When you gather up the daily information on investment markets, it can be a little bewildering. How are you supposed to know when (not to mention where) you should or shouldn’t invest?
Fear of being left behind can make an investor chase a ‘hot’ investment. Research suggests1 this fear stems from our innate survival instincts. Rather than actively seek as much information on a topic as possible, people grab hold of small pieces of information and miss out on the bigger picture.
An investment appears attractive if it recently delivered strong returns. This highlights a significant difference in behaviour when buying financial versus other purchases.
Stock clearance sales – when to buy
The best time to buy a new car, TV, whitegoods, or clothes is during a sale or special discounted offer. We wait and buy when the items are at their best price, which is sensible. In contrast, investor research shows people find it more tempting to buy financial assets after they reported strong returns – right when the stock is at or near its highest price.
So, emotional responses encourage us to buy financial assets when prices are higher rather than low. Extreme examples of this sort of behaviour result in asset prices reaching high and unsustainable levels.
A recent example was the late 1990s ‘bubble’ in technology stocks. The higher the stock prices went, the more investors wanted to buy – which in turn pushed the prices up. These sorts of ‘bubbles’ seem to occur with regularity – and the latest example may be the past year’s resource boom in Western Australia.
How to lose money
On the flip side, investors respond to poor returns too. If a fund has had a poor period it can be tempting to sell. Selling out after a period of negative returns means investors tend to sell when prices are low. By selling low, you may not only be realising losses on the investment, but you’re missing out on any potential recovery.
The combination of buying high and selling low is exactly the strategy to adopt to generate the poorest outcome.
Clever investors look after their own backyard
Rather than focusing on past performance, a clever investor will concentrate on what is within their control – how much they save, their investment time horizon, their investment goals, and getting the strategy right to achieve those goals. With an understanding and a tolerance for market fluctuations, the rational investor is not deterred by short-term noise.
The advice of a financial planner is invaluable in getting these things right – and most importantly, helping you stick to that carefully thought-out strategy and ensuring you’re not seduced by the latest ‘hot’ opportunity.
Important information and disclaimer
1 Professor Daniel Kahneman, Prospect Theory, Princeton University, 1996.
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