In routine many investors tend to buy the fund after a fund has performed well in hopes that it would remain continue to perform well. Similarly, they churn their portfolio after they have had good performance in hopes that performance would sustain in the future. It clearly translates that they are just chasing the past performance. Of course, they have not been recognizing the fact of chasing risky funds in an attempt to maximize their returns, may prove a costly investment scheme. Though there is often a positive correlation between the risk you take and the return you get in investing, this relationship is imperfect, especially in the short term. The truth is that the market, especially over the short term, is random, volatile and unpredictable. But investors are still influenced to buy yesterday’s performers, even though empirical evidence illustrates that it is a very costly strategy. Anytime you feel like selling an underperforming fund and purchasing one that is outperforming, you are buying high and selling low. But chasing returns feels good in the short term. This is because our brain, being a pattern detecting machine, detects a pattern of outperformance it believes that it is likely to continue. We also attribute positive investment performance to an individual’s skill rather than luck. However, if investors were truly skillful why wouldn’t they outperform all the time? Why would they choose to be skillful one year profit and then choose to not be skillful the next year loss? Sound familiar!
Control over the Risk
All market gurus have no power to influence the performance of the stock market. When we purchase a stock we do hope it will perform well subject to what all other investors, speculators and high frequency traders do. Let’s face it, we have no control over the return, but we may have control over the risk of the portfolio. Many risky assets have done very well over the past several years; they did horribly in 2008-09. The constant is the risk or volatility of the stock– it goes up and down quite a bit; the unknown is when the risk will work in our favor i.e. positive returns and when it will work to our detriment. Many investors today are blindly chasing risk as purchasing assets based upon good prior performance without calculating the upside and downside potential return and its risk. Also Read : Syndromes of Risk-taking Ability!
Having earlier said, risk has a positive correlation to return over the long term. But over the short-term returns are random and that correlation can be negative such as in a bearish market. You may be a long-term investor, but others are you are influenced by short-term performance, news and emotions. When it comes to investing, it is crucial that you understand the downside potential of any investment rather than being blinded by the performance you hope for. Risk assets may provide you with greater returns over time, but the risk means that they can also lose you money…and a lot of it. Be sure the potential payoff is at least worth it. Also Read : The Right approach to Ride the Bull Run
Expect Average Returns
Many times our decisions and responses to situations are based on the specific performance for the specific period rather than on the performance relative to something else. When we come to investing in something else, may be past performance or predicted by analysts or index. If we did relatively better than analysts or index, we feel good. If we did relatively poorly, we feel bad.
Let’s say one year from now you open your 2015 annual investment statement and analysis that your return on investments was 40% for the year. Of course you would be happy. For most people the immediate response is “it depends”. What if the stock market was up 8% during the same time period? What if the stock market was down 17%? Your degree of satisfaction or discontent is based on how you did compare to something else. The brain is a horrible judge of absolute values, but is excellent at judging values relative to something else. An annual average return of 12% does not mean that you should expect that each year, it means that is the calculated average over a period of time. The actual performance could be down 20%, followed by a recovery and eventual 12% annualized return. Be sure when investing that you are not focused on the average historical or expected return, rather you consider the likely variations/volatility in returns that may occur. We should be rational one and should expect average returns which tell us nothing about the variance of actual returns that will occur. Also Read: Rebalancing – a passive way of Timing the Market!
Goal based Investing
Investors need to be reminded here, what is more important to them in investing, making a large chunk of money in a short period of time or eventually reaching their financial goals. Rational investors often want peace of mind and greater surety they will reach their goals, that’s why they are being rational. Yet, after witnessing significant gains any rational investor could also be influenced to abandon the rational approach. They key is to have investors remember how important peace of mind is to them when investing. Most people invest with a specific goal in mind, such as retirement or to put the kids through college. But after significant market gains, they often supersede the long-term goal with a focus on relative performance. The goal becomes “do better than the market”, or at least to do as well as the market. This needs to be re-framed correctly. Investors should remind themselves of their initial and continuous goals for investing, not beat the market. Also Read : Busting Your Myths about Investing!
Since we know that our brain needs to compare performance to something else, we want to be sure it is being compared with the right perspective, or frame of reference. We often compare their performance to an index, such as Nifty. This can be dangerous. Every rational investor should recognize that an index does not get retirement, does not sleep at night and has an infinite time horizon. So, if we really compare ourselves to a benchmark that does not have the same goals or portfolio constraints, it is like comparing apples to oranges. We need to recognize that an index is neither representative of themselves, nor their goals. When you have had your financial plan, you have the right frame. But external market forces, such as significant index changes, may divert you to re-frame your perspective. You should re-frame the situations and get back to the realities of investing and their personal goals before making any significant changes to their investment plan or portfolio. Also Read : Are you Conservative Investor? Think Again
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