Sunday, 29 November 2009

****The most insidious risk of all - Investor Risk

Investors are justifiably wary of the various risks that can beset a portfolio.  In addition to the eroding effects of volatility, there's
  • business risk,
  • currency risk,
  • market risk,
  • interest rate risk, and
  • inflation risk. 
Perhaps the most insidious risk of all, though, is the one that's the hardest to protect yourself from - investor risk.  Investor risk is the risk we face just by being human.

It is easy to understand the concept that to be successful as an investor you should buy low and sell high.  But if you invest over a long enough time period to see both rising and falling markets, you'll see just how hard it can be to actually bring yourself to do this. 

  • Buying at highs and selling at lows is the opposite of success and can cause yur portfolio irreparable harm, but it's .  extraordinarily common
  • Had you asked those investors who were rushing into Internet or other high-flying stocks in early 2000, after the Nasdaq had just jumped more than 85% in 1999, if they thought they were buying high, you probably would have heard all kinds of reasons why this time was different.  There was a "new paradigm"; the old rules of valuation no longer applied.  
  • Had you asked many of these same investors in early 2003 if they felt they were selling low after three years of crushing stock market declines, you would likely have heard that the market was going to keep falling, the world had changed, and prospects looked bleak for as far as the eye could see.

Investors were once thought to be "rational," efficiently processing all known market data and making decisions on the basis of the logical pursuit of their own best interests.  A whole branch of study called behavioural finance has sprung up to study the question of how investors really behave, and the short answer is that it's rarely rational. 
  • Nature has 'wired' us to react in certain ways so we can quickly process information, understand patterns (like those that occur in nature), and make good, quick survival decisions. 
  • Unfortunately, many of the same ways of thinking that have proven so helpful to our survival as a species can get us killed as investors.

Emotional responses, uneven reactions to risk and reward, looking for patterns where none may exist, believing our recent experience will persist, and overconfidence in our initial judgements are just some of the natural tendencies that can lead us astray.  Rather than trying to overcome our nature - to overcome the thinking processes and habits that have been woven into our very beings for millennia - we can try to invest in such a way as to reduce this investor risk and increase our odds of financial survival.

The markets will continue to rise and fall, but if your account doesn't fall so much that it triggers your primal urge to sell, you'll still be invested for the rebound. 
  • Even the most robust market recovery doesn't help the investor who has already sold everything before it starts. 
  • To reap the long-term performance advantages of being an investor, you have to find a way to stay invested for the long term. 

To the extent a lower volatility, dividend-based portfolio provides you with an investment experience you can live with in all kinds of markets, your portfolio is more likely to evolve into a fortune - and less likely to face extinction.

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