levels, but assuming you’re already invested at the right level, the wrong thing to do at any point in the market cycle is to start judiciously or subjectively adjusting your risk level according to what your gut tells you right now.
RP: In summary, you should decide on the right level of risk for you and stick to it.
Don’t let the news or your emotions tempt you into changing course.
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