When Stock Prices Fall: Investors & the Cycle of Faulty Reasoning

In the first of two guest articles on investments, Hannah Goldsmith of Goldsmith Financial Solutions discusses the challenge investors face of remaining disciplined through volatile markets...

Placing your capital into an investment portfolio can offer you an element of control over your financial future returns - if implemented correctly. However, staying disciplined through rising and falling markets can be a challenge. But it is this discipline that is crucial for long-term success and to ensure that your capital value increases, at least in line with inflation.

The ‘Holy Grail’ of investing is ‘to buy low and sell high’. Wealth management companies claim they stand a better chance of doing this for you than you would yourself – and they charge a healthy fee for doing so. However, often you can do better than them provided you set up your portfolio correctly and hold your nerve.

The biggest challenge always comes when the markets are volatile and big losses are incurred over long periods of time. Obviously, the ideal solution is to enter the market just as it bottoms and exit the market right at the top. But precisely timing your exit and entry is close to impossible.

Here’s a useful way of underscoring the timing issue that I got from a seminar I attended. The suggestion was that by investing £1000 from the 1st January 1990 to the 31st December 2009 (20 years) only in the FTSE All Share Index you would have grown your investment from £1000 to £4,712.31 (8.06% per annum).

Hannah Goldsmith

By investing your £1000 only in UK 1 month Treasury Bonds you would have grown your £1000 to £3,301.29 (6.15% per annum).

If you or your Wealth Manager could accurately forecast 1 month in advance whether to position your investment into either the FTSE All Share Index or into the UK 1 month Treasury Bonds, your £1000 investment would have grown to £205,399.57 (30.51% per annum).

If you could call the 240 scenarios (each month for 20 years) correctly the odds would be: 1 in 1,766,847,064,778,380 followed by another 57 ‘0’s!

As timing financial markets quite clearly requires psychic intuition, I believe those of us wishing to become successful investors should be disciplined enough to look beyond the promises of well-intentioned discretionary fund managers and wealth management companies and make our own decisions.

Investors should consider buying across the global market at the most financially efficient cost and sit tight. Paying additional fees for somebody to make guesses in a random market seems pointless when the object of investing is to make more money for you, without fear of running out of money in later life. However it is important to understand the psychological dynamics at play, particularly when markets are falling.

Why investors lose money

The ‘fight’ or ‘flight’ human instinct is ingrained deep within us, which means we run away from fights we don’t think we will win!

We react quite quickly when we sense trouble without always taking time to think our actions through carefully. When we read scary headlines screaming ‘panic’ and ‘sell’… the investor, scared of losing his/her money, sells. The problem the investor then faces is when to buy back into the market. If the stock has started going down, then you may already have made a loss, so you’ll be looking to recoup that. But, how do you know when it has hit the bottom?

Once it starts going up, can you predict tell if this will continue to do so or if it is only a short-term rally? Leave it too long, and you’ll miss out on any potential gains to make up the earlier losses, and jump back too soon and you risk losing even more.

By rushing to sell you may lose any profit you have already made, and you run the risk of greater losses due to fees and the uncertainty of the market.

It is important to remember that when stock prices are falling, you can only sell if there is a buyer. If a buyer is found, you should then ask yourself a simple question. If a buyer thinks the stock is cheap enough to buy today, why I am I selling it?

Many investors don’t ask this question they are too keen to get out of the markets they get caught up in behavior based on their faulty reasoning.

If you stay invested and the markets keep falling, you become anxious about the money you have lost. If the portfolio value falls below what you invested, you may become fearful that you will lose more of your money, but if you sell you will create a real loss. This loss, if substantial, creates a real fear. Could you really afford to lose this money?

The worst scenario is that your nerve goes, you cannot hold out any longer and you sell at the bottom. After a few more months the markets begin to improve and the time for optimism begins. However, you’ve been burnt and you will not be burnt again so you hold out… just in case it’s a false rise.

The market keeps climbing but you are still nervous about going back into the market. The media is excitedly talking about the ‘Bull’ run. At last you get you optimism back and jump into the market. This is often too late, because all the gains have been recovered and you still have your losses to make up..

And then the markets fall… and the investor’s cycle of faulty reasoning continues.

Investors need to become aware of our psychological tendencies: the flight instinct, the fear of loss, and the dangers of faulty reasoning, and the need for discipline. This is an important first step in becoming more successful. With this understanding investors are in a stronger position to find the options that will increase their future ability to invest well.

Faulty Reasoning: How To Make Better Investment Decisions

Hannah Goldsmith is founder of Goldsmith Financial Solutions and author of Retire Faster. You can find find Hannah on Twitter @HannahGFS