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Foolish ways?

While most self-delusions are relatively costless, those relating to investment can come with a hefty price tag.

We delude ourselves for a number of reasons, but one of the principal causes is a need to protect our own egos. So we look for external evidence that supports the myths we hold about ourselves, and we dismiss those facts that are incompatible.

Psychologists call this “confirmation bias”—a tendency to select facts that suit our own internal beliefs. A related ingrained tendency, known as “hindsight bias,” involves seeing everything as obvious and predictable after the fact.

These biases, or ways of protecting our egos from reality, are evident among many investors every day and are often encouraged by the media.

Here are seven common manifestations of how investors fool themselves:

    1    “Everyone could see that market crash coming.” Have you noticed how people become experts after the fact? But if “everyone” could see a correction coming, why wasn’t “everyone” profiting from it? You don’t need forecasts.

    2    “I only invest in ‘blue-chip’ companies.” People often gravitate to the familiar and to shares they see as solid. But a company’s profile and whether or not it is a good investment are not necessarily correlated. Better to diversify.

    3    “I’m waiting for more certainty.” The emotions triggered by volatility are understandable, but acting on those emotions can be counterproductive. Uncertainty goes with investing. Historically, long-term discipline has been rewarded.

    4    “I know about this industry, so I’m going to buy the stock.” People often assume that success in investment requires a specialist’s knowledge of a sector. But that information is usually already in the price. Trust the market instead.

    5    “It was still a good call, but no one saw this coming.” Isn’t that the point? You can rationalize a stock-specific bet as much as you like, but events or external influences can conspire against you. Spread your risk instead.

    6    “I’m going to restrict my portfolio to the strongest economies.” If an economy performs strongly, that will no doubt be reflected in stock prices. What moves prices is news. And news relates to the unexpected. So work with the market.

    7    “OK, it was a bad idea, but I don’t want to sell at a loss.” We can put too much faith in individual stocks, and holding onto a losing bet can mean missing opportunities elsewhere. Portfolio structure affects performance.

This is by no means an exhaustive list. In fact, the capacity for human beings to delude themselves in the world of investment is never-ending.

But overcoming self-deception is not impossible. It just starts with recognizing that, as humans, we are not wired for disciplined investing. We will always find one way or another of rationalizing an emotional reaction to market events.

But that’s why even experienced investors engage advisors who know them, and who understand their circumstances, risk appetites, and long-term goals. The role of that advisor is to listen to and acknowledge our very human fears, while keeping us in the plans we committed to at our most lucid and logical.

Market Volatility, here we go again. Up, down, left, right

Volatility is back. Just as many investors were starting to think markets only ever move in one direction, the pendulum has swung in the other direction. Anxiety is a completely natural response to these actions. As data and history has proven, acting on those emotions, though, can end up doing us more harm than good.

There are a number of so-called theories about why markets have become more volatile in recent times. Among the issues frequently splashed across newspaper front pages: global growth fears, policy uncertainty, geopolitical risk, and even the neighbor's dog. 

In many cases, this is not the first time we have seen these issues. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing (an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective). Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere. 

In some ways, the increase in volatility in recent weeks could be just as much a reflection of the fact that volatility has been very low for some time and now it's starting to show itself. Investors in aggregate were satisfied earlier last year with a low price on risk, but now they are applying a higher discount rate to risky assets. 

So the increase in market volatility is an expression of uncertainty and more importantly an expression of typical, traditional market behavior. Markets do not move in one direction. If they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry. 

As to what happens next, no one knows for sure. That is the nature of risk. In the meantime, investors can help manage their risk by diversifying broadly across and within asset classes across the globe. We have seen the benefit of that in recent weeks as bonds have rallied strongly. 

For those still anxious, here are a few simple truths to help you live with volatility:

  • Don't make presumptions.

Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.

  • Someone is buying.

Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.

  • Market timing is hard.

Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was at its worst—the S&P 500 turned and put in seven consecutive months of gains totalling almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

  • Never forget the power of diversification.

While equity markets have turned rocky again, highly rated government bonds have flourished. This helps limit the damage to balanced fund investors. So diversification spreads risk and can lessen the bumps in the road.

  • Markets and economies are different things.

The world economy is forever changing, and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector but good for consumers. New economic forces are emerging as global measures of poverty, education, and health improve. A recent OECD study shows how far the world has come in the past 200 years.1

  • Nothing lasts forever.

Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

  • Discipline is rewarded.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable and familiar to those who have seen this before. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.